By Stephanie Raimbert
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The U.S. economy has essentially shut down, leaving many venture-backed businesses facing challenges beyond simply launching a successful business. Small businesses are struggling to sustain their operations, customers, workforce and cash-flow. For businesses that were and are planning to raise venture capital (VC), the landscape has been altered. For example, VC investment funding usually decreases during recessions as venture capitalists (VCs) want to extend the investment period of their current fund so they are most likely to wait until the current market has improved. Venture capital funding is the most common type of equity financing that helps fund businesses. Generally, venture capital investors who make an investment in a small business, take an equity or ownership stake in the company. You will find venture capital through private-public partnerships or private venture capital firms. Based on a National Venture Capital Association report, a significant amount of the capital used in 2019 came from nontraditional investors (i.e., such as corporate venture capital groups, private equity investors, asset managers, and sovereign wealth funds) who are likely to restructure investment away from high-risk businesses. As of now, venture capital funding in the small business world is expected to drop significantly. Therefore, it is critical for business owners to probably seek other alternative forms of funding for their businesses.
Recent VC Funding levels impacted by COVID-19
Uncertainty about the coronavirus’ economic consequences has passed a tipping point and caused a rapid drop in the markets, said Joseph G. Hadzima, Jr., senior lecturer at MIT Sloan. “This had at least two effects on venture capital,” he said. “It slowed commitments to VC funds that were in the fundraising stage, and it caused VCs to assess the financial conditions of their portfolio companies.”
As said by WSJ, some limited partner investors are asking venture firms to slow down or cut their pace of investing because the limited partners (e.g., public pensions, university endowments and foundations) are the ultimate sources of funding that businesses receive from venture capitalists. Therefore, the economic shocks, such as the one caused by the coronavirus pandemic, filter down to the small business world. Based on a Q1 2020 Pitchbook report, as more employees work from home, organizations are turning to technology to help ensure business continuity. This will prove relatively painless for businesses in the technology and information industry. Additionally, many remote-work companies, especially small businesses, cite the advantages of being able to hire candidates from anywhere.
The world is being reshaped by COVID-19, and it’s important that VCs take the time to understand the new landscape and how each business will fit into it. According to Forbes, business models may need to be reorganized; products and services may need to be reimagined in line with new customer needs and preferences. Furthermore, the cost of capital, which is the cost of a company's funds, or, from an investor's point of view "the required rate of return on a portfolio company's existing securities” is eventually going to be higher than pre-pandemic, both for investors and entrepreneurs. This will mean some small businesses will have to think differently about when to take on an external investment. For investors, however, it means getting back to basics by emphasizing on profitability over and beyond growth. The fundamentals will also include a preference for proven business models, the requirement for management teams to demonstrate a deeper understanding of profits and losses (P&Ls), unit economics, and customer turnover, and, of course, priority given to the leaders that have successfully navigated their way through the crisis.
However, venture capital funding is not always a good fit for every small business owner or business. If VC funding is not the right fit, that’s where VC alternatives can come into play. Below are 5 alternatives to venture capital funding: 1) debt financing, 2) equity financing, 3) small business grants, 4) crowdfunding, and 5) bootstrapping. It all comes down to your business, the options that are available to you, and what you choose as the best path to your business’ future.
Alternatives to VC Funding for Small Businesses
Debt Financing
Debt financing is financing a business with a loan. It occurs when a business owner receives money from a lender to use as working capital or capital expenditures. In exchange, the owner has an obligation to repay the lender the principal of the loan plus interest. Debt financing includes both secured and unsecured loans.
It is best for business owners who want to maintain full control over their business. If you want or need financing right away, this is also probably your best option.
Debt financing encompasses a broad category of loan types including term loans, equipment financing, invoice factoring, business lines of credit and personal loans.
Term loans
A term loan from a bank allows you to borrow a specific amount of money which is then repaid over a set period of time. Term loans typically have fixed interest rates and may include charge fees, prepayment penalties or other fees.
It is best for businesses with at least two years of operating history and owners who want predictable monthly payments.
Equipment Financing
Equipment financing is the process of purchasing equipment using a loan or leasing business equipment. Depending on the lender, you may be able to borrow up to 100% of the equipment's value, with repayment terms lasting for the life span of the equipment.
