Alternative Funding For Startups

The sheer volume and scale of money in the venture capital space has roughly tripled over the past 15 years. It’s a trend reflective of the growth in the entrepreneurship space overall, as well as the result of an enormous amount of wealth existing in a small slice of the economy. Between 1990 and 2014, the number of university entrepreneurship programs offered has grown from 180 to over 2000 and counting. And as of 2017, the U.S. topped the Global Entrepreneurship Index, with over 27 million Americans starting or running new businesses.

Those 27 million Americans don’t look quite like they did 20 years ago. They’re increasingly Latinx and Asian, with a greater share of women at the helm, in locations across middle America. But the growing diversity of the individuals leading startups has highlighted opportunities to transform approaches to funding. Whether individuals are leading small, local startups or transformative, scalable enterprises, it’s become clear that traditional means of accessing startup capital are limited by gatekeepers and infrastructural flaws.

In some cases, these challenges are the result of the business model—those who came of age during the 2008 recession or are from disadvantaged backgrounds are less likely to build the illiquid models that VCs tend to prefer. In other cases, the challenges stem from the ever-present question of ‘who you know’. Many successful VC-funded startups studied by Bloomberg in 2016 came from a very small group of Ivy-league schools, and an even smaller number of cities. While this approach typically isn’t ill-intended, a growing body of research points to the fact that diversity in firm leadership (particularly venture capital firms, ironically) improves financial performance.

Perhaps most importantly, the issue remains that rural, poor, and minority America is becoming increasingly disadvantaged. Investors’ and entrepreneurs’ obsession with VC, that once-in-a-lifetime savior funding, is the exact funding that’s structurally least likely to meet the challenges facing rural, poor, minority Americans. If anything, it continues to exacerbate issues stemming from a lack of generational property ownership.

Out of all these contributing factors is an emerging demand not only to solve funding problems but also to create new, sustainable funding models.

It’s not enough for today’s entrepreneurs to work within the bounds of the status quo because the creativity that’s leading so many individuals into the entrepreneurship space will also lead them well beyond it. The alternatives presented here are just the first wave of a tide shifting away from current problematic models.

For small, local businesses, entrepreneurs’ best options will most likely be things like Kiva, bank loans, or grants. But for those startups with the opportunity to scale, who require greater up-front funding, whose first choice might be venture capital—what alternatives exist? Three promising solutions have emerged as sustainable, realistic options for today’s startup.

Revenue-Based Financing

One of the most proven alternatives to equity funding is revenue-based financing (RBF). In an RBF approach, investors provide funding to a business in return for a share of ongoing revenue. Typically, payments are made by the startup until the initial funding amount is repaid in addition to a return multiple. Once the initial agreement is fulfilled, an option to buy equity in the business is often available based on the success of the investor/investee relationship to that point.

For entrepreneurs, RBF offers a far more flexible and forgiving payment structure. It’s responsive to the organization’s growth rate and can flex in response to slow seasons or downtimes. In contrast to equity funding, RBF allows business owners to adhere to a strategic approach that values the health of the business above all, with payment to investors as a consistent proportion of the budget but not the primary portion of the budget. RBF also enables entrepreneurs to retain full ownership in their company, which can translate into greater long-term strategic realization or even into other ownership structures, like employee ownership.

The risk associated with investing via revenue-based financing is typically much lower than a venture capital approach, making RBF an attractive alternative to investors as well. The lowered risk is a function of a comparatively predictable repayment schedule that’s not dependent on the sale of the business to make a return. And while returns are also lower, the tradeoff between lower risk for lower reward helps make RBF a competitive investment opportunity. When it comes to knowledge capital, RBF generally does not introduce the same lopsided power dynamics into an investment relationship as equity approaches can, making RBF a more collaborative approach for both investors and entrepreneurs.

Employee Stock Ownership Plans

The introduction of private equity helped blur the lines between ‘ownership’ and ‘funding.’ Employee stock ownership plans (ESOPs) are one of the approaches that qualify both as an ownership structure and as an approach to funding. An ESOP is actually a form of retirement plan as designated by the IRS, allowing companies to distribute ownership of the company internally via stock. The most common way in which ESOPs are used is as part of a succession plan within a privately held company whose owner is relinquishing control, but some high-profile companies like New Belgium Brewing strategically structure the company that way without a change in leadership.

