Olusola Olarewaju

Start-up financing This is a topic that a lot of persons find interesting, it deals with money, but there are things that i’d like you to consider when it comes to financing your start-up and that’s very important, having that understanding is critical. We will be discussing financing in two forms or under two paradigms. First we will be discussing financing from what type of financing is available and then what framework should you use in determining what type of financing you should seek. Let’s begin first with the type of financing that is available. When it comes to the type of financing that is available, we will be considering the type of financing available from, we will be categorising them using the following; First we will be categorising them according to who provides; Number two we will also be categorising them, what those that provide receive, what’s the consequences of if they provide certain finances, what do they receive in return Then three; we will also be considering it in the context of what is the consequences on the start-up for receiving such type of financing. Let’s begin therefore, with what type of financing is available; I’m going to categorising them in simple terms. The first type of financing that is available is free financing and you know what free financing is, free financing is the one that the provider gives to you without you giving anything in return. So let’s use those three frameworks; Who provides it: of course different organisations provide it and you know what its called, it is basically a grant, that’s free financing, most of the time there are no strings attached to grants, I do not think I’ve heard about conditions attached to grants , I mean, it’s a grant, i grant it to you, conditions attached to it in the context of , ‘if we give you this money, this is what you need to do, or else you pay us back our money, I’ve not heart anything relating to that. That is the free one; there is no consequence on the company or the start-up when he takes the grant. Like i said, there are different organisations that provide it, then the grantors do not expect anything, they don’t take anything from the company in return. Maybe that has led to some consequences of grants anyway, i have my issues with how people use it but those are my issues. So, the first type of financing is free financing which is grant. The second type of financing is equity. Again, we look at who provides it. Well, individuals or companies provide equity financing. What do they receive? This is where I need you to follow me, equity financing means that the provider provides you with money essentially and what the provider gets in return is ownership of the company, that is equity financing, so in a sense he invests in the shares of the company so that he will be able to get part of the company. So equity financing means that the financing institution or the individual financing gives the start-up a certain amount of money and then becomes a part owner of the company, certain shares is now bequeathed to him as an owner of the company. The consequence of this in the company is that you as a start-up founder, your percentage ownership has been reduced or like we use the word, most times, has been diluted, so you do not own as much as you own. Of course the other consequence is when profit is shared, you do not take all the profit that you should take or that you used to take, the equity owner , the person that has invested equity gets to take a particular share, the consequences of equity financing is that the investor in that sense has taken the risk of the company succeeding, so if the company succeeds or if the company fails the only thing he loses is his investment, he can’t ask you to pay him back his investment because what he did was that he bought the shares of the company. So there’s the third type of financing which is debt financing. This type of financing is a loan. Who provides it? Several organisations, banks and the rest they provide this type of financing but it’s a loan. So what they get back is; they don’t get equity, they are not investing in the company, they are providing loan for the company, so what happens is that at the agreed time, the start-up pays them what is called interest. And of course you know the interest the start-up pays is irrespective of the fact, whether or not the start-up makes profit. The start-up must pay the financing house interest. So that’s what happens when the type of financing is debt financing. Let me take this example, you need money for certain things as a start-up and then I give you the money and you are going to give me interest on the money and pay me back the money, that type of financing is called debt financing, as against the equity; when I give you money then you give me part of the company, so I only share from the profit, that is called equity financing. There is a fourth one which is not yet very popular around here but is beginning to because I have been involved in some financing deals when that has become important and that is called; its an hybrid form, what do I mean an hybrid form? It’s a hybrid form of debt and equity. How does this work? The financing person or house provides a particular amount of money as a loan and this amount of money will at the happening of certain events or after the passage of time it will now convert into equity, let me explain that, remember I said it is hybrid, that means it’s both loan that will become equity at the happening of certain events. There are several reasons why lots of investors use it, it is basically very common with VCs anyway. If you’ve read some works it’s called a convertible note, but in Nigeria we really don’t have in a sense a convertible note, what we have in Nigeria is called a convertible debenture but that’s a discussion for another day. So the way this type of financing works is, say I like your start-up, so I then say okay, you require money but I will not give you this money as equity, I’ll give you this money as loan if certain things happen or if you do not repay this money after so and so time, that my money I have given you as a loan will now convert into shares, into equity investment, that is also a model that is used. So I’ll repeat the four financing that are available; One is free: that’s a grant and there are no consequences on the company and there are no consequences on the