August 15, 2022

Alternative forms of funding create options for founders in volatile times

From venture debt to revenue-based financing, there are more and more options for founders who need cash

Christian Stein

8 min read

In the old days of startup funding, equity was practically the only choice you had to grow your startup, whether you raised from a traditional VC or from angels. It wasn’t rare for founders to find themselves in a "take it or leave it" situation.

In Europe, things started to change around five years ago when, little by little, new forms of funding and capital were introduced. Those include options like venture debt and revenue-based financing.      

Traditional equity VC still plays a major role in funding new businesses, and I believe they will remain indispensable due to their ability to provide large amounts of cash even under uncertainty. But now, as markets have become more volatile and funding more challenging, alternative forms of finance are stepping into the spotlight.

As markets have become more volatile and funding more challenging, alternative forms of funding are stepping into the spotlight

One reason is clear: when cash is harder to come by, different forms of financing provide better chances of pocketing a cheque. But higher volatility also means that companies need to be more resilient. And higher resilience often means lower burn and slower growth, making some forms of funding a better fit than VC. Finally, a mix of financing forms can make a company more resilient.      

The following offers an overview of the main forms of funding for young companies, their pros and cons and how they can be used. Given that different sources of funding and capital add complexity, founders should take time to understand the alternatives and resist the urge to outsource the decision to colleagues or advisers. Note that this list is not exhaustive and that there are many shades of grey that can’t be discussed in this format.

The future of funding will be raising the right kind of capital at the right time

Venture Capital (equity)

  • Model: Get investment in return for sharing control and ownership in the company.
  • Pro: Investment amount is virtually unlimited and can be provided in the earliest stages (ie, raising funding on an idea is possible); VC (ideally) provides coaching and network.
  • Con: Equity dilution and partial loss of control; usually the most expensive kind of capital (which is ok if you consider the risk it can bear); the business model of VC is to create outlier returns/exits even if that means increasing risk (and burn) beyond long-term sustainability.
  • Prerequisites: Potential for an outlier return/exit with high growth rate and revenue potential in a very large market.
  • Right choice if: Your business has the potential to become big and valuable within five-seven years and you need a lot of cash to achieve that (e.g., burn rate >$250k); you are still in seed stage.

Venture Debt (with a warrant)

  • Model: Loan with interest plus a warrant (ie, the option to receive a pre-agreed share of exit proceeds) which means that venture debt providers' business model is significantly based on successful exits of their investees. That puts them in the same category as VCs with the same implications.
  • Pro: Can significantly increase existing funding to support even stronger growth (and higher burn) without the full dilution from an equivalent equity/VC funding round.
  • Con: Accepting a warrant means giving away a share of the company’s value which means dilution; not an alternative to VC because a) equity investor/VC is required and b) has the same exit/valuation-driven business model — it is essentially an extension of (or leverage on) equity/VC.
  • Prerequisites: Equity investor/VC needed to significantly invest alongside or in close temporal proximity.
  • Right choice if: Your business has outstanding growth potential and can use a lot of cash from VC plus venture debt to scale massively.

Revenue-based financing: mid-to-long-term

  • Model: Loan in return for a temporary revenue share agreement — the startup agrees to pay a percentage of revenue in the future in return for funding.
  • Pro: Truly non-dilutive and independent of other investors; lightweight funding as repayments adapt to company performance; preserves optionality for future development paths through less dependence on exit and valuations.
  • Con: Investment amount usually limited to <50% of current annualised revenues (or ARR)
  • Prerequisites: Does not work for seed-stage or companies with low revenues.
  • Right choice if: Your company seeks growth investment and has a sustainable burn rate of <$250k; works well for VC-funded companies to prolong runway, keep dilution under control or cover working capital requirements; or if a company cannot or does not want to follow the traditional VC funding path.
  • Very important to distinguish between different repayment terms according to the intended use case of the funding: one-year repayment models used for short-term investments like working capital, online marketing, or inventory acquisition; five-year repayment models used for long-term investments like product development, hiring or brand building.

