When thinking about ways to fund your business without giving up equity it is critical to understand the pitfalls and rewards that come with it.
In this article, we are going to explore how to fund a start-up through non-dilutive financing, while outlining the advantages and disadvantages of doing so.
What is Non-Dilutive Funding?
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The classic approach to funding a start-up is through dilutive fundraising. This is where you offer a percentage stake in your business for an agreed amount of money. You receive the investment necessary to reach your goals, and the investor owns a part of the startup which will become more valuable as the business matures.
However, another way to fund a start-up is through non-dilutive funding.
Non-dilutive funding is a type of financing where you do not give away any equity percentage in your business. In short, the business receives funds to reach its goals without selling sections of itself to outside investor ownership.
Why Non-Dilutive Funding?
Most successful investors will look to own a part of a business in which they are investing. This is not always preferential to start-up entrepreneurs. There are a number of reasons why startup founders choose to use non-dilutive investment instead.
In some circumstances, a start-up founder will put the future value of their business at a higher level than potential investors. For this reason, investors may not be able to reach an agreement with the founder over how much equity they should receive for their investment.
In this scenario, the entrepreneur simply believes their business is worth more than the investors.
Another scenario is that a start-up founder feels so passionately connected to their business that they do not want to share it with anyone else. Likewise, they may not wish to give any control over to 3rd parties. For this reason, they will not favor dilutive fundraising.
Finally, dilutive fundraising requires interest from investors. Sometimes, no matter how forward-thinking a start-up concept is, investors fail to see the potential. In this situation, no dilutive investment offers are made. This means the start-up founder has to go it alone and find non-dilutive means to fund their start-up.
Non-Dilutive Ways to Fund a Startup
There are several ways to fund your business without giving up equity. These include loans, grants, license agreements, royalty financing, vouchers, and tax credits. Let’s look at each of these.
1. Loan Agreements
Loan agreements are pretty straightforward and one of the best ways to fund your business without giving up equity. This is simply a credit line a bank or other financial institution offers a start-up founder.
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Such a loan can be secured against personal assets or assets the business owns. Alternatively, it may be an unsecured loan based on the efficacy of the business plan or the start-up founder’s credit history.
The lender makes a profit from the interest a startup entrepreneur must payback on the loan, while the entrepreneur secures the necessary finances to get his or her business to the next fundraising milestone.
I always stress this point in my articles that you should never put yourself in financial dire straits for a business idea. If you or your business is not going to be able to pay a loan back, then it’s not a loan worth having.
2. Grants as Non-Dilutive Financing
Another one of the ways to fund your business without giving up equity is to apply for a business grant. These grants often do not need to be repaid. They exist to help entrepreneurs get their businesses on their feet.
These grants are offered by philanthropists, government programs, research and academic institutions, and other business organizations
The application process is usually a lengthy one, grants are often green-lit when a business plan with a sound concept and a realistic outlook is used. These grants usually only fund new businesses to reach a specific milestone.
Those supplying such finances will sometimes require regular financial reports on how the money is being used, which will directly affect whether more financing will be released at a later date.
3. License Agreements
In some situations, start-up founders can access non-dilutive financing by signing a license agreement with an existing business. This could be to secure funds in exchange for incorporating the existing business’s brand, product, or service alongside what the start-up business is producing.
Alternatively, a license agreement can grant another company the use of a start-up brand or IP for a monthly or quarterly fee.
4. Royalty Financing
An alternative form of non-dilutive fundraising involves royalty financing. This is where investors purchase a percentage of future revenue, rather than an equity stake in the startup.
Royalty financing can include a percentage of revenue generated by the entire business or just by a single product/service. This way, the startup founder doesn’t give up any control or ownership but does get the investment required.
Though this will impact revenue, it can open up networking opportunities as investors will want your business to generate significant revenue. This means they are usually willing to share access to other business partners and assets to help the startup reach its potential.
Vouchers are usually offered by governments, though they can sometimes be provided by other business organizations. While vouchers have no cash value, they do allow a start-up business to access something of value with the voucher.
This could be access to facilities, equipment, services, or even expertise.
By using vouchers, this nullifies the overheads which would otherwise be required to access the same goods or services. It’s a form of indirect funding.
6. Tax Credits
Finally, depending on the region in which a start-up is operating, there may be access to tax credits. A tax credit essentially reduces the taxes required for a business. This reduces overheads once more but is usually only applicable when funds have already been spent.
7. Convertible notes, SAFE notes, etc
A convertible note is a short term debt agreement with an investor. Instead of accepting investment for immediate equity, the investment is treated like any other loan.
However, instead of paying back the loan plus interest with cash over time, the investor receives a guarantee of stock in the company to that valuation.
This transaction is fully completed in the next fundraising round. For example, an investor provides a loan of $100,000 to a start-up. A convertible note agreement is signed for that amount. Once the start-up has reached its initial goals and requires further investment, other investors are attracted to the business.
At this stage, as new investment is brought in, the initial investor receives $100,000 worth of stock in the business. On top of this, more stock is given based on any accrued interest on the loan.
In this way then, convertible notes are usually seen during the earliest stages of start-up development. They are a hybrid of debt and equity where equity is later provided at the same valuation of the principal investment plus any interest accrued.
Advantages of Non-Dilutive Funding
As mentioned previously, non-dilutive funding provides a number of advantages. The most important of these is that a start-up founder does not need to give up any control of their business. With the exception of royalty financing, non-dilutive funding also significantly reduces future payment levels, meaning that the start-up founder receives a larger slice of the profits.
Disadvantages of Non-Dilutive Funding
Disadvantages of non-dilutive funding include having limited access to investor expertise and market contacts. Future investment may also be more difficult to secure as non-dilutive financings, such as loans or other debts, may put off future investors or buyers until the loans are paid back in full.
Also, when applying for grants, loans, vouchers, or tax credits, start-up businesses are often forced to alter their practices and immediate goals to qualify. While this will not dilute the equity of a business, it will dilute the vision of a startup founder.
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