Bridging The Gap: Exploring Hybrid Funding Models For Early-Stage Startups

Exploring hybrid funding models for early-stage startups is crucial for their sustainability and growth. Typically, founders rely on capital sources like bootstrapping and friends and family loans for starters. Then, they move on to applying for government grants and approaching investors.

However, accessing conventional funding can be very challenging when the startup is in its initial setup stages. Non-availability of assets and low valuation could make getting large amounts of capital harder.

Further, investors could be more interested in supporting specific verticals only and unwilling to explore unusual concepts as funding candidates.

Hybrid funding models are an excellent option for founders since they combine the best of both worlds. They offer the advantages of traditional funding models with innovative financial instruments.

You can negotiate terms and conditions aligning with your startup’s needs. Investors could also be willing to accept these options over commonly offered stock and equity.

Understanding Hybrid Funding Models for Early-Stage Startups

Hybrid financial instruments include features of both equity and debt by choosing a middle ground to offer multiple advantages. These benefits work for both founders and investors by securing their interests.

Entrepreneurs needing capital for their fledgling ventures can go with equity or debt financing. Debt financing is typically a loan you’ll repay along with interest per pre-determined terms and conditions. On the other hand, equity does not carry interest, nor do you need to repay it.

This is, in essence, ownership funding and will remain invested in the company until the owner exits the company. Or sells out their shares back to you or third parties. When comparing the two options, debt financing carries low returns but has low risk.

Equity financing has the potential to yield rich returns as the startup grows and values over time. At the same time, it carries a higher risk of losses if the company fails. If that happens, investors can only reclaim assets in proportion to the money they invested.

In the case of equity financing, investors can get seats on the board and a say in the decision-making. Per their investment stake, they can have management rights. Debt financiers, however, have no voting rights in the company’s operations.

Hybrid financing models fall somewhere in between on the financial spectrum, offering an array of benefits. These pros include and are not limited to tax breaks and regulatory benefits. And extend to the cash and assets associated with the equity and debt capital investors offer to entrepreneurs.

As a rule, debt financing is unsuitable for early-stage startups because they need higher amounts. At this stage, companies are not yet stable or demonstrate impressive metrics on their pitch decks. So, exploring hybrid models is a better option.

Hybrid Financial Instruments for Early-Stage Startups

Several hybrid funding models for early-stage startups are now available for founders to choose from. You’ll pick the options that best align with your funding needs. Here’s a quick look:

Compulsory Convertible Debentures (CCD)

Compulsory convertible debentures combine features of equity and debt financing. Investors can provide capital via these securities on condition that the debentures must convert into equity after a predetermined interval.

These financial instruments are suitable for startups that cannot be valued using traditional methods. Investors can expect to receive interest during the holding period, and conversion ratios are outlined in the investment agreement.

However, dividend payouts to CCD are done after fixed-income holders receive payments.

Investors can claim preferential treatment if the startup liquidates before the CCD maturity. On the flip side, startups must present a valuation certificate to issue CCDs, which takes away from the benefits of deferred valuation.

Compulsory Convertible Preference Shares (CCPS)

Compulsory convertible preference shares (CCPS) are a form of equity financing and one of the most popular hybrid funding models. CCPS award preference over common stock. This means that, in the event the startup liquidates, investors get back their capital on priority.

CCPS also earn dividends during their holding periods, with pre-determined maturity deadlines, similar to CCDs. Further, dividend payouts to CCPS are done before conventional stock equity.

Share Warrants

Investors can choose to purchase warrants in the company that carry the right to purchase shares in the future. Warrants carry conditions like a pre-determined price at which investors can purchase stock.

The terms may also set a time interval within which they can complete the purchase or a specific date.

Founders leverage these hybrid funding instruments when raising money in the initial stages. Investors can convert warrants into equity shares at a 20% discount during the next funding round. That is if the rounds occur within a specific period or valuation limit.

Venture debt firms may prefer warrants since they get the right to purchase equity in the future. However, this is not an obligation and is more economical than equity shares. From the founder’s perspective, warrants carry a higher risk since not all may convert into equity.

Convertible Notes

Convertible notes work similarly to compulsory convertible preference shares (CCPS), but with a key difference. The notes convert into equity at the owner’s discretion. Conversion notes are a quick and easy way to raise capital for entrepreneurs looking for hybrid funding models for early-stage startups.

Startups with low valuation can issue these notes that convert into equity shares according to certain conditions. Convertible notes are essentially low and carry interest. However, this interest adds up to the principal, and investors can purchase stock equivalent to the total amount.

However, interest rates are typically calculated per ongoing rates and are not exceptionally high. Since investors provided funding to the startup in its early stages, they can purchase equity at discounted rates. This discount covers some of the risks they took in investing in the company.

Convertible notes are issued with pre-determined conditions, such as a fixed maturity date, when the notes automatically convert into stock. Investors may also have the option of purchasing shares when the startup reaches a specific valuation limit.

These hybrid funding models come with some amount of risk for founders since investors can opt not to convert. They may choose to delay until the valuation is higher and the conversion can yield higher stock.

