Bridging the Gap Between Debt and Equity

Many growing companies are limited—to hire, buy inventory, advertise, etc.—by the access they have to capital. But most don’t qualify for traditional debt nor are they ready to sign on for the “all or nothing” hypergrowth required by most venture capital.

The absolute best source of funding is revenue from customers, but founders usually have to pay expenses before customers pay them. In order to grow, founders must find sources of funding that can be used before they collect better capital– from revenues.

Traditional sources are debt (from banks) and equity (from investors), but only about 18% of small companies qualify for bank debt, and a very small fraction of companies have the potential for hypergrowth that equity requires.

This leaves a large gap where most founders figure out how to “bootstrap” using whatever assets they happen to have—savings, credit cards, friends, family, HELOC, etc. This is truly a luxury for those who have the means or connections and greatly limits access to entrepreneurship.

The good news: We have seen a lot of innovation in this space from two directions.

1. The cost of starting a business has dropped dramatically
2. The models for providing capital have evolved beyond the typical debt-equity structures

Let’s run through a few of the latter. We’re excited to help you find an option or two that resonates.

Long Term & Short Term Debt

This type of capital requires a very low failure rate for the funder. Too many unpaid loans and the lender will lose money, be unable to access more capital to lend, and fail. So, this structure requires a focus on the security of the loans.

Traditional debt is backed by “current assets”

Debt security requires a “healthy” company, meaning consistent cash flow that can pay the bills, and collateral, which is what a lender can acquire to make them whole if the loan isn’t paid. Collateral typically needs to be an asset that has current value more than future value.

Assets recognized by traditional banks include cash and real estate—these are relatively easy to access and/or turn into cash to cover the loan. The banks are also tightly regulated by the government limiting who they can lend to and what assets they can recognize. (This explains the 18% mentioned above.)

As you would expect, equipment financing or inventory financing is secured with those respective assets, but will typically not loan on 100% of the value.

Other alternative lenders recognize different assets. Factoring* uses short-term assets related to the sale of goods to make loans ahead of time: Invoices (paid upon delivery), Shipping paper (paid upon shipment), and Purchase Orders (order contract).

These types of loans are riskier and more expensive, but sometimes make more sense than taking on a longer, less expensive loan. (More on that here.)

*Merchant cash advance tools are in this category but they aren’t usually connected to a specific short-term asset and are some of the most misused, over-marketed financial tools on the market.

Bridging the gap = redefining “assets”

Most of the innovation we see is how lenders are measuring the value of different categories of assets, expanding where debt tools can be applied.

If the purpose of the funding is to make capital available in advance of customers providing revenue, then it makes sense to look at the derivatives currently driving that revenue.

• Subscriptions – PIPE, Founderpath, Capchase, etc.
• Paid advertising – Clearco
• Real-time sales data – Stripe, Shopify
• Future revenue – Lighter Capital, Novel, BigFoot Capital

All of these take into account the current health of the company (as a bank does) but expand the reach of debt by analyzing more of the tools driving future revenue and profits.

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Long Term & Short Term Equity

Based on the value of a future transaction, an investor puts money in and expects money back at a later date with a return. This isn’t secured with assets and typically costs more because they are taking a short or long-term risk of losing all of the investment.

Traditional Equity is based on a “future exit”

Although Convertible notes are technically debt that can convert into equity, the investor would be disappointed if it never converted and is commonly considered an investment, not a loan. This is a common way for equity investors to structure their investment without a lot of the complexity and negotiation required for typical equity investments.

For example, because shares aren’t changing hands immediately, the founder and investor don’t need to debate over how much they think the company is worth… other investors will determine that later. This is a very common path for angel investors who expect to ride along when a larger investment firm manages the negotiation and complexity later on.

Variations on this theme include:

• “Standard” Convertible Note – interest, maturity date, converts into equity at a discount
• SAFE – Simple Agreement for Future Equity (no interest, maturity)
• KISS – Keep It Simple Security
• SAFT – Simple Agreement for Future Tokens

All of these are optimized for an “exit” in the future after the company has raised a round or two and had time to become exponentially more valuable.

Bridging the gap = changing the timing

Innovation on the timing of an exit—and what exit means—has created more opportunities for equity transactions.

Even the required exit that creates the return for investors is becoming more accessible by designing in smaller, faster exits.

For example, TinySeed invests with the intent to create smaller, but a higher percentage of “wins. Sureswift, Tiny Capital, MicroAcquire all enable smaller exits instead of all-or-nothing.

This math is bridging the gap by allowing high-growth companies to achieve success for the investor without requiring the company to achieve “unicorn” status.

Hybrid Models

Hybrid financial tools are all structured to optimize for variations in both asset type and timing. They rely less on traditional assets than debt does while also valuing a future asset like equity without relying exclusively on an ultimate exit transaction.

• Mezzanine – Debt with an equity upside (larger transactions)
• Founder earnings (SEAL – Shared Earnings Agreement)
• Income (CISA – Convertible Income Share Agreement)
• Profit with a conversion (SPACE – Shared Profits and Collaborative Endorsement)
• Redeemable Equity – Structured to be re-purchased by the company
• Convertible Revenue-based investment – This is how Capacity Capital invests.

Our fund makes an investment in exchange for a right to equity, but that equity right can be redeemed back through a revenue share. This aligns us with the founder and gives them true optionality so they can raise more capital, drive to a big exit, or grow fast while maintaining their ownership and control.

The flexibility of these models helps overcome one of the timing problems of a “one size fits all” funding approach that drives growth at all costs. The Startup Genome Report noted that premature scaling was the primary reason for failure in the 3,200 startups they studied. 74 percent that failed due to premature growth took on two to three times more capital than was necessary.

Bottom Line

There are far more options available for funding line-of-sight growth opportunities. An entrepreneur can consider more than just the traditional funding mechanisms that require already having assets, personal wealth, or a hyper-growth business model.

Be sure to match up the uses and the sources so they fit your business. If you have assets to leverage you have different choices than if you only have a “take over the market someday” strategy. There are tradeoffs to these decisions and choices limit your options, so make sure your funding decisions are in line with your vision.

If you want to apply this to your company, we also have a 1:1 Capital Strategy Workshop designed to help you optimize your funding sources for your business.

Let us know if we can help you explore what’s available.

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