Compared to a decade ago, the funding landscape for tech companies has changed dramatically. Where venture capital and interest-based loans were the historical status quo for businesses, a wave of alternative finance options have arrived on the scene.
Whether it’s revenue-based financing or crowdfunding platforms, you have more liberty than ever to find the funding that best fits your needs. Funding for tech companies is no longer one-size-fits-all.
So today, we’re going to check out five alternatives to traditional venture capital and interest-based debt financing. Understanding what new alternatives exist, their advantages and disadvantages, are key to successfully navigating fundraising in 2021 and beyond. We hope this will help you, founders, get exactly what you want out of raising capital for your tech business.
Before we dive straight into the realm of alternative finance though, let’s first fully grasp when venture capital shines.
Post-VC era? Definitely not.
Though alternative financing options have grown in popularity, this doesn’t mean that we are entering a post-venture capital era in tech. There’s absolutely no chance of that happening because venture capital continues to thrive in certain circumstances.
As the king of high risk, high return funding, venture capital continues to have a very strong fit at the earliest stages of tech entrepreneurship.
Specifically for businesses in the pre-revenue stage, many forms of alternative finance simply won’t get you as far as venture capital. Essentially, exchanging equity for capital protects founders from signing unattractive personal guarantees that often comes with interest-based debt financing. This allows founders to walk away from failed ventures without losing private wealth – a huge win.
To offset the risk of failure, equity sold at the earliest stages of a company has (theoretically) unlimited upside. $25,000 checks can turn into $100m returns for investors, as was the case with a slew of early stage investors in Coinbase’s recent IPO or notorious first checks into Facebook.
When alternatives might make sense?
If you’re a later stage tech business with established product-market fit and growth, then things can be a bit different. And this is where alternative finance solutions are finding their place in the market.
When growth costs are known, selling equity can become extremely expensive for you and your co-founders. This is where calculating the cost of capital is critical for you to understand how venture capital stacks up against other alternative financing options. Stay tuned, we’ll break down how we think of the cost of capital calculations at the end of this article. But first, let’s check out what alternatives have burst onto the scene in recent years and when each might be right for you.
Though crowdfunding platforms like Kickstarter have been around since the late 2000s, the crowdfunding industry has become much larger and more specialized than it was in its early days. Then, the status quo was always that tech companies create tangible, physical products that they could then ship directly to their earliest financial supporters. There was no selling of equity in the company, nor was there any of the common stipulations that come with debt. Now, the tides have changed and crowdfunding can include equity-based and cryptocurrency approaches to financing the launch of a new tech company.
With equity-based crowdfunding platforms like Seedrs or Republic, the realm of crowdfunding is no longer blocked off to software companies. If you are not looped into pre-existing relations with venture capital investors, these platforms can be a convenient way to pursue equity-based fundraising. When done successfully, crowdfunding platforms can help you generate more inbound leads than all of the outbound, cold-emailing that often comes with traditional venture capital fundraising.
That said, success in crowdfunding isn’t a simple task. It requires a full-out marketing and PR blitz from you and your team to push your name and product to potential investors. This can be equally cost- and time-intensive as other forms of fundraising.
Out of all the alternative finance options, grants hold a very special place. That’s because grants are non-dilutive and do not require repayment. That’s right – grants are effectively free money if your business meets the application requirements. Venture capital and interest-based debt simply cannot compete on those terms. Whether it’s through Small Business Innovation Research (SBIR), commercial organizations (like the Fedex Small Business Grant Content), or other state entities, grants typically offer small to medium size lump-sum payments to tech companies.
Though there are no better terms for capital than a grant, there are plenty of challenges that you will have to overcome to acquire this form of alternative funding. Primarily, meeting all the application criteria and going through the often tedious grant writing process are both no easy tasks.
And like all other highly competitive forms of funding, there is no guarantee that your hard work will pay off at the end of the application process. If you pursue this form of alternative funding and find success though, then you’ll have secured the lowest cost capital to you as a founder.
Friends and family funding
Compared to every other form of financing tech companies, raising capital from friends and family tends to be a much more casual and fast process for founders. This approach can be fast because you have history with these potential investors – you’re already an insider. Communication often occurs without many hiccups, getting to a yes or no is usually fast, both of which make this type of funding preferable for many entrepreneurs.
