Why Equity Funding May Not Be the Best Loan Choice for Your Small Business Four questions to ask to ensure you're going after the right type of loan.
By Larry Baker and Charlie Tribbett Edited by Dan Bova
Opinions expressed by Entrepreneur contributors are their own.
Tech companies that quickly achieve multi-billion dollar valuations have been referred to as "unicorns," a term that implies a sort of mythical achievement in the world of startup financing. Today, however, these so-called unicorns have become commonplace, popping up in the news on a weekly, if not daily, basis.
Related: How to Find the Right Lending Alternative for Your Small Business
New investors, such as family offices, corporations, sovereign wealth funds, mutual funds and individual accredited investors, have poured money into private markets, enabling tech companies to achieve scale and stay private longer than ever before.
While it's worth debating whether the tech world is approaching another bubble, there is still readily available private capital for consumer-business owners ready to expand.
But diluting ownership early by taking large amounts of equity funding isn't the only way to achieve scale. Unlike tech companies that scale fast and often don't generate revenue in their early days, small businesses have many other tools, including credit products and new marketplace-lending platforms to turn to. Here are four questions you need to address, to ensure you're making the right choice:
1. Why should my consumer businesses be cautious of early equity funding?
For most tech businesses, the barrier to entry is relatively low, meaning that entrepreneurs need to move fast in order to hold on to their first-mover advantage. Often, that means raising substantial amounts of equity funding in order to guarantee the ability to scale quickly and stave off the competition.
But for consumer businesses, the same rules do not apply. Unless you need a huge sum of money -- one that's greater than the fundamentals your business could support -- it's best not to sell off equity too early. Doing so means you risk selling away ownership at your company's lowest valuation.
2. Why do tech company valuations get calculated differently than consumer goods companies?
Tech companies have a much higher capacity for rapid growth than traditional consumer businesses, as tech concerns tend to disrupt big markets despite having very little upfront capital. This means that they tend to be more capital-efficient than consumer businesses as they scale, and can deliver higher returns to investors in a fraction of the time.
As a result, investors are more willing to dole out higher valuations early on, because of this prospect for rapid or exponential growth.
Related: Startups: Don't Make These 3 Financial Mistakes
Consumer businesses, on the other hand, are more constrained in terms of growth because of physical space, manufacturing limitations, inventory, geographic constraints, etc. Scaling these businesses is capital-intensive and valuations are more closely tied to revenue multiples. This makes investors wary of dilution as the company raises additional capital at valuations that are typically more controlled and less exponential.
Larger capital requirements for growth at lower valuations mean the potential for greater dilution for investors (and for you!). This causes angel investors to value companies much lower than their technology counterparts as they aim to achieve a 5-to-10-times return.
3. What can I as a consumer business owner do to prepare for future valuations?
The private capital markets are booming, and equity funding is not the only option for consumer businesses. As a consumer business, you have the advantage of cash flow, meaning you can grow your business using credit before giving away equity. That way, in the event that you do want to raise an equity round later on, your valuation will be greater than it would have been if you took a big slug of equity funding at the start.
Although bank financing continues to dry up, thousands of accredited investors, family offices and hedge funds are now readily lending to small businesses through a growing crop of marketplace lending platforms.
Our recent article, "Seeking Capital Online Instead of From a Bank May Be Your Startup's Best Option," has more information on how you can use marketplace lending platforms, like our company Bolstr, as a way to grow your business.
4. How do I know if a valuation is reasonable?
When your business is ready to raise equity funding, be sure to do research on what businesses similar to yours have sold for in the recent past to get a good sense of what your business might be worth. Realize that it's okay to have a certain amount of debt, as long as you have a path to positive cash flow.
And, remember, while business owners should be careful not to scare away potential buyers and investors by shooting for exorbitant valuations, you'll never forgive yourself for setting your sights too low and giving up equity and ownership too early.
Related: Money Talks: Alternative Financing Might Be Right for Your Business
