Starting up a Start Up – “Show Me the Money”

Start ups are a big deal. Their ability to disrupt traditional modes of business have attracted sky-high valuations and the recent news is that Airbnb is in the process of a $900m-1bn funding round which values the private company at $24bn, and Uber is currently in a $1.5-2bn round which values the ride-sharing service at an eye-watering $50bn. To put these figures into context, Airbnb now has a higher valuation than international hotel chain Mariott International ($20.46bn) and Uber’s new valuation takes the company higher than 406 public companies on the S&P 500.

But before a start up can become a unicorn (a company with a valuation of at least $1bn) and reach such dizzying valuations through ‘Private IPOs’, a start up needs to first start up. There are two main financing options for a fledgling company: debt finance by way of a bank loan and equity finance via venture capital (‘VC’) investment. There is also a hybrid method of financing known as convertible debt. Which of these is more suitable?

Option 1: Bank Loan/Debt Finance

A bank loan is the provision of money from a bank in exchange for regular repayments plus interest. There is no dilution of equity so existing shareholders’ control of the company will not be affected, but the youthfulness of the company will prove problematic.

The lack of a financial history means that the bank will impose onerous obligations on the company to ensure repayment. The company is likely to be a high credit risk so the loan will be secured on the start up’s assets, such as any physical property, intellectual property rights, contracts etc. This security will grant the bank priority in the event of the borrower’s insolvency by allowing it to enforce its security over these assets so as to settle the outstanding debt. This security causes administrative problems because any dealing/disposal of these assets would require the bank’s consent. A start up requires agility and freedom, but a bank’s security would introduce a layer of bureaucracy within the company that would previously have had a fluid operational system.

Note also that, since the company is so young and is not seen as having a stable foundation, banks often require the start up’s founders (often also the directors) to guarantee the debt. They will therefore become personally liable if the company defaults. This is obviously very risky for the individuals guaranteeing the loan due to the substantial personal liabilities that can be incurred, so personal guarantees must be taken into account when considering debt finance.

As another result of the company’s credit risk, the bank will require repayments to be made on a regular basis plus interest. This is vital to the bank because it wants to ensure the safety of its investment and maintain a regular income stream. Consequently, regardless of its profits, the start up will have to stick to its repayment schedule otherwise it risks the bank calling an event of default and accelerating its loan (requiring immediate repayment) and enforcement of the security. Bearing in mind that failure to repay already indicates the start up’s financial ill health, any steps taken by the bank in such a situation would likely break the company. It is also important to note that the threat of defaulting is likely to change the culture of the start up since early development companies are generally more concerned with their products and traction, rather than pure financial figures.

Because of these onerous impositions, a standard loan is unlikely to be suitable for a start up.

Venture Debt

This is a specialised loan aimed specifically at start up companies that have assets, an existing customer base and/or financial history. Especially popular with niche banks in Silicon Valley and growing in use, this method of finance combines the advantages of a loan and VC in that there is no dilution to shareholdings and the company will obtain expertise and connections. However, venture debt would still require the debt to be fixed to the company’s assets, possibly require personal guarantees and will require the company to make regular repayments plus interest.

Option 2: Venture Capital/Equity Finance

First utilised in what was not yet known as Silicon Valley in the late 1950s/early 1960s, VC is characterised by the provision of money in exchange for a percentage of the company’s shares on a preferred basis, rather than common stock, so as to protect the investor during insolvency.

The very first issue to overcome in relation to VC is the fact that shares will be issued. This will require the company to follow company procedure, as set out in the start up’s articles of association/constitution, and is a more complex process than obtaining a bank loan. Once shares are issued, existing shareholdings will be diluted and the Investment Agreement (the ‘Agreement’) would import controls necessary to protect the VC investment. For example, the investor would gain consent rights so that the company must seek approval for any significant decisions, and the Agreement would also grant rights to board representation and impose restrictive covenants on the company so as to reduce the risk. In addition to a restriction on the dilution of the VC firm’s shares, the Agreement would also typically include ratchet provisions that scale up the investor’s acquired equity in the event that targets are not achieved. Entrepreneurs must therefore carefully compare the terms of the Agreement against the capital being receive and make a decision on whether or not the terms are proportionate to the level of funding.

Despite these drawbacks, VC investment would present the company with a much better prospect of growth than a bank loan. The main benefit is that the start up will obtain the expertise and industry connections required to expand the company. This is why Don Valentine in the documentary ‘Something Ventured’ states that his approach to investments was “[i]s our Rolodex strong enough to help these people?” The support that a start up will receive is not offered by a bank and is a key factor that will drive the growth of the company.

Also in contrast to a bank loan is the fact that there are no repayment obligations. Although VC investors will join as shareholders and receive dividends, a regular income stream is not the priority. Instead, the aim of VC is to create a capital gain upon an exit from the company. This therefore minimizes the short term pressure that the start up will face and gives the business time to maximise success.

The Double Edged Sword of Venture Capital

Since VC is provided in exchange for shares, the risk is shared which alleviates some pressure from the pre-existing shareholders’ shoulders. The investor will therefore also have an interest in the company’s success and strive to make it as profitable as possible. However,  at Internet Week 2015, Gary Vaynerchuk perfectly summarised the double edged sword of VC:

“A VC’s playing a game of just one “unicorn” and it pays the whole game… VCs are pushing all these young entrepreneurs in the right direction because if one breaks who gives a **** if you failed on the other hundred, your [return on investment] is so intense on that one Uber, on that one Facebook, that it makes the math work… They’re managing a portfolio and so they’re giving the advice that’s best in their interest…”

The problem is therefore that, although the overall aim for both the start up and the investor is to build growth, the way in which the mission is completed can create tension between the parties. It is because of this that entrepreneurs must ‘separate advice that’s in someone else’s best interest and take the advice that’s in their best interest’, and carefully vet potential VC investors.

Another issue that needs to be considered when evaluating VC investment is the current culture of companies celebrating giving away equity in order to achieve a ‘milestone’. The start up needs to carefully evaluate whether external investment is truly needed or whether it can make a go of the venture on its own. For example, Vaynerchuk is attracted to ‘building from zero’ instead of unnecessary VC investment because it teaches you core principles of business. He states that the ‘lack of patience… will be the death to 95% of the businesses that are in play right now. Lack of patience is the vulnerability in the marketplace right now.’ These ideas, along with the notions of ‘learning to fail’ and ‘learning through failure’, perhaps sound romantic, but they do need to be taken into account when deciding whether or not to issue equity.

Option 3: Convertible Debt/Hybrid Financing 

This form of financing is a hybrid of options 1 and 2 because it starts out as a loan but converts into equity capital after a certain period of time or upon the occurrence/non-occurrence of a particular event. Obtaining convertible debt is a much cheaper and quicker process than issuing shares, but companies need to be aware that an investor will often set the term of the loan so that it expires after the next round of financing. In such a case, if the loan expires prior to further funding, the investor will require the money to be repaid or the loan will convert into equity – the former has the potential to require the business to be sold at a distressed price so as to settle the debt, and the latter will dilute shareholdings.

Conclusion

Whichever method of financing is chosen, the company needs to evaluate the impact of external investment on the business. External financing must be in the business’ best interests and it must not be obtained purely for the purposes of any internal gratification of reaching a milestone. Additionally, while VC is the most popular route, entrepreneurs need to be wary that it is a double edged sword and not get caught in the excitement of VC investment.