Simple Agreement for Future Equity (SAFE)

Simple Agreement for Future Equity or SAFEs work similarly to convertible notes and are an excellent hybrid funding strategy. Investors can purchase SAFEs with the right to convert them into equity during the next funding round.

They can avail of discounted rates to offset some of the risks they took when investing in a startup. The terms and conditions can also include a cap table.

However, unlike convertible notes, SAFEs don’t have maturity dates. Investors must wait for the next funding round, which can occur at 12 months or six years.

SAFEs are not debt instruments, which means that if the startup fails, repayments are not a priority. Investors can only regain the liquidity available after distributing it to other stakeholders. Of course, they do get priority over the entrepreneur’s stake.

Keep in mind that in fundraising, storytelling is everything. In this regard, for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend Peter Thiel (see it here), which I recently covered. Thiel was the first angel investor on Facebook, with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.

Why Hybrid Funding Models are Beneficial for Investors

Since investors offer a larger quantum of funding, their risk factor is also higher. Hybrid models allow them to diversify the risk across multiple financial products and thus lower their exposure to risk. Essentially, the risk is spread out across several potential failure points.

For instance, a venture capitalist could invest in equity in one company and enter into a revenue-share agreement with another. Even if one investment option fails, the other may run up high growth and profits. As a result, the portfolio remains balanced.

Hybrid financial instruments have several terms and conditions that can secure the investment. Or, at least offset some of the risks that investors must carry.

Why Hybrid Funding is Beneficial for Startups

As mentioned earlier, accessing capital for startups is challenging because they lack assets to offer as collateral. Their valuations are low, and many operate in capital-intensive sectors that require high initial investment before demonstrating results.

A good option is to source funding from multiple sources. For instance, startups with disruptive ideas can apply for government grants to develop the initial prototype or MVP. Next, they can run an online crowdfunding campaign to start production, a debt-based solution.

Offering samples in exchange for funding is a great solution to create hype for the product. And test it on actual consumers. Using the feedback to improve product features is another win.

Once the startup is stable and generating revenues, you can consider raising funds from VCs and angels and transitioning to equity-based financing.

Multiple hybrid funding models for early-stage startups allow founders to avoid relying on a single investor. They get access to a bigger pool of investors. Adopting this method also enables them to be agile and pivot to other investors if funding is in short supply.

The best advantage is that showing funding from multiple investors in the cap table and balance sheet is beneficial.

Companies leveraging this model will have a balance of equity and debt. They can align the structure according to the industry benchmarks and growth trajectory.

Each investor brings positives to the startup. Crowdfunding is a great option for accessing capital from small investors. But, campaigns can be time-consuming. You can issue SAFEs and CCDS in the interim.

Influence on Credibility, Growth, and Exit

Hybrid funding models for early-stage startups bring diversity to the cap table and balance sheet, which raises the startup’s credibility. It can demonstrate extensive backing. Like, for example, the government, the crowd, and later, VCs and angels. Raising further rounds will be easier.

A startup that has successfully landed a government grant will certainly attract attention from angels and VCs. Then again, running a successful crowdfunding campaign demonstrated an established customer base, which points to traction.

Using a blend of different funding sources promotes growth. The startup does not need to wait for a particular class of investors to inject capital for growth. Different exit terms and conditions also mean the startup will not have to deal with an unexpected investor exodus.

You’ll have a fair overview of when holding periods are expected to end. This predictability allows you to plan for further funding to replace exiting investors.

Raising funding for early-stage startups is very challenging, and hybrid models are a great option. But what to do if your investor outreach is not working? Check out this video, where I have answered your questions.

Downsides of Hybrid Models

From the startup’s perspective, having multiple investors also means extensive management. You’ll maintain records and entries in the balance sheet of the different investors, interest payable, and exit terms.

This factor can lead to an investment of time and sweat equity, typically in short supply for founders.

You may also need to retain the services of accountants and legal advisors, which can drain your resources unnecessarily. The most crucial downside to consider is that different instruments have legal and regulatory compliance requirements.

You’ll have to stay on top of the complexities and manage the documentation.

Although having multiple investors can lend credibility, it can also be a downside. You may have to deal with a conflict of interest with different stakeholders making demands.

The Takeaway!

When you start to research hybrid funding models for early-stage startups, you’ll come across an array of options. You can get your startup off the ground by using a blend of hybrid financial products. Don’t let a lack of funding get in the way of exploring a disruptive idea that could turn into a unicorn.

At the same time, you’ll select the funding options that align with your business needs, not just for the present but also for the future. Put together a well-designed game plan and then work the available funding options into the plan.

That’s how you can build a robust foundation for the business that will ensure stability and scalability. Weigh the pros and cons of hybrid funding models for early-stage startups carefully. Some could be advantageous for the investors; others may better serve the founders’ interests.

Whatever your choices, consider the possibility of aggressive negotiations and designing an agreement with favorable terms and conditions. However, you’ll also ensure security and profitability for investors to get their backing.

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