Overview of Funding Options
Funding your new start-up can be a stressful endeavor. Most entrepreneurs start their businesses with their own savings, growing it bigger with small personal loans from financial institutions, or even friends & family. However, as the start-up scales, these small funds may not suffice and entrepreneurs must switch to alternatives to sustain the business. This article will take you through your funding options as you contemplate this next step.
1. Grants and government funding programs
Food processing sector has come under increased focus after the 2021 report of the Standing Committee on Agriculture and Agri Food. There are numerous grants and funding programs launched at federal and provincial levels that specifically target small scale food processors to help them strengthen their businesses. More recently, there has also been some interest in providing equity based funding to women entrepreneurs leading to a $15 million investment in the Inclusive Women Venture Capital Fund.
2. Business Incubators
Researchers in the food processing space, like Dr. Sylvain Charlebois have highlighted the importance of specialized Business incubators in the food processing space. Entrepreneurs often need specific supports and mentorship for their food processing projects given the capital-intensive nature of manufacturing units and the slow roll of profits. However, apart from providing support, business incubators may also provide seed capital that may be crucial to the success of a business endeavour.
Per the 2021 Standing Committee report referenced earlier, business incubators and accelerators can bridge the gap between research and commercialization. Debt Financing
3. Debt Funding (and Mixed Instruments)
Debt funding can be accessed through financial institutions like banks, as well as through other sources including angel investing and venture capital funding.
Debt accessed through banks is backed by collateral and may be difficult to come by especially for women food processors. This is in part owing to the general lack of understanding among bankers with respect to small scale food processing as an industry, as well as to the challenges of accessing capital as a woman. The Small Scale Food Processors Organization is currently working with multiple traditional banks to redesign lending guidelines specific to this sector in light of the research conducted by SSFPA and its partners.
Bank debt is a straightforward form of financing that leads to zero loss in equity. Interest on this is tax deductible which makes it an attractive form of financing for stable businesses with predictable cashflows.
However, if your business is new and growing, it may not have established predictable cash inflows and may not be able to sustain the additional monthly expense of debt payments. This uncertainty makes small businesses dubious candidates for traditional (business) bank loans.
However, angel investors and Venture capital firms have added some novel debt instruments into their arsenal that solve this specific dilemma.
b) Convertible Notes
Convertible Notes are a form of mixed debt/equity funding and are used in early stages of start-up financing when the true value of the company is still unclear. Convertible Notes accrue interest which increases over a period of time and can be converted into an agreed upon number of shares at a later point. Senior convertible notes have priority over all other kinds of debt funding the company may have on its balance sheet.
In simpler terms here is how this works – an investor agrees to issue a note (or capital) for a certain interest rate and the note has a maturity rate by which the loan must be repaid. As an added incentive for risk, the investor has the option to convert this note into equity at a discount once the start-up goes for an equity financing round. Convertible notes should be handled very carefully by entrepreneurs as they have the potential to turn predatory if the initial valuation cap is too low or the conversion discount rate is too steep.
c) Revenue-Based Financing
For high-growth companies, another alternative to equity-sharing financing is Revenue-based financing, or royalty-based financing. The invested capital is repaid as a percentage of future monthly revenues for a period of time. Since the monthly installments are not fixed as is the case with traditional bank debt, the business has greater flexibility during months or periods where revenues are lower.
4. Equity Funding
Equity funding is arguably one of the riskiest forms of financing, both from an investor and entrepreneur’s perspective. Without a sound understanding of business valuation, one’s own unique business or product proposition, and potential future value, an entrepreneur risks losing a significant portion of equity when the business begins to thrive. On the other hand, it is also a risky investment for investors who may risk seeing their entire capital evaporate if the business fails. For more information on valuation models used by VC firms, please refer to our guide here.
Equity funding instruments have also evolved over the last couple of decades to cater to the unique needs of start-ups incubated in the age of technology. Let’s look at some of the options.
a) Traditional Equity Investment (VC/PE)
Traditional equity investments most often happen in priced fundraising rounds (Series A, B, C) where an investor contributes capital to gain equity in the company post-money. Investors often also want to secure their financial standing (vis-à-vis shares), as well as their voting and exit privileges in further equity rounds. This means that equity investments often involve lengthy term sheets laying out exactly how an investor would fare in different scenarios that might play out as the company scales and grows.
The most pertinent items included in the term sheet are:
- Valuation: Rational evaluation of a company’s valuation based on due diligence by the investors and market research of potential value by both parties is crucial to reach an agreement between the parties on the true value of the company that can give me a good return on capital invested.