grantors, on those granting the facility. The second one is equity and the equity means that an investor pays a certain amount for some shares of the company. The third type of financing is debt, the guy is not interested in taking some part of the company, he wants you to pay him interest for using his money and returning his money at a particular time. And then the hybrid is a mixture of both of them, like I said mixture of debt and equity, debt at the beginning and equity at a particular point in time. That’s the mixture between both of them. Having an understanding of the type of financing that is available, let me just say this, no matter how complicated or how it sounds sophisticated, you would actually be able to put all types of financing under any of this four arms that I have identified. So having understood the types of financing that is available, what type of financing should you as a start up seek because that’s importing because there’s a reason for each type of financing, what type of financing should you as a start-up seek. What type of financing should you seek then? The framework for determining the type of financing you seek is pretty simple. First, what stage is your business/start-up in, very important, so that leads us now to discuss what is the stage of a start-up, so let’s break it down. We have start-ups that are in the idea stage or commonly you would say ideation stage, they have ideas, then we have start-ups that are in the testing stage, they are testing their ideas. The distinguishing factor of this is when you have the idea stage you basically do not have any product yet. When you get to the testing stage you have a product you are testing the viability of the product, at the stage you are testing the viability of the product you know that revenue is pretty low. When you are done testing, you then start executing, of course you’ve gotten all your hypothesis correct so you are executing. At the beginning stage of executing revenue is still not high, so after the executing stage there is a component part of the executing stage which at the time that your revenue is now high, you understand your market, right now you need a lot of money to execute, you know that if you put in a million bucks you are going to have so so and so many users giving you revenue of three hundred million dollars or naira at a particular stage. At that stage the company is actually growing. The stage your company or your start-up is in should determine the type of financing you take. Now let me flip it, what i mean flip it, let me give the worst case scenario, let’s say your start-up is in the idea stage or you’ve even started testing and i come to you and i say I want to give you twenty million naira as a loan and at that stage you basically do not have a revenue, would you take that money? If you are also at the testing stage or you’ve started executing and your revenue is just growing and i then come to you and offer you twenty million naira for a particular percentage of your company, would you take it? Assuming that the percentage i want to take is agreeable to you, will you take it? I used that example to portray a point. The type of financing you require would be determined by the stage of your business, the most critical component of your business is revenue. Remember, i said if you take a loan you’ll have to pay interest to the provider of the loan and you will have to pay back the loan, but if you take equity you do not have to pay back the money and the person becomes an owner of the company and what he gets is what is called dividends or a share of the profit at the end. So, what type of financing should you be seeking at the idea stage when your revenue is not high, at the testing stage or at the early execution stage when your revenue is not high as you would love to. The type of financing you should seek should be grant or equity, because equity means at that stage that the person is part owner of the business, so the person will not be requiring you to pay him back his money or to pay him interest on the money. So if you have that kind of financing, it gives you the time to grow your business without the added pressure, but if your revenue is not certain and you take a loan, this is what happens, you will have to pay back the interest, so lets assume you take a twenty million naira loan, to pa y 10% per annum, I know you’d say that’s very simple wait until you take the loan you will then understand. When you take the loan of twenty million naira to pay 10% per annum, what that means is that you need to be able to raise with that twenty million, the interest at 10% is two million. So you should be able to make a profit of at least eight million to be able to pay that two million to the lender. The consequences of this therefore is; if you have not factored out your business and so you are not sure of your market, you are not sure of your revenue, that adds massive pressure to your business but if on the other hand your business is on that stage and you have someone that invest in your business and so becomes a part owner of your business because the person has taken equity, what happens therefore is that because the person does not require interest, it gives you a period of time to be able to raise your revenue without adding additional pressure. I hope this is clear, the best type of financing therefore that you would require as I normally would advise is that at the idea and pre-revenue, before revenue is certain, the best type of investment is equity investment. When your business is grown to an extent that you can predict revenue and then you need short burst of money to be able to raise certain things, it might be best for you at that stage to take loan this is one of the reasons government intervention funds do not sit well with me because most of the government intervention funds particularly in Nigeria are all loan based so they normally do not sit very well with me and most of the times I do not advise start-ups to take those loans except they are grants. So that’s the framework you should use when you are determining the type of financing you should take, what stage are you in your revenue and what stage are you in your business development process, that should determine it. And I’ll wrap this up by saying we’ve discussed the four types of financing available and which you should seek at every particular stage.