Though venture capital has helped support the rapid explosion of startups over the last few decades, founders have increasingly become more inclined to seek out alternatives to venture capital to fund their growing businesses.
Why is venture capital losing its appeal?
For one, founders don’t want to give up control over decision-making or limit their own potential to profit from their ideas — two outcomes that are typical of venture capital deals.
For another, venture capitalists often look for the highest possible rates of return, compelling startups to pursue an aggressive, unrealistic growth strategy that does not work for the business in the long-run.
Venture capitalists have also shown the greatest amount of interest in funding tech companies or those that can market themselves as tech ventures. This Silicon Valley favoritism has unfortunately left many companies looking elsewhere for funding, particularly those that manufacture, sell and develop physical products or are largely seasonal in nature.
For all these reasons, many startups and middle-market businesses often find themselves seeking out venture capital alternatives out of pure necessity. Thankfully, there are many popular alternatives that allow for a far stronger control over the vision and future of your business, while providing much-needed capital to spur a great idea forward to profitability and long-term success.
In this article we’ll review the top alternatives to venture capital and explain the pros and cons of each. While many were already popular prior to the COVID-19 pandemic, the following funding options have continued to thrive and grow thanks to their borrower-friendly terms and higher degree of flexibility than traditional venture capital loans provide.
Alternative 1: Venture Debt
Venture debt is a great alternative to venture capital for businesses that have already given up some of their equity through capital investments. Many founders are resistant to losing an even greater equity stake in their company through another round of VC financing or they may need funding for a specific project that is less appropriate for venture capital equity investment. Business development companies (BDCs), private equity firms and other companies may all offer venture debt opportunities.
Startups often face obstacles when seeking out lenders, because traditional banks require a record of profitability that is typically lacking at such an early stage of growth. Even some of the big-name startup standouts like Airbnb and Uber have used venture debt to fund aspects of their growth rather than seeking a new round of traditional fundraising.
Companies that pursue venture debt must be certain that they will have the finances necessary to pay back the loan. While startup finances may not be suitable for a traditional bank loan, this doesn’t mean venture debt is a good solution for companies with a shaky financial foundation. Venture debt is traditionally senior debt, and if the borrower cannot pay back the loan as mandated in the agreement, they could face bankruptcy or repossession of their goods.
However, venture debt has tremendous upside because it can provide much-needed capital for growth at a significantly lower cost than further rounds of venture capital funding. For that reason, venture debt is often a great complement to equity financing since founders do not stand to lose any more equity in their company.
If you’re interested in exploring venture debt opportunities, check out Saratoga’s typical investment parameters to see whether this might be the right option for your business.
Alternative 2: Annual Recurring Revenue (or Monthly Recurring Revenue) Lending
Annual recurring revenue (ARR) or monthly recurring revenue (MRR) funding is similar in many ways to venture debt and an important venture capital alternative for startups that rely on subscription-based payments, service-based systems or other mechanisms that benefit from recurring, scheduled revenue.
A software-as-a-service (SaaS) company is a good example here; individuals and businesses schedule months or years of payments for continued access to an updated, cloud-based software program.
A lender, such as a business development company (BDC), private equity firm or even some banks, will assess annual or monthly recurring revenue (ARR or MRR), rather than traditional metrics of past-year profitability or assets held. After all, SaaS companies may have few typical accounts receivable but strong planned revenue projections due to the nature of the business. They will also look at related metrics, like the customer renewal rate to determine the viability of ARR or MRR lending for a particular startup.
In many cases, lenders provide ARR or MRR funding as a line of credit to provide ongoing financing for a company. This can provide significantly more capital than a company could secure with a bank loan, and like venture debt, it does not consume an equity stake in the firm. In addition, many companies may find that their borrowing limit grows as their revenue grows.
However, this is not necessarily the best alternative to venture capital for all companies. Businesses must have some kind of recurring revenue payment structure, typically subscription-based, and they usually must be able to show annual revenues of at least $3 million to become eligible for ARR or MRR lending.
If ARR/MRR lending sounds promising and your startup’s revenue numbers pass muster, your next step will be to research the relevant lenders to discuss terms and opportunities. Hedge funds and private equity firms are both great options, though business development companies (BDCs) often provide the most charitable and flexible non-dilutive funding terms.
Alternative 3: Structured Equity Products
Structured equity products are a form of non-dilutive funding designed for small and middle-market enterprises (SMEs) who want to fund their companies’ growth without further diluting the founders’ equity stake in the company.
These pre-packaged investment deals include a number of assets: they typically involve some kind of bond or debt issuance for the company, and they are derived from stocks, commodities, currencies, derivatives or another index. In other words, the investment return is dependent on some underlying asset with pre-determined features, such as capital protection level or maturity date.
While structured equity products may not be particularly vulnerable to immediate market shifts, their viability can be significantly affected by market trends over the term of the structured product. Even so, these products can be extremely borrower-friendly when implemented effectively, empowering founders to preserve their equity while securing access to much-needed capital.
For that reason, Saratoga Investment Corp. provides several structured equity products that serve as compelling alternatives to venture capital funding.
Alternative 4: Mezzanine Financing
Mezzanine funding is a combination of debt and equity financing that can combine aspects of both for more stability for company founders. In case of a loan default, the lender may be able to convert their stake to an equity interest in the company. This can provide significant benefits to entrepreneurs, family-held businesses and other SMEs and middle-market businesses.
This type of financing is meant to bridge the gap, or provide a mezzanine, between equity financing and debt financing. Many business owners benefit from this type of funding, as the influx of cash allows them to realize dividends, given their own equity stake in the company, while providing greater liquidity for the company as a whole.
