In an all-embracing sense, capital makes the world go round. It is perhaps the most permeating invention of the human race – an efficient and ubiquitous medium to exchange goods and services. However, for you managing a start-up, capital takes a much more tactical stand.
Crudely, without cash in the bank, you will not be able invest in equipment, not be able to pay your employees, not be able to travel, not be able to pay your suppliers, etc. Simply put, you’ll perish. Needless to say, capital is the lifeblood of a startup, in fact, of any company for that matter.
Often, capital has to be raised. Surely, you can raise capital by selling equity – that’s what venture funding is all about. But there are a couple of other options that you, as an entrepreneur should evaluate.
The first option is that of raising capital through loans. Contrary to what perhaps Finance textbooks administer in that loans as a source of capital is not accessible to startups because of their deficient track record, I have seen many start-ups access this source. However, they do not source debt capital from financial intermediaries; instead they source debt capital from friends and family.
A subset of loans that is quite popular with entrepreneurs in the valley and is fast gaining popularity locally is convertible debt. Convertibles are loans that, on a pre-decided event get converted into equity at a floating valuation. If you’ve ever raised capital through the equity route, you can surely acknowledge the cumbersome nature of coming to agreement on a pre-money valuation.
At an early stage of your business, this valuation estimate is fleeting at best. This process is entirely avoided when working with convertibles and the only agreement that remains to be reached is a discount to a would-be, if-so, Series A valuation. That’s a much easier task. Other than that, paperwork needed to execute capital infusion through debt, including convertibles, is lesser and consequently the infusion can be completed much faster. Money in the bank sooner than later can be a crucial advantage.
The second option, again often passed off as inferior, is that of raising capital from your customers and suppliers. This may sound absurd but if you have customers who are willing to pay you an advance, and/or suppliers who are willing to wait for their payment, you enjoy what in finance circles is called a float, or more technically a negative working capital. Float is money that a company temporarily holds and is free to use in whichever way it sees fit.
However, few startups, especially in the software products space have any revenue come its way, at least not initially. Yet, for those who do have revenue, it definitely does not harm to see if you can get to a negative working capital cycle. Even if you don’t have revenue, creative ways of structuring deals with anchor clients can be very fruitful. Often, if they like you, they would not mind taking a piece of your equity in return of giving you business as well as bragging rights of working with a Tier 1. Both are priceless.
If you can get access to either of these options, you would have hit upon a cheaper source of funds than selling equity. Selling equity outright is, averaged out, an expensive proposition.
[About the Author(s): This article, second in the series on “The Science of Entrepreneurship”, has been written by Aniket Khera, Director (Programs) at Sunstone Business School, who are part of NextBigWhatSelect, a curated set of regular contributors to NextBigWhat.