Early stage companies are financed with equity, period.
If you are an entrepreneur looking to fund an early stage company, don’t expect to do so with unsecured debt. Early stage funders want to realize at least a 10-to-1 return on their money (a 100-to-1 return is a home run), and equity is the only way to achieve that.
A loan would merely repay the money with comparatively modest returns, while keeping the big upside potential for the entrepreneur. Here are three misconceptions about debt and start-up funding.
* We’ll borrow start-up funds from the bank.
Most banks have greatly reduced lending on anything but secured assets, such as real estate, accounts receivables and inventory. They are not doing much cash flow lending, even for established clients.
A start-up has virtually no chance of getting an unsecured bank loan. It doesn’t have cash flow, and even if it did, it would be a very high risk proposition.
If you personally sign for the debt or put up collateral, you, not your company, is assuming the debt. Don’t fool yourself into thinking your company received funds based on its prospect when it is really a second mortgage on your house that secures the loan.
* We’ll get a bridge loan until we get equity.
A bridge loan is a short-term vehicle which can be used when the borrower needs additional time before obtaining permanent financing.
While it might sound like an ideal source of funds, it is only available to operating companies that are certain to soon receive permanent financing. As entrepreneurs trying to raise capital for a start-up know, success is anything but certain.
Without certainty, there is no event being “bridged to,” so this form of funding is not applicable.
* We’ll attract investors to lend us money by paying them a premium interest rate.
Some entrepreneurs do get FF&F (friends, families, and fools) to lend modest amounts. But these loans are based on the lenders’ relationships with the entrepreneur, not the company’s prospects.
They trust the entrepreneur to repay the loan, even if the company is not successful or if the loan is made for family or other noneconomic reasons.
Capital is an essential partner for the entrepreneur, so don’t create a roadblock by trying to use some imaginative form of debt that pays interest, royalties or percent of profits in place of equity. Organized capital simply won’t do the deal.
If you have a world-class deal, money is available, but only for an equity stake. Erwin Bruder ([email protected]) is chief economist & managing director of emerging enterprises at Prim Capital Corp. Reach him at (216) 830-1111, ext. 2220.