Revenue-based financing: short-term (aka Factoring)

  • Model: Sell customer contracts/receivables to receive the respective contract value in cash up-front at a discount from programmatic lenders or fintech platforms. Most of the RBF investors which have appeared in the past two years belong to this category.
  • Pro: Quick and easy funding process through high degree of automation; very flexible to ramp funding up and down as you go.
  • Con: Future cash-in from customers is merely pulled forward and may be missing down the road; hard to invest in long-term growth which would require consecutive selling of receivables and creates dependency.
  • Prerequisites: Does not work without revenue.
  • Right choice if: Smaller amount of cash is needed quickly (<$1m) to cover low cashflow months or one-time costs for initiatives and projects with a short-term payback period (eg, in sales, marketing and for working capital).

Term loans

  • Model: Mostly resembles traditional loans, ie, interest-bearing and/or with a lump sum repayment (“bullet”) after a couple of years.
  • Pro: Truly non-dilutive with a simple funding model.
  • Con: Less flexibility in adapting to changing business environment; a company may face a significant lump sum repayment at the end of the term which could be hard to take.
  • Prerequisites: Usually only for companies with a clear path to break even independent of additional funding; most lenders also require a strong existing equity investor base and sound financials.
  • Right choice if: Your company has stable finances, a clear path to break even, and wants to cover the remaining burn with a simple loan.

Asset-Backed Lending

  • Model: Loan granted against the security/collateral of a company’s physical assets.
  • Pro: Since the loan is backed by physical assets, it tends to be cheaper.
  • Con: The transaction is more complex because of the necessary documentation (collateralisation).
  • Prerequisites: The physical assets which serve as collateral must be easily saleable and of value for potential buyers — consumer electronics, cars and inventory to sell on Amazon work well, speciality equipment not so much.
  • Right choice if: Your business model involves hardware (usually equity funding is too expensive to buy such assets and revenue-based financing might be repelled by the lower margins on hardware).

The future for VC add-ons and alternatives 

The relevance of alternative forms of funding is not a one-off as, generally speaking, VC may not always be the best match for every company. Some companies, for example, cannot or do not want to comply with the high growth demanded by traditional VC or do not want to take significant dilution that comes with selling a stake in your business for cash. As the market continues to develop, we may see all forms of financing increase in volume, some more in relation to others.

Venture debt investment volume may increase at least in lockstep with VC due to its function as leverage on equity, and disproportionally in Europe as debt loses its unwarranted bad reputation and shareholders of startups discover the virtue of leverage. Asset-backed lending will most likely stay relatively small as it requires real assets which few startups have. The share of all other forms of funding, especially revenue-based, may expand even stronger as founders realise the benefits from diversified financing sources and from acquiring the right kind of capital at the right time.

To benefit from this development as much as possible, founders will have to change the way they think about funding. Three questions will be key:

  1. What do I need the money for? Which form of financing supports my operational investment case in the best way? For example, will investing the money deliver economic benefits in the next couple of months or will it take a year or longer? Do I just need the money, or do I need a long-term partner to support me? Can this form of financing provide sufficient cash to support my growth plans?
  2. What is the business model of the respective investor and what are its implications on my company? Is there a strong alignment with the interests of my investor? For example, am I aspiring an outlier success? Will this investor do "whatever it takes" to help me achieve my goals? Am I okay with others influencing my company’s strategic development path?
  3. How much risk and, therefore, burn do I want to accept in relation to probable outcomes? For example, does my business really provide the potential for an exceptional exit valuation? 

As these questions illustrate, new forms of funding create real optionality for founders in how to develop a company in the long run. And they can be an option to avoid the "VC treadmill" of chasing funding rounds and valuations altogether.

Every fundraising choice is an individual one — but by understanding the rainbow of options out there, founders can raise the right kind of capital at the right time.

Christian Stein is a partner at Riverside Acceleration Capital

*For informational purposes only. Information provided should not be considered an offer or sale of, or a solicitation to any person to buy, any security or investment product or investment advice. Content should not be relied upon for investment decision making and is not to be construed as legal, business or tax advice.