- Liquidity Preference: Exit preferences ensure that investors secure adequate returns at the time of exit. These can be activated when a business is liquidated, merged, taken over, sold for cash, or pursues an IPO.
- Voting Rights: Management influence within a company that an investor is pursuing ensures their rights are secured through the investment period. However, as an entrepreneur, you need to ensure that the management rights don’t become so overbearing as to curtail the potential growth of the company, and distract from its goals. Voting rights include the ability to appoint a certain number of members to the Board of Directors, veto structures, and so on.
- Forced Sale: Sometimes founders may get overly attached to the company and may not want to pursue an exit at all. This can have negative consequences for investors. A forced sale provision will ensure that the company does take an exit at an opportune moment that benefits both the investors and the company. Founders should be very clear on their ultimate goals with respect to their business before entering an agreement with potential investors who are keen on an early exit.
- Anti-dilution: For investors, this is an important clause because as a fast-growing start-up it is understandable that the company will spend faster and seek quick additional rounds of funding to meet its growth needs. However, new investors may want a bigger part of the ownership of the company or may not be happy with the terms set by the original investor. Anti-dilution ensures that an early investor’s standing stays intact through additional funding rounds. This is why it is particularly important for entrepreneurs to gauge the right value of their startup as they go in; early investors may become an albatross around your neck if they have very high equity or too much control that may turn away investors in additional funding rounds.
- Protective Covenants: This may include provisions that protect the Investment Agreement, capital and stock structures, issue of options and so on. Entrepreneurs should be careful of covenants that may preclude them from entering a merger/acquisition or joint venture relationship without prior approval of existing investors.
SAFE, or Simple Agreement for Future Equity is a simpler form of equity funding. Instead of valuing the company outright, the investors agree to receive the right to purchase stock in a future equity round based on the valuations at that point. SAFEs are an especially useful financial instrument for pre-seed or seed stage start-ups because while they may seem very similar to convertible debt, they are not debt. The two metrics of interest to close a deal on a SAFE agreement are valuation and capital invested. SAFEs also tend to be shorter, and easier to understand as they skip much of the legal lingo that makes these agreements often incomprehensible to the very people involved in the deal-making process.
Now in layman’s terms here is how this plays out – suppose you value your startup at $10 million before you strike a deal. This is called pre-money. Now, if your investor wants to infuse $2 million into the startup, the post-money value would be $12 million. This means that the investor now possesses 16.6% equity ($2million/$12 million) in your business at your first priced round (Series A).
Kirsty Nathoo breaks SAFEs down in very simple terms for YCombinator here, which you might find useful.
Crowdfunding, as the name suggests, involves seeking a small amount of capital from a large number of retail investors and is typically done through the internet.
The uncertainty created by the pandemic, and lower availability of funding opportunities for start-ups that are still in the early stages has led to reduction in valuations, and the term sheets have become increasingly tilted against founders. Regulation changes in the USA (Regulation Crowdfunding, JOBS Act) have made it easier to seek crowdfunding, and as internet access improves, and retail investors start looking more avenues to diversify, crowdfunding will continue to grow in the future. Crowdfunding can be of four types: Unregulated (Donation or Rewards Based) and Regulated (Lending or Equity Based). There has been an increased interest for the latter in recent years, and as fintech platforms become even more sophisticated, we will see more polished investment avenues for lending and equity-based crowdfunding for retail investors who have a higher risk appetite. In Canada, Equity Crowdfunding is regulated through two systems “prospectus exemptions” (System 1: Start-up Crowdfunding Exemption, and System 2: Regulation Respecting Crowdfunding). ECF must be raised through registered portals only.
Each investor also effectively becomes a stakeholder in the company’s success, and thus an ambassador for the start-up’s offerings. This also allows founders to retain more control over their company in the early stages, as they determine the terms of the fundraising.
Crowdfunding also makes it easier for start-ups that are not based in prime investor locations like Los Angeles, Toronto, and New York to seek funding while continuing operations at base, without having to relocate to these investment hubs just to procure funding. This is not to say that crowdfunding can replace traditional VC/Angel capital – there are regulatory limits placed on the amount of capital a start-up can seek in total per fundraising round ($5 million in the US, CAD 1.5 million in Canada), as well as the amount each retailer can invest ($2200 in the US, CAD 2500 in Canada). Thus, it would be difficult to scale up quickly solely on crowdfunding. However, this has the potential to become an important avenue for companies who are still in the product development phase, and which may not have direct connections or access to Angel investors and VCs.
Additionally, there are fewer accounting obligations, and disclosure requirements when raising through crowdfunding which allows founders to focus on the product and fundraiser marketing, reducing the paperwork required to raise capital.