For entrepreneurs, particularly those whose approach is impact-oriented, an ESOP represents a way to put their money where their mouth is. ESOP organizations are not required to function democratically, but dispersed ownership is shown to lead to greater employee drive. ESOPs can also provide equity opportunities to people who may not otherwise be able to access any form of long-term wealth building or ownership. Paul Hudnut of the New Belgium Family Fund offers insight into how ESOP status has shaped New Belgium: “Employee ownership was an important part of how the company was managed and how the culture was built. The leaders are big believers in open-book management and worked really hard on making sure employees had access to financial information, as well as the regular ‘state of the business’ meetings…Plus other aspects, like preferring to promote from within, and having people learn many different aspects of the business.”

From a financial perspective, ESOPs create enormous tax breaks that can improve cash flow for companies, since the company’s equity is essentially housed within a retirement fund. Of course, the cash flow is a huge benefit to the company itself, allowing for more freedom to reinvest in the company, but lenders and investors also find that ESOPs have extremely low default rates and greater financial health as opposed to private equity-owned companies.

Security Token Offerings and Initial Exchange Offerings

As crypto startups continue appearing on the scene, alternative funding options based around cryptocurrency are emerging to meet their unique needs. Early on, initial coin offerings (ICOs) were the funding method of choice for cryptocurrency entrepreneurs, but after an influx of scams and China’s ban of ICOs in 2017, they’ve mostly fallen out of favor. Instead, initial exchange offerings (IEOs) and security token offerings (STOs) have cropped up as the preferred method of raising capital.

In an IEO, similarly to a stock exchange, token issuers pay to list their tokens on a third party exchange platform. Typically, the exchange will conduct an audit of the issuers who apply for the platform to ensure that the offering is technically sound and has potential. Buyers can then purchase tokens via wallets loaded with cryptocurrency.

A security token is “any cryptocurrency that pays dividends, profits, shares or interest or invests in any other asset that also generates profits.” In an STO, security tokens are offered in essentially the same process as an IPO and are SEC-compliant, helping to limit fraud and improve confidence in the offering itself.

In both IEOs and STOs, the process allows cryptocurrency- and blockchain-based startups to securely raise funding while potentially working around the traditional gatekeepers of public offerings. On the other side of the exchange, investors can confidently participate in funding crypto entrepreneurs with little to no barriers to entry.

The Transformation of Entrepreneurial Activity

There are 25 million entrepreneurs in the American economy. They come from all backgrounds and exist in a variety of sectors. It’s an encouraging sign. But what’s concerning is the extent to which the highest-value startups are led by a homogeneous group of individuals. They are overwhelmingly white, male, and highly educated, the byproduct of generational wealth and centuries of infrastructural bias.

The difference between this group and the broader demographic of American entrepreneurs is vivid and begs the question of why the entrepreneurs at the top look so different from those whose enterprises are modestly successful. The answers are complex and stem largely from the unintended consequences of policies and people that favor in-groups. Complexity isn’t unsolvable, though, and it begins with where and how our dollars are invested.

The impact of entrepreneurs on our communities and economies cannot be overstated. A 2014 report from IZA showed that entrepreneurs:

– Boost economic growth with the introduction of innovative technology, products, and services
– Introduce new competition to the marketplace, forcing existing firms to become more competitive
– Provide new jobs both immediately and in the long term
– Raise the overall productivity of firms and economies

And as the profile of the entrepreneur continues to evolve, these benefits will expand into new communities who have historically been excluded from growth like this. The crux of the issue is whether or not new startups will be able to get off the ground—which requires capital. The question of who realistically accesses startup funding via typical approaches is producing concerning answers. To be able to lean into the possibilities of diverse entrepreneurial activity, we must creatively innovate our approach to every point in the startup journey, beginning with funding.

Interested in learning more about Alternatives to Equity? Consider downloading our free resource that provides more information about accessing capital for small businesses and entrepreneurs.

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