Beyond the Tip of the Iceberg: How Traditional Capital Sources Threaten Startup Owner Returns

Everything about captaining a young company is challenging, but no waters are quite as gut-wrenching to navigate as those of the capital markets. Fundraising is so draining that most founders accept whatever capital they can get their hands on. Most don’t realize that the headline costs of traditional financing sources are merely the tip of the iceberg; most also don’t realize that today’s funding options go well beyond traditional equity financing and bank debt. Savvy startup founders should take full advantage of these novel capital sources, which will increase the likelihood that their company’s voyage ends in success – and boost those founders’ returns. 

The Murky Depths of Equity Funding

One aspect of equity financing is widely understood: loss of control. Owners raise rounds of equity to keep the ship sailing onward, and over time end up being significantly diluted. Often, investors even force founders out of their own companies – 2019 was a record in this regard. This cost gets plenty of attention, but it is merely the tip of the iceberg; other costs lurk just beneath the surface.

While equity financing incurs no direct financial costs, it is in fact tremendously expensive over the long term for the company’s owners. Say that a company raises an equity round and then goes on to great success. Over time, the company’s value grows ten-fold. That’s great… sort of. The value of the shares sold to fund that growth has also risen by 10x.

Compare this with debt. When a loan is paid off, the founders still own the company outright. Achieving the same outcome after raising equity financing would require buying out the investors: paying them 10 times more than they initially put in. Obviously, no one would accept a loan with such an astronomical interest rate.

This example is closer to reality than you might think. At Capital, we’ve analyzed data from hundreds of startups and found that the average annualized cost of early stage equity financing is an astounding 58%, versus only 16% for debt (if you’re curious, Capital provides a handy cost of equity calculator here). This gap is the true, hidden cost of equity funding.

Chart depicts real company data analyzed in aggregate by Capital

The Interest Rate Iceberg

Like equity, bank loans have one well-known cost: interest. Higher rates are bad, lower rates are good. It’s that simple, right? Unfortunately, it isn’t. Hiding beneath the surface of most bank loans are hidden costs, as well as serious threats to your company’s growth potential.

All loans generally include covenants: restrictions on how the borrower manages its finances. While covenants are not all bad, some can completely suck the wind out of your company’s growth potential. For example, banks often want borrowers to keep lots of cash on hand. But the average small business keeps only 27 days’ worth of cash, and 25% keep less than two weeks’ worth. It makes no sense for high growth startups to hold cash – after all, if you can deploy cash with a 2x ROI, do you really want to leave funds sitting around collecting dust?

Traditional bank loans can also threaten your company’s growth by simply providing insufficient funding. A whopping 83% of today’s pre-IPO companies are losing cash – which makes securing any loans at all difficult. Even when early stage companies can raise debt, they often receive only a tiny fraction of the capital they need to thrive. Among higher-risk small businesses that apply for credit, 54% receive none, and another 27% receive less than half of what they applied for. That’s one key reason why venture-backed companies have only one nineteenth as much debt as other companies: 2% of total capital, versus 38% for the average US corporation.

Bank loans also come with substantial hidden costs. Consider warrants, which give lenders the right – but not the obligation – to purchase equity or another security from borrowers in the future at a predetermined price. Because lenders exercise this right only when it benefits them to do so, warrants are in effect another cost of the loan… but the loan’s headline APR doesn’t take them into account.

Bank loan provisions can also combine with unexpectedly expensive results. For example, an inventory financing line might include a daily cash sweep and an unused line fee. In combination, that can leave a borrower unable to exercise the full credit line (lest the cash sweep leave them unable to meet other obligations), forcing them to pay for the unused portion – even if they want to utilize the full line. Sadly, this problem is no longer limited to bank loans; venture capital firms are also increasingly attaching onerous conditions to the capital that they offer startups.

Fundraising’s New World

Fortunately for startup founders, emerging capital providers recognize that lenders win when a young company achieves its full potential. These providers offer solutions designed specifically for today’s fleet of rapidly growing companies, helping startups avoid the icebergs and murky depths of traditional capital markets so that they can keep exploring the frontiers of possibility.

Emerging lenders are leveraging big data and machine learning to offer credit tailored to individual startups, with a specific eye toward maximizing the borrower’s growth potential. Instead of requiring substantial cash balances, for example, these lenders might allocate monthly payouts to fund growth spending, tying the release of each month’s tranche to target ROI metrics.

According to the Fed, the share of small businesses applying to online lenders rose from 19% to 32% from 2016 to 2018 (while the share applying to banks fell by 5 percentage points), and riskier firms are more than twice as likely to apply to online lenders.

As the number of startups plying our economic seas continues to grow, the capital markets are adapting by offering new financing solutions. Startup founders should take advantage of these new options, rather than sticking to the well-known waters of traditional equity financing and bank debt. While those waters may be well-known, their dangers and true costs are poorly understood, and more innovative sources of capital are likely to provide startups with smoother sailing through less dangerous waters.

Capital provides both financial analysis and funding to companies looking to navigate alternatives to traditional financial options. The Capital Machine helps founders, owners and operators navigate many of the issues discussed in this post. To learn more visit https://captec.io/.