There are a few things to bear in mind though here. Friends and family rounds are generally reserved for the first investments in the company, where check sizes are “relatively” small. This can range anywhere from $1,000 to $25,000 per investor, depending on how deep the pockets of your network are. For companies trying to raise a full seed or series A round (between $1-10m), you will likely run out of potential friends and family investors much faster than the funding adds up. That’s why this approach to financing your tech company makes the most sense at the pre-seed stage, where simply getting a little bit of capital will help create your MVP and acquire initial users.
It’s often left unsaid, but there’s another major aspect of friends and family rounds – you need to already have affluent connections to make it work. And that’s simply not feasible for every founder.
As alternatives to venture capital and traditional bank loans have gained popularity over the last 5+ years, so has a return to the “oldest” form of building a business: bootstrapping.
More and more SaaS companies have bootstrapped successfully to $1-10m+ ARR, etching out space for what some venture capital investors think of as “Non-VC compatible” SaaS. We’ve also seen some notable venture-funded SaaS businesses revert back to full private ownership, effectively bootstrapping, like Wistia, Buffer, and Sparktoro.
The journey can be notably more difficult this way, since speed to get to revenues and profits is paramount in success. It’s not enough to simply see cash flow here, you need to push your company to create profits over a fairly quick period of time – usually within 1-2 years. The imperative for immediate profitability is notably less for many venture-funded startups, where growth generally serves as the top priority and monetization comes after the product, business model, and sales strategy are all settled.
Beyond the immediate challenge of generating revenues, bootstrapping has serious advantages. You never have to worry about the fundraising process taking you away from duties to your team and customer, and moreover, you can maintain ownership over your business. Of course, bootstrapped companies that find sustainable growth or larger opportunities to pursue can always seek outside investment later. The optionality to stay fully founder-owned, sell some equity, take on an interest-based loan, receive revenue-based financing, or any support is always in your hands.
Only in the last 5 years has revenue-based financing burst onto the scene in tech. For SaaS founders that are beyond product-market fit, generating revenue, and seeing modest to high growth, revenue-based financing offers a middle ground funding option between equity investing and interest-based bank loans.
Unlike venture capital investments where there’s an imperative to exit or go public to generate returns, returns are determined in advance with each funding agreement. Though there are no industry-wide standards in the revenue-based funding market, returns on investment tend to be capped at 1.2-2.5x. As is the case with us, our returns are capped between 1.2 and 1.9x. And compared to typical interest-based, fixed payment loans, revenue-based financing offers a flexible repayment alternative.
Flexible royalty payments allow your repayments to scale with your cash flow. So in the case that your revenues dip momentarily, you don’t have to worry about a fixed payment cutting deep into your cash reserves. This ensures that you never are prohibited from reinvesting cash or covering basic operating costs.
Overall, revenue-based financing has found traction in tech recently because it tends to be more inclusive than typical venture capital investment targets. The venture capital imperative for large markets and extremely-high growth rates means only hyperscaling companies fit the profile.
Calculating the cost of capital
Across all of the alternative funding options covered above, it can be a challenge for you to understand how the costs of capital compare. How does one even begin to compare venture capital to revenue-based financing or equity crowdfunding platforms? Well we have a simple formula to calculate the cost of capital. It’s called an annualized cost percentage (ACP), and it’s a simple equation to help you think about different forms of funding in apples-to-apples terms.
This simple formula is a great way to create an accurate comparison to understand how much each form of financing will cost you on an annual basis. Though not a perfect calculator, this framework will give you a much better sense of how all your options stack up against each other and most importantly, how much each will impact you and your business in years to come.
Choosing the right funding option is all about your priorities
At Novel, we’ve been in the trenches. Each member of our team has first-hand experience with early-stage technology companies and the challenges entrepreneurs face. That means, we know that choosing the right funding solution for your SaaS business is never easy.
As we do with all the founders in our portfolio, we’re here to help and always happy to connect with you to discuss what makes the most sense for your needs. If you’re thinking through funding options for your SaaS business, then fill out the form on our homepage. We’d love to set up a call!