Finding The Right Type Of Capital For Your Business

Editorial

Aug 21

For most entrepreneurs, fundraising to build and scale the business is both a necessity and a pain-point. There might be many challenges in the process of accessing capital, but before you even go into that process, it’s important to identify and seek the right type of capital for your business needs.

It can be tempting to cast a wide net when fundraising. This approach may help you test the waters when you’re unsure of how to proceed, create some visibility, and potentially explore which investors are the right fit. However, for a successful long-term strategy, it would help to have a structured approach to the fundraising process, in order to find potential investors or donors that will provide appropriate support to grow your business. It’s important to note that the most critical aspect here is finding investors or donors whose mandate for funding fits with your requirements. There must be alignment with your social impact, business principles and values, and the direction of growth you want for your business.

Each year, Upaya invites subject matter experts to work with our Accelerator Program participants through a series of hands-on workshops. We were pleased to welcome Priya Shah, Principal at Yunus Social Business Fund to share her knowledge and insights with our 2020 cohort on the topic of “Finding the right capital” for specific business needs.

To understand the different types of capital available, Priya encourages entrepreneurs to ask themselves two key questions: “What stage is your business at?” and “What do you need funds for?” The answers to these questions, Priya explains, will help you identify the type of capital you should be raising – whether that is equity, debt, grants, or even a mix of all 3 – as well as the best way to raise and utilize the funds.

Here are some insights from the session which might help you identify the right type of funds required for your business based on your answers to those key questions.

Equity

This is the right type of capital to raise when you need funds for operational growth, such as technology development, core team hiring, geographic expansion to other locations, etc. Equity capital works well when you are looking to scale and expect your business to grow in market value in the future. Equity investments can be made at the pre or post-revenue stage. A typical investment horizon for an equity investor is 5 years, and for impact equity investors who invest ‘patient capital’ the investment horizon is 7-10 years.

This is also a good option for businesses with innovation-driven products or services which have a market validation and are looking to very quickly replicate and expand. If you’re able to raise equity funding from an institutional player, it will allow you to grow your business further and scale-up at a ‘more than steady growth’ per year.

Key Considerations

Loss of ownership: Investors will take a percentage share of the business depending on the size of their investment in the value of your company. Investors might have different approaches in the process, but keep in mind that terms and conditions for this are negotiable.

Typically, the earlier the stage of business, the more the dilution takes place, depending on how much money is being put in. The extent of dilution would reduce as the business grows overtime.
No pressure on cashflows: There is not much pressure on immediate cash flows , since equity investors are looking at returns at the end of the investment horizon.

There could be a pressure on cashflows if the instrument is structed differently – such as convertible debentures, which will have a periodic interest payment initially before converting into equity shares after a predefined period or at the next equity round. In most of these cases, investors do convert to equity and might not exercise their right for interest payment.
Investment horizon: Investors are typically looking at a period of five to seven years in the case of equity, and maybe more in case of impact investors, given the lower rate of growth for social impact businesses. Most investors will exit after the business has scaled, where they will get ‘x’ times value or percentage return on the principle amount of their investment or when their fund is about to close. The expectations for returns will vary across investors – typically lower for impact investors, such as Upaya, where the focus is on ‘impact first,’ and higher for commercial investors focused on profit maximization.

Debt

One of the main uses of debt capital is to manage your receivables gap, basically for your working capital needs. Typically, there is a time lag of 30 - 45 days for receiving payments from customers, to making payments to suppliers / vendors, and capital is required to continue operations during this period. Debt instruments are typically most ideal in this situation.

Debt capital (such as term loans) can also be used for capital expenditures (such as equipment and machinery) which will contribute to revenue generation.

Debt is the right type of capital for post-revenue, execution-driven business models with predictable future cash flows. This means that there is a ready market for your products / services, and you are certain about consistent revenue streams, which will ensure your ability to repay the debt.

Key Considerations

No loss of ownership: It’s not as expensive as equity; there is no dilution of ownership / shares.
Pressure on cashflows: Debt comes at a price. While raising capital through debt instruments, you need to think about your cashflows since there is an expectation of repayment (interest and principle over a period of time) at pre-defined periods depending on the terms agreed upon and also the type of institution. Most debt capital is repayable at a monthly or quarterly frequency.

It’s also important to note that your businesses should ideally be EBIDITA positive to be able to sustain these financing expenses
Investment horizon: Debt instruments are typically for a shorter-term period – up to three years. ‘Impact first’ debt investors such as Yunus Social Business, might extend the tenure until the business is in the growth phase, since at the early stage, the business might not have the repayment capacity right away. For NBFCs and larger institutions, the tenure might be less than three years and you might want to think about whether your business can sustain that.

Grants

Grant funding can be sought after for a variety of reasons, but in the case of for-profit businesses, this is typically utilized for R&D, product development, initial pilots or specific projects, prototyping new products, or for an impact study.

To be eligible for and secure grant funding, you have to prove that the business model very clearly creates social impact and you will need to use impact metrics to prove the breadth and dept of the impact.

Key Considerations

No loss of ownership and pressure on cashflows: There is absolutely no dilution here and no expectation of repayment.
Some investors will be wary of enterprises that take grants. It will be important to demonstrate that grant funds are being used for a discrete project or development of a new program and are not being used to subsidize an unprofitable business model. Both impact and commercial investors will be reluctant to invest in an enterprise that cannot be sustainable without grants.
Milestone driven: Grant funds are reporting-heavy and funding ‘tranches’ are released based on milestones achieved. Donors typically require periodic reports on utilization of funds and impact metrics.
Investment horizon: Grants are either disbursed up-front or span out over up to three years and may extend on a case-to-case basis. Depending on the type of project and ability to meet milestones and showcase impact, donors can agree to longer term grants as well.

To wrap up, these are some basic insights that you as an entrepreneur can start with to identify the type of capital you need. It’s also important to do your research on investors in the fundraising process to know what type of businesses they are looking to work with – their sector and impact focus, stage of business and type of business model. This would lead to a better success rate.

As part of Upaya’s annual Accelerator Program, we conduct workshops with sector experts around the theme of “Finance & Fundraising” and provide one-on-one consulting support for the cohort participants.

If you are an early-stage business focused on job creation and livelihoods, we encourage you to learn more about our Accelerator Program and subscribe to our email list for application cycles and other updates. You can also apply for investment here to begin the investment application process.