In late 2008, I was the managing partner of a local startup in Kuwait, 6alabat.com and was preparing with the rest of the team an expansion plan for regionalizing the business. As we rolled-up our sleeves and started diving into the numbers, we were looking at a serious funding round ahead of us for financing the required working capital. Although the Kuwaiti government has committed over to KD200mn of SME’s funding through different vehicles, the commitment was only limited to first-money-in (seed capital) which did not cover growth capital. After a few months of long conversations with a few local parties, I came to realize that 6alabat’s best source of funding is revenue due to the lack of venture understanding and overall, an entrepreneurial ecosystem. I started learning more about early-stage-funding and realized there are a lot of building blocks missing in our community; Here are a few thoughts on key aspects of venture funding which might be useful for your next round of financing:
As startups move on from the seed stage and ideas further develop into prototypes, most ventures will require fresh capital to finance working capital/fixed assets. Although entrepreneurs project future cash flows and profitability for the financiers, the forecasts will have a degree of uncertainty to it that needs to be factored in the fund-raising equation. Whether the provided finance is in the form of debt or equity (funding round), both providers will require a form of return, but with varying expectations to the level of uncertainty. Accordingly, hybrid finance, in the form of debt and equity, will have different types of obligations on the business.
The funding round must also serve the best interest of the founding entrepreneurs. The entrepreneurs are key to realizing the potential of any opportunity and so, the funding round must offer extrinsic (potential financial gain) and intrinsic (self satisfaction and operating culture) incentives to the entrepreneurs; alignment of interest between all stakeholders is therefore key to the success of the business.
Understanding the basics of finance and the debt/equity instruments is essential for building a proper capital structure when financing the entrepreneurs. A well-shaped entrepreneur should always be aware of the instruments he/she seeks capital through, which may vary depending on how sophisticated the venture community surrounding him/her is. As an entrepreneur, seeking “smart capital” versus “dumb cash” should always be an aim especially during the development/expansion phase. Smart money is usually sourced through angel networks/investors and early-stage or late-stage venture capitalists that usually stress on proper capital structures with technical and strategic value-add and is healthy for going through multiple rounds of financing.
Despite a wide array of available financial instruments in the venture community, the main difference is in the risk/reward tradeoff each instrument offers. To set the risk/reward parameters, the financing package will impose certain conditions on the entrepreneurs and the company. This may be achieved by either imposing fixed requirements or by providing means to limit possible outcomes from the business.
Equity Vs. Debt Financing
Equity and debt investors use different control measures to protect their risk/reward positions. Debt financing agreements tend to minimize the probability of not collecting back the financed debt portion to the entrepreneur if the business goes under; lenders would want to have control over the business if the covenants are breached. Although debt instruments in venture funding are not popular in this part of the world, they are quite popular in more developed markets. On the other hand, equity investors will often hold a minority position in a given company to maximize the entrepreneur’s vested interest but will also require special rights to protect their position. Unlike debt holders, equity investors want a front seat in driving the business strategy to ensure their returns are realized through dividend payouts and capital gains. The uncertainty in the timing and size of these returns has led equity investors to creatively have different share classes with different preferred rights.
In spite of the creative solutions developed by equity financiers to resolve a lot of uncertainties they may have, exits still remain the key option for realizing gains. Many would argue that valuations on different funding rounds validate the financiers’ position, however those are unrealized gains, and therefore exits are the only option to realize all capital gains. For a startup to be venture-friendly, exit is also key.
All in all, understanding and aligning the interest of different stakeholders in venture funding is essential for graduating a startup to enter a growth company stage; With smart money backing your startup, you have a better opportunity of being the next THE-99!
Join us in the next Startup Q8 event this coming Saturday where we will be shedding more light on Early Stage Funding.
Have a good weekend everyone!
Abdulaziz B. Al Loughani