As with other forms of debt, it is important for companies to opt for funding that they expect to repay, as they may lose their equity if they fail to repay the mezzanine loan.
Alternative 5: Private Equity
Private equity firms share many characteristics with venture capital investments, including their likelihood to require a significant amount of equity in exchange for funding. Founders may be particularly concerned about private equity investors due to the reputation of some companies for excavating companies for profitable pieces and leaving the main company behind. However, there are different types of private equity investments, and they can serve as valuable venture capital alternatives for many businesses.
Private equity, like venture capital, often looks for rapid growth and restructuring. These companies typically want to sell their stake in a few years for a significantly higher value than they paid.
This option often involves large sums of money, with most private equity deals ranging from $500 million to $5 billion, making it a good choice for larger, more established enterprises that may fall out of the traditional interest range of many VC investors.
Founders that are concerned with keeping control of their companies may want to seek a different alternative, however, because private equity firms typically expect a significant stake in the company and expect to play a decision-making role in the future of the business. However, for companies looking for a big change and in need of large-scale investment, private equity may be an important alternative.
Alternative 6: Angel Investors
As with venture capital and private equity, angel investors also often seek significant equity stakes in the businesses they invest in, and they may seek substantial control over decisions, although this varies from investor to investor.
Good connections can be key in finding an angel investor, and these individuals may rely more on their own sense of a company rather than extensive paperwork and bureaucracy. Like hedge funds and venture capital firms, angel investors may be willing to take on high-risk projects, and may also introduce their projects to other potential funding opportunities.
However, access to these types of investments is limited — there are only so many angel investors — and the flow of funding can itself be slow. In most cases, angel investors put in lower amounts than venture capitalists, and they do expect an equity stake in the firm.
It is important to arrive at a clear understanding and delineation of roles, as a lack of clarity may lead to conflicts between startup founders and the angel investors who have come on board.
Alternative 7: Loans from Friends and Family
Startup founders may find that they have friends and family members who like their ideas, believe in their potential and want to help their businesses succeed. They may be willing to put their own money in to ensure that a great business idea can move forward and prosper.
However, as in any business deal involving friends and family, it is important to come to clear terms before moving forward. The financial and emotional costs of a deal gone bad can linger for years or even decades.
When deciding to accept a friend or family member’s money, make sure that they are in good shape to invest. This means they have the money and the financial experience to recognize the risks they are taking on.
For example, experts advise ensuring that any friend or family member investor has at least $1 million in assets or a stable income of $200,000 a year or more. This helps to ensure that founders are dealing with financially sophisticated individuals who can afford to take the risk inherent in any type of loan or investment.
Even though a company may be dealing with friends and family of the founder, it is important to spell out the terms of the loan clearly, especially because close lenders may expect to have a say in company decisions, even if they do not receive an equity stake. Repayment terms tied to cash flow should be clearly defined, and everything must be put in writing.
The primary advantage of loans from friends and family is that the lender loves and cares about the company founders; it is not an impersonal transaction. This is, of course, also the primary downside; a financial problem may lead to long-lasting relationship damage.
Alternative 8: Crowdfunding
When it comes to venture capital alternatives, crowdfunding is about as different as you can get. Companies who use crowdfunding solicit cash through online platforms like Kickstarter or Indiegogo from a mass customer base, rather than from traditional sources like banks or even venture capitalists. In most cases, crowdfunding involves many small contributions from hundreds or thousands of individuals rather than one or two large-scale investors.
In many cases, companies provide some form of reward to crowdfunding investors in return for their investment, such as a promise to deliver a physical product once it has been manufactured.
Other types of crowdfunding exist, too, including peer-to-peer business lending where companies gain access to secured or unsecured loans through a variety of online platforms. There are even venues designed for equity investments through a crowdfunding platform.
It is important that a company chooses a trustworthy crowdfunding platform, and that an entrepreneur budgets for the fees these platforms charge. But the plusses are many. Beyond raising needed capital, an enterprise creates a customer base among those who are backing its product.
Alternative 9: SBA Loans
These loans, sponsored by the U.S. Small Business Administration (SBA), are appealing to some companies for their favorable terms. They are designed to promote the growth of small and mid-sized businesses by definition, and they offer low interest rates, low down payments and favorable repayment terms.
In addition, companies need much less collateral for an SBA loan than they would for a bank loan. However, like other types of government-backed funding, the process for loan approval can be long and cumbersome. A significant amount of paperwork is involved, and there are more requirements for the borrower, like a personal guarantee that repayment terms will be met.
These loans can be an important source of support, but they are not known for their flexibility. Some of these loans may restrict how much capital is available to the borrower and how it may be used.
Conclusion
Given the VC industry’s predominant focus on early stage tech companies, venture capital funding can be particularly hard to secure for the vast majority of businesses.
Those who do manage to secure VC funding also need to contend with considerable downsides including relinquishing equity ownership, contending with overly aggressive growth efforts and losing control over business decisions.
For these reasons, entrepreneurs have flocked toward venture capital alternatives that offer funding for businesses in various industries and stages of growth, and with investment terms that are far more borrower-friendly.
The right alternative for you will depend on a few key factors, not the least of which is whether you want to sacrifice control or not, whether you have dry powder available, whether you will be able to meet the lender’s terms and whether your ARR or MRR will enable you to pursue certain options.
If you’re interested in developing a flexible, comprehensive approach to funding that fits your specific company’s needs, review Saratoga’s typical investment profile to see if you may be a strong fit.