What does the term ‘Entrepreneurial Finance’ mean?
Entrepreneurial finance is the study of value and resource allocation, applied to new ventures and the questions which confront all entrepreneurs:
- How much money can be raised?
- How much money should be raised?
- When it should money be raised?
- What sources of funding should be approached?
- What is my startup worth, e.g. what is its value?
- How should funding contracts and exit decisions be structured?
The importance of entrepreneurial finance for your startup
Depending on the industry and your goals you may need to attract money to fully commercialise your idea, but who should you approach? You could consider friends and family, a bank, government grants, angel investors, venture capital funds, an initial public offering (IPO) or some other source of financing. Entrepreneurs face numerous challenges:
- Scepticism towards their business and financial plans,
- Lack of understanding of your business and its potential,
- Requests for large equity stakes,
- Restrictive Term Sheets that spell out the conditions that must be met for that investor before they invest money,
- Performance hurdles that must be met.
Investors will consider the desire to invest in your business and the risk factors associated with the company and the product or service you are supplying. These will include:
- Your competition,
- How you can protect (e.g. Patents, Copyright) your idea,
- Barriers to entry for other companies trying to copy you,
- Market size,
- Political risk (also known as Sovereign Risk) where a government can introduce laws that will affect your business,
- The strength of your team and its ability to carry out the Business Plan
How do I get funding for my entrepreneur idea or project?
The landscape for entrepreneurial finance, however, has changed over the last years. New players such as crowdfunding, accelerators, and family offices have entered the arena, and several new entrepreneurial financing instruments such as peer-to-peer business lending and equity-like mezzanine financing have been introduced. (Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in the company in case of default, generally, after venture capital companies and other senior lenders are paid). In addition governments around the world are increasingly considering these new players and instruments as fundamental mechanisms to alleviate the financing difficulties of entrepreneurial firms.
An overview and comparison of new players in entrepreneurial finance
Venture capital (VC) and business angel (BA) financing have traditionally been advocated as important sources of financing for young innovative firms that find it difficult to access bank or debt finance.
Some of the new sources of finance for entrepreneurs players value not only financial goals but are also interested in non-financial goals such as social goals in case of social venture funds, strategic and technological goals in case of corporate venture capital (CVC) firms, political goals in case of government-sponsored funds, and product-oriented and community-building goals in case of reward-based crowdfunding. In many cases they have different investment approaches, valuation methods or measures, and business models of entrepreneurial financing.
Entrepreneurial finance has changed with the median pre-money valuation of young companies reaching new heights, especially in later-stage financing evidenced by the increasing number of unicorns (private companies valued >1bn US $).
High valuations sound exciting for entrepreneurs however, caution should prevail as a high valuation will put pressure on the founder/s to perform and deliver the results that will give investors a return of several times what they have invested.
The increasing number of startups, new sources of finance, new financial instruments and new ways of valuing a company have combined to make the task of finding the right investor much more difficult.
Some of the new entrants in entrepreneurial finance are shown below:
|New player||Debt or equity||Investment goal||Investment approach||Investment target|
|Active or passive||Non-financial support|
|Accelerators (and incubators)||Depends on type of accelerator/ incubator||Financial, strategic, political (depends on type of accelerator/incubator)||Active||Management support, training, network access||Early stage start-up|
|Angel networks||Equity||Financial||Active||Management support, network access||Early stage start-up|
|· Debt-based||Debt||Financial||Passive||None||Early stage start-up or project|
|· Donation-based||–||Social||Passive||None||Social venture or project|
|· Reward-based||–||Product-related||Passive, Sometimes active||Sometimes product testing||Early stage start-up or project|
|· Equity-based||Equity||Financial||Passive||None||Early stage start-up or project|
|Corporate venture capital (CVC)||Equity||Financial, technological, and strategic||Active||Management support, technology support||Early and later stage start-up|
|Family offices||Equity||Financial||Mostly passive||Little||Later stage start-up|
|Governmental venture capital (GVC)||Debt or equity||Financial and governmental||Mostly passive||Little||Early and later stage start-up|
|IP-based investment funds||–||Financial||Passive||None||Patents|
|IP-backed debt funding||Debt||Financial||Passive||IP-based start-ups and established mid-sized firms|
|Mini bonds||Debt||Financial||Passive||Established mid-sized firms|
|Social venture funds or social venture capital||Debt and equity||Financial and social||Active||Management support, network access||Social ventures|
|University-managed or university-based funds||Mostly equity||Financial and university-related||Active||Management support, network access||Academic and student start-ups|
|Venture debt lenders or funds||Debt||Financial||Passive||None||Later stage start-up|
What are the new sources of entrepreneurial finance?