It is best for businesses with at least six months of operating history which can meet the lender's minimum credit score and revenue requirements.
Invoice Factoring
Invoice factoring (also known as receivables factoring) involves selling your outstanding invoices to a financing company in exchange for a lump sum of cash. You may be able to borrow 70% or more of your accounts receivables, and perfect credit is not a requirement to qualify.
It is best for businesses that need flexible funding and are able to meet minimum revenue requirements.
Business lines of credit
Similar to a business credit card, this form of financing is a revolving line of credit you can draw against as needed. The advantage is that you only pay interest on the amount of your credit you're using but are subject to credit review and annual renewal.
It is best for businesses with at least six months of operating history in search of a flexible financing option.
Personal Loans
Personal Loans are shorter-term loans that you can receive from banks, credit unions or private lenders. Personal loans can be used for funding business operations, though borrowing limits may not be as high as those for business loans. Personal loans can be secured or unsecured and have fixed or variable interest rates.
It is best for businesses and entrepreneurs that don't meet the revenue, credit score, or operating history requirements for other financing options for small business.
Equity Financing
Equity Financing is accepting money in exchange for an ownership portion of your company or stock. The biggest advantage of equity financing is that you don’t need to take on debt the way you would with a loan or line of credit discussed above.
It is best for high-growth businesses that are set to expand quickly, most likely in such fields as technology, health care or finance. You may be better suited to this type of financing if you’re seeking a long-term relationship with one investor or a group of private investors who may also serve as mentors.
Angel investment
Similar to venture capitalists, angel investors provide cash in exchange for some type of return. Unlike venture capital, an angel investment may be a one-time transaction rather than an ongoing source of financing. Angel investors may be more difficult to find and have specific criteria they’re looking for in businesses they finance.
It is best for businesses who want more control of their management since angel investors don’t aspire for board memberships or take interest in future funding.
The pros include the following: private investors can offer millions of dollars in funding, no credit score, operating history or revenue requirements to meet, and money raised from private investors typically does not need to be repaid. The cons include the following: investors may expect an ownership stake in the business in exchange for funding, angel venture capital funders can be very selective, obtaining funds may require more work than getting a loan and it may be necessary to raise multiple rounds of funding.
Small business grants
Grants offer the advantage of not having to be repaid, but are typically given to mission-oriented businesses. Business grants are offered by nonprofit, for-profit and government organizations. However, there may be a lot of competition for limited funding. If you're interested in applying for small business grants, you'll need to do your research. That means looking closely at different organizations that offer grants, which types of businesses are eligible for grant funding and what is required to apply.
It is best for small businesses that would like to access working capital without taking on debt.
Crowdfunding
Crowdfunding (or crowdsourcing) means raising money from multiple investors. For example, you might list a funding proposal on an online platform like GoFundMe or Kickstarter and ask ordinary people to contribute money to your cause or business. This is another way to legitimize gifts made from family and friends and widen your circle to the larger community.
It is best small businesses less than a year old that need funding to launch or scale.
The pros include the following: credit isn't a requirement, launching a crowdfunding campaign could help raise visibility for your brand and funding can be more accessible for businesses compared to getting a bank loan. The cons include the following: crowdfunding can be a competitive landscape for small businesses, and depending on the crowdfunding platform you use, you may have to pay a fee to list your campaign, which could be deducted from the money you raise.
Bootstrapping
Bootstrapping is the process of an entrepreneur using existing resources such as their personal computing equipment, garage space or personal savings to grow their business. The company stretches the resources it has as much as possible to reduce costs. For example, business owners might use personal credit cards or dip into their savings accounts to help fund the business.
It is best for small businesses that can use their own cash flow to run the business.
The real effects of COVID-19 and the current market changes may truly only show until next year, which means small businesses should start preparing now on how to navigate beyond the COVID-19 pandemic crisis. Most importantly, before you start the process of trying to raise funds for your small business, make sure you find solid reasons for a positive mental outlook.
Resourceful Links to deepen your understanding of VC funding alternatives:
1. To learn how to successfully crowdfund in a difficult global scenario, click here.
2. To get your idea off the ground or expand your business with some extra cash, learn how to use microlending to fund your business, click here.
3. Here are 4 options to resolve cash-flow issues besides loans.
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