When raising money as an entrepreneur, deciding on the type of capital to use is one of the first and most crucial decisions you need to make. Equity, debt (loans), grant, and mezzanine (a combination of equity and debt) are the four types of capital covered in this guide. Most African entrepreneurs, as well as those in other parts of the world, can use one or a combination of these four types of capital.
Starting with grant capital since it is the easiest to understand. Grant refers to any funding source that provides an entrepreneur with funds without imposing any financial claim in return. Donations from crowdfunding campaigns, awards and prizes from start-up competitions as well as grants given by international and local organisations are some typical examples of this type of funding.
Grants that businesses get from organisations are usually between thousands and millions of dollars. However, they are often less than $100,000 in most cases, and as such, they are most suitable for new entrepreneurs and start-ups, or already established entrepreneurs who need more capital to run their businesses.
When giving out grants, organisations generally ask interested start-ups to submit their applications. Interested start-ups are expected to describe how their idea or business applies to the grant. The winner or winners are then chosen, from an initial list of several finalists, by a judging panel.
Although no form of financial return (such as a promise to pay back or a stake in the business) is expected from grants given by organisations, a follow-up check is often carried out by the organisations during and after giving out funds to the grantees to ensure they use it for the intended purpose. To make sure the recipient uses the grant as planned, grant payments are sometimes released in stages by the organisations.
→ Funders have little control over the business operations
→ It has no payback interest or equity, as the money is free
→ The application takes a long time to process
→ It provides no mentorship or networks apart from the funding
→ It sometimes requires a lot of post-funding reporting
→ Grant recipients may not be allowed to change their business strategy
A very common way of getting funding is through debt financing. This simply refers to the process whereby a financial institution gives an entrepreneur a loan at a particular interest rate, which the entrepreneur is expected to pay back within a stipulated time frame.
Several types of funders such as impact investors, microfinance institutions, peer-to-peer crowdfunding, development finance institutions, mobile and online lenders as well as others can provide debt funding.
Debt financing is most suitable for well-established entrepreneurs with a steady cash flow, since parts of the interest on the loans are usually paid monthly. There are two factors that determine the amount of money that can be borrowed by an entrepreneur. The first factor is the type of organisation from which the entrepreneur is seeking funding. For instance, a mobile lender platform offers a smaller loan than an impact investor or bank. The second factor is the extent of debt that the entrepreneur can bear. For example, more established entrepreneurs with healthy cash flows can have access to huge amounts of loans, while new entrepreneurs with no customers and products will often get smaller amounts of loans.
Entrepreneurs need to provide financial projections and a business plan before they can apply for a loan. A description of how they intend to pay back the debt is contained in these documents.
The tenor (i.e., the time frame for repaying the loan) and the interest rate are the two major aspects that borrowers consider when applying for a loan. Generally, the interest rates depend on the riskiness of the borrower. In other words, a lender is likely to impose a higher interest rate on a loan, as a price for taking additional risk, if the borrower is less likely to repay the loan. The rates also depend on the current interest rates of the country’s central bank. This is justified by the fact that no bank will want to lend money to a riskier entity at a rate lower than that of the central bank’s rate, since lending money to the government through bonds is almost risk-free.
Unlike equity investment, debt financing is a safe investment for lenders because assets owned by the business are claimed by the lenders when the owner of the business is unable to repay the loan.
→ The company doesn’t need to give up its ownership
→ Collaterals are often required by lenders
→ Cash-strapped entrepreneurs may have difficulty in paying interest
In equity funding, a company gives an investor a part of its shares in exchange for the investor’s fund. This implies that the business is partly owned by the investor.
The entrepreneur’s needs determine the amount of money involved in equity investment. It ranges from small amounts of capital (less than $100,000), provided by angel investors or family members, to huge funds (millions of dollars) provided by private equity firms.
Equity investors thoroughly screen companies through a process known as due diligence before they make an investment. During the screening process, they examine the ability of a start-up to yield huge profits in the future. Equity investors do not focus on the steady cash flow of a business, but rather on its growth potential because they know that most start-ups do not succeed in the long run. While equity investors are scared of investing in traditional mortar and brick businesses, they readily invest in technology start-ups because these businesses require relatively small capitals for their operations.
Generally, entrepreneurs need to provide a detailed business plan as well as good financial models that show their proposed marketing approach, competitor analysis, growth potentials and other market analyses, before they can receive equity investment.
From an investor’s point of view, the riskiest type of funding is equity because investors can lose their whole investment if the business fails.
→ There is no payment of interest
→ Investors can provide useful incentives such as connections, advice and mentorship
→ There might be conflict in time horizons, as investors may want to invest their funds for a short period of time, while companies may be planning to utilize the funds for the long term
→ Entrepreneurs may have less control over their business
As the name suggests, Mezzanine is a mix financing instrument that combines both aspects of debt and equity funding. It is commonly used by some investors due to its ability to provide returns to investors when a start-up becomes highly successful and, at the same time, protect them from certain risk involved with equity investment.
Mezzanine funding comes in different types, which include equity kickers, convertible notes, and subordinated debt. These types of mezzanine funding are usually combined into one single financing instrument. In mezzanine financing, the ratio of equity to debt depends on the risk appetite of the investor.
New start-ups in Kenya mostly use convertible notes (which are sometimes called convertible debt) as a source of funding. Due to several reasons, entrepreneurs and investors may choose convertible notes over equity or debt. Firstly, convertible notes allow investors to recover their investment when the fund is used in a fraudulent manner, as they are entitled to pursue the issued debt which is usually at 0% rate. Secondly, it reduces the share dilution of entrepreneurs who are expecting the equity value of their company to increase in the future. With the introduction of institutional investors, delay in valuation can benefit both entrepreneurs and investors. It may be quite difficult to really understand the concept of convertible notes, but the major thing to bear in mind is that the funds an investor gives as debt will be treated as equity after a particular period of time specified in the contract. The number of shares that is equivalent to the invested funds depends on the share price.
Here is a simple illustration on convertible notes. If an investor and a founder strike a bargain of $100,000 convertible debt at a rate of 10%, it means that the early investor can buy shares at 90% of their current value when the company raises funds in the next round. For example, the investor can buy a unit of the shares for $0.90 if each share is valued at $1 in the next round. This implies that the early investor can actually buy 111,111.1 shares with the $100,000 convertible debt, instead of 100,000 shares at $1 each.
The investor and the entrepreneur also need to agree on other clauses such as a valuation cap. This guide does not contain a detailed overview of convertible notes, as this is beyond its scope. Nevertheless, there are a lot of books, online resources and business professionals that can help shed more light on this.
→ It provides better protection for investors than equity
→ It can delay a company’s valuation, which is not precise in companies at their early stage
→ Regular payments may be made to funders by entrepreneurs
→ Its implementation is expensive and complex
– What you need to do before fundraising
– Overview of 10 investor types
– Mobile Lenders
– Accelerators & Incubators
– Angel Investor Networks
– Impact Investors
– Public Funds
– Venture Capital Funds
– Private Equity Funds
– Funding Cycles & Stages
– The Come-Up
– When to Fundraise
– Get Your Pitch Deck Ready
– V is for Valuation