Accelerators and Incubators
Their objective is to help start-ups with mentorship, advice, network access, and shared resources to grow and become successful. Sometimes they also offer physical space and financial resources, which often comes in the form of equity. They could be a private company or a governmental institution.
These are a group/network of Business Angels (BAs) who invest together in early-stage high growth ventures providing equity and offer management support and network access. As a group, they can provide higher amounts of financing than individual BA investors.
Crowdfunding is where your company is presented on a platform (website) together with your Business Plan summary and other information with the objective of raising money from individuals.
There are four main types of crowdfunding:
- Investment-based (equity) crowdfunding
Equity crowdfunding is a form of financing in which entrepreneurs make an open call to sell a specified amount of equity or bond-like shares in a company on the Internet.
- Reward-based crowdfunding
The most typical reward to backers is the delivery of a (sometime customized) product or service, which makes this type of crowdfunding somehow similar to financial bootstrapping
- Donation-based crowdfunding
Donation-based crowdfunding is used by individuals or non-governmental organizations raising money for a cause.
- Lending-based crowdfunding
Motivations for the crowd to invest are mainly financial as lenders receive fixed interest rates for their loans.
Corporate venture capital (CVC)
Corporate venture capital refers to investments that are made by large, established firms into start-ups or growth firms. Instead of buying a startup they take a stake (shareholding) in innovative young firms, which remain independent, and help them further develop their promising technologies and markets. CVC investors have invested either in later or earlier stage ventures, with their inclination to early stage deals depending on the institutional characteristics of the entrepreneurial finance ecosystem in different countries.
High net-worth families owning large firms increasingly establish their own family offices to manage their wealth. Family offices also invest in growth ventures and have evolved into an important player in the market for entrepreneurial finance.
Governmental Venture Capital (GVC)
Many governments have set up programs that seek to foster VC financing, through the establishment of Governmental Venture Capital (GVC) funds, with the aim to alleviate the financial gap problem as well as at the same time to pursue investments that will yield social payoffs and positive externalities to the society.
IP-based investment funds
IP-based investment funds invest into intellectual property (IP), i.e. patents This way, innovative firms or investors can monetise their IP and use the funds generated to grow their venture. Thus, IP-based investment funds neither provide equity nor debt but acquire intellectual assets of a company.
IP-backed debt funding
IP-backed debt funding allows firms to exploit the economic value of their IP to obtain loans from banks or other financial institutions IP rights can indeed be used as a source of capital collateralised by the stream of revenues deriving from licensing or royalty agreements, which typically involve portfolios of copyrights or patents. Although these instruments involve high structuring costs, they can be an important component in the funding processes of innovative start-ups.
Mini bonds are public bonds issued in special bond segments Mini bonds reflect also the desire by firms to decrease their dependence on bank financing.
Social venture capital funds
Social venture capital funds provide seed-funding to for-profit social enterprise. The funding can come in both debt and equity, and the goal is to achieve a reasonable financial return while also delivering social impact.
University-managed or university-based fund
University-managed or university-based funds have recently been launched, mainly to support ideas from university faculty, staff, and alumni. These funds are important for getting the technology ready to hand it over to a development partner from the private sector.
Venture debt lenders or funds
Venture debt lenders or funds are specialised financial institutions that provide loans to start-ups, but unlike traditional bank, financing do not require securities or positive cash flows from start-ups.
The markets for entrepreneurial finance have changed rapidly over recent years. Many new players have entered the arena including debt venture funds, angel networks, and family offices.
- Only a small fraction of new businesses obtain money from someone who is not a founder of the business. Therefore, unless your business has a lot of assets that can be used as collateral for a loan, or one of a handful of startups that has the super-high growth potential and exit plan to attract accredited angel investors and venture capitalists, seeking outside money is unlikely to be fruitful. You are better off developing a less capital-intensive business model and financing the startup yourself than you are spending your time trying to raise money.
- Your personal credit and personal collateral are important when financing a startup. Only a minority of businesses borrow externally meaning that most of the capital that entrepreneurs borrow is personally borrowed or personally guaranteed.
- You are more likely to get a loan than an equity investment from an outsider, however, most of the companies that get outside financing obtain debt, not equity. Only a tiny percentage of startups are financed by selling equity to accredited angels or venture capitalists. History shows that around 1 percent of companies get their financing from angels or venture capitalists. Therefore, unless your business is the type that angels and venture capitalists look for, you shouldn’t waste your time seeking equity investors.
- Approaching trade creditors is where your odds of obtaining financing for the business itself are highest. Because trade credit is offered by suppliers to help you buy their products, even the newest businesses can obtain it.
In summary, unless you have a rare, super-high-growth business with plans to exit through an initial public offering or acquisition within five to seven years, your best bet is to minimize your capital needs and finance your start-up with your own money, money that you borrow personally, and trade credit.