Is it time to consider alternative financing strategies? | Foley & Lardner LLP

The economic turmoil of the past six months caused by everything from inflation to interest rate increases to supply chain disruption, not to mention full-scale war in Europe and then massive increases in the gas prices, combined to trigger a bear market on Wall Street. A bear market on Wall Street is defined by a twenty percent decline in valuations from the nadir of exuberance. We briefly saw the first post-GFC (Global Financial Crisis) bear market in March 2020 at the start of the pandemic, before governments started printing money. The current bear market arrived in June 2022 in response to interest rate hikes by the Federal Reserve aimed at stemming inflation.

Unsurprisingly, public bear market valuations have started to trickle down to private markets. There is no need to look further than the announcement last week by global fintech giant Stripe that it had lowered the internal value of its shares by 28%. Recently, Crunchbase released venture capital funding data for the second quarter of 2022, which revealed a 23% drop in venture capital funding for startups globally compared to the previous period, the second highest quarterly percentage decline as well as the largest quarterly percentage decline. in transactions over the past ten years. Digging deeper, however, we find that venture capital funding for startups in the second quarter of 2022 was still the sixth highest total on record. Indeed, it was higher than the totals recorded in each period preceding the pandemic.

So, we’re assuming there’s still plenty of venture capital funding available for startups, but not at the record highs of last year. That said, there are alternatives to venture capital funding, and founders may want to take a closer look at these alternative methods of securing capital.

Alternative financing can provide benefits to founders, including allowing them to retain more control and avoid dilution. With venture capital funding becoming a bit more difficult to obtain, this could be an increasingly attractive option for startups. Below, we take a closer look at some of the alternative financing options available.

Multi-year contracts

When venture capital is expensive or valuations are low, startups should seek to accelerate the receipt of cash by signing multi-year deals with distribution partners for larger amounts that can fund the business in the outside periods. Earnings acceleration may be conditional on discounted prices, essentially the net present value of future payments, or more, but it allows you to cash out now.

Non-dilutive government incentives

Soon after the pandemic, governments around the world rushed to put money in the hands of small and medium-sized businesses to keep them afloat and workers on the payroll. In the United States, the Small Business Administration has been tasked with implementing the Paycheck Protection Program and the Economic Injury Disaster Loan Program. These programs kept the economy afloat until the economy had a chance to rebound.

Governments of all types and sizes provide other incentives and incentives for new business creation that will boost jobs and tax revenue. The R&D tax credit is intended for taxpayers who design, develop or improve products, processes, techniques, formulas or software, and is calculated on the basis of R&D expenditures and rewards companies that pursue innovation with increasing investments. . It reduces federal and state taxable income and allows certain companies to receive a dollar-for-dollar tax credit while being able to deduct R&D-related expenses, which can total a 10-15% return on investment. .

Government incentives usually come with strings attached, so it’s important to read the fine print and understand the terms.

Loans, venture capital debt and other forms of IOUs

When equity is hard to come by or expensive, just look at debt, which can come in all shapes, forms and sizes. A traditional bank loan is likely reserved for profitable businesses that generate enough cash to put a “Main Street” bank credit committee at ease.

Existing investors may want to inject capital to send a signal to the market that your business can weather the storm and has support. This can take the form of a new convertible loan or a “bridge” financing that converts to equity on the next financing, usually at some sort of discount and at some sort of capped valuation to give lenders an edge. .

Venture Debt is basically a loan designed for early-stage, high-growth startups that have already secured venture capital funding. This is important to note, as risky debt is not necessarily a first step for a startup. It’s really for startups in growth mode that need additional funding after they have their VC funding in place.

Venture loans can vary widely, with loans being based on equity already raised. Loans typically range between 25-50% of equity raised in the last round of funding. This means that loans to start-up companies looking to finance their expansion are often much larger than those to start-up companies.

The obvious benefit of taking on risky debt is that it allows companies to focus on growth, while allowing founders to retain more control rather than accepting more venture capital funding and further diluting their property. But, as with any loan, the venture capital debt must be repaid at a later date, which must be carefully considered when evaluating this option.

Think of venture capital debt as an extension of your venture capital runway so you can wait to exit for your next round with better numbers at a higher valuation.

Venture capital debt can take the form of term debt or revolving debt, and can be asset-based or receivable-based. Typically this requires oversizing and the cost is comparable, albeit discounted, to venture capital if it all works out.

Revenue sharing agreements

A revenue sharing agreement, or SEA, is an agreement between investors and founders that gives investors the right to receive future revenue from the business. Income includes founder’s salaries, dividends and retained earnings. Because an AES includes founders’ salaries as revenue, these agreements typically include a salary cap for founders.

SEAs can also include a revenue share cap, allowing the investor to receive a predetermined amount of the revenue, with the founders then able to keep the revenue once that cap is reached.

So when does an SEA make sense? The goal for businesses using an SEA is profit. This allows the investor to generate a return on their investment, and then the founder to retain future income. This means that they work best for small and medium-sized businesses that are very likely to generate profits, but they are not suitable for high-growth companies that are considering an IPO. It is therefore not a great alternative for VC-backed startups or startups looking to raise significant capital.

One of the great benefits of SEAs is that founders can keep future earnings once the revenue share cap is reached. However, reaching this ceiling is determined by the amount of profit generated by the business, and the ability of the business to generate a substantial profit should be a key consideration in determining whether this type of financing is suitable.

Revenue-Based Funding

Revenue-based financing allows startups to raise capital by pledging a percentage of ongoing future revenue to investors. A regular share of the income is paid out to investors until a certain predetermined multiple of the initial investment has been repaid. This multiple can vary from three to five times the initial investment.

Investors are paid based on the success of the business and payouts are not fixed. Payments to investors will increase or decrease monthly based on company performance.

One of the reasons revenue-based financing can be beneficial for founders is that it allows them to retain a greater level of control. Investors actually have no direct ownership in the business, although they do have a strong stake in the success of the business.

In the current economic climate, we expect to see more startups seek outside venture capital to secure the funding they need. Each type of alternative financing has its own risks and benefits, all of which must be considered. There is no one-size-fits-all solution, and founders must weigh all options to determine what works for them.

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