An entrepreneur needs a roadmap for growing his or her business into the “next big thing,” but the road ahead is a dead-end path without capital funding.
You know—easy, low-stress stuff, right?
Later, after the business has seen some success and is ready to grow, securing financing usually means taking on, a high-interest bank loan with a personal guarantee (like the family home) on the line.
But there are two financing avenues that most growing businesses fail to consider.
- Equity-based financing
- Revenue-based financing
With this article, we’re going to take a closer look at the pros and cons of each of these capital funding paths.
The three most common sources of equity-based financing are: Angel Investors, Private Equity Funds, and Venture Capital Funds.
As private companies start to grow, angel investors can provide funding, usually paired with operational expertise. Angel funding is typically offered by experienced business leaders, so the consulting they bring can be as valuable as the investment itself. An “angel round” typically typically allows the founders to maintain majority control in the company .
When founders need to scale quickly in a competitive, fast-growing industry, venture capital becomes an option. Sometimes it takes millions of dollars to build a team and turbo-charge growth. Venture capital investors can open doors to key business relationships and help steer the direction of the company.
Of course, the founders must be give up a considerable amount of control in the bargain. And if the company’s management makes decisions that end up interfering with growth projections, they may very well get their walking papers, courtesy of the venture capitalists who are now calling the shots. Private equity investors expect to see profits.
Whether funding comes from angels or VCs, business owners who choose to go the equity-based financing route should put it off as long as they can while the business is growing. If you’re in a stronger position in your market, you can get the same investment in exchange for less equity.
Revenue-based financing is a type of funding in which the company shares a percentage of future revenue with investors in exchange for up-front capital. As the leading alternative to equity financing for startups, RBF raises capital quickly, letting you invest in your business without the distraction of fundraising.
This financing option offers an upfront investment with monthly repayments based on a percentage of monthly revenue. There is no equity dilution and, in the long run, the cost of capital is cheaper than equity. RBF requires no personal guarantee, board control or covenants. It’s also usually a fast and easy application and funding process.
Unlike equity financing, revenue-based financing requires active repayment. Although the monthly payment amounts are flexible, it can cause a company to be tight for cash, especially if they are pre or early-revenue.
Startups with high gross margins and subscription-based revenue models, such as SaaS businesses and businesses with steady monthly recurring revenue, are choosing revenue-based funding to scale their operations.
There may be situations where both revenue and equity financing are advisable. For example, if a strategic investor is interested in an equity position but is not capable of fulfilling your funding needs, revenue financing could be used to bridge the gap and reduce your overall total cost of capital.
Straight debt simply isn’t always the best option for sustaining the most dynamic startups. The choice between revenue-based financing and equity-based financing can be tough. Business leaders and founders have to choose the financing structure that’s best for them, since legal, tax and regulatory issues may hang in the balance.