United States: It's Okay To Venture Away: Alternative Financing Structures For Startups

When it comes to scaling your startup business, choosing your financing partners is critical.  Luckily, entrepreneurs have many choices with new entrants into the market on almost a daily basis.  The Kauffman Index estimates there were approximately 530,000 new business owners each month in the United States during 2015, and we have observed continued new business formation thus far this year.  In addition, the Kauffman Index reported that less than 5% of entrepreneurial financing came from venture capitalists.

So what are some of the current alternatives to institutional VC funding, and how should a new business owner consider the choices?  Presented in ascending order based roughly on a startup's capital requirements and maturity stage, alternatives include: bootstrapping, raising money from family and friends, crowdfunding (either rewards-, equity-, or debt-based), investments from angels and other high-net worth individuals, investments from angel syndicates, securing a traditional bank loan, winning a grant, transacting with corporate investors, and working with state-owned or sovereign wealth funds.  Choosing the financing path for your business will inevitably depend on context, opportunity, your vision, and your relationships with your advisors. 

As a general matter, we counsel our clients to balance the cost of the current capital (whether via a SAFE, convertible note, or priced round) with softer factors (such as reputation of the investor, ability to help directly and indirectly in growing the business and attracting more capital in the future, and likelihood of being supportive if the business hits a bumpy road).  When executed correctly, choosing a compatible investor can neutralize a company's shortcomings and complement its strengths.  If entrepreneurs are deliberate with their growth decisions, they can reduce friction with their investors down the road and capture benefits that go beyond mere capital alone.

The most recently publicized alternative constitutes a middle ground.  This middle ground embodies pushback against two extremes – the "grow-or-die" paradigm of venture capital on one end, and the potential hubris of bootstrapping on the other.

Recently, the Wall Street Journal wrote at length about Indie.vc in an article titled "Venture Capital and Its Discontents."  The article addresses a growing frustration that founders are increasingly seeking validation through spiraling rounds of fundraising, rather than through the realization of their idea itself.  In these scenarios, startups risk losing their direction as they rush to raise funding without regard for cost or implications.

In contrast, Indie.vc is a freshly launched investment fund that self-describes as seeking portfolio companies that have "a clear path to profitability that do not fit the traditional venture capital model."  For Indie.vc, repayment comes from sharing in the portfolio company's profits and/or the founders' salaries.  For founders, such repayment occurs as the business scales organically, which allows ample space for the company to hammer out its vision.  Sharing in the company's upside potential remains a principal concern for investors; but unlike convertible notes or SAFEs, whose conversion into equity is generally triggered by a later round of funding at a specific valuation, agreements may be tweaked to trigger conversion only upon an exit (e.g., through an IPO or acquisition).

In addition to modified funds like Indie.vc, startup businesses should also think long and hard about corporations that are playing broadly in their vertical.  We have witnessed an explosion of interest and funding from corporations in early-stage businesses.  Corporate venture capital offers access to many of the same soft factors that companies should already be seeking out, such as industry knowledge, operational synergies, and access to growth channels.  In contrast to institutional VCs that invest primarily for financial returns, corporate VCs often invest to foster strategic relationships.  It is beyond the scope of this article to capture the varied approaches different corporations are using and considering but, in short, the financing alternative is real – and data suggests that it's growing.

For us, the continuing lessons and reminders about Indie.vc are as follows.  First, there will continue to be exciting new opportunities in the market, and entrepreneurs should remain aware of the possibilities.  We foresee copycats to the Indie model and tweaks to it.  Second, we see more and more corporations and others who are seeking to complement their core business by expanding into early-stage business financing.  Third and finally, with all of the reporting that fundraising has become cookie-cutter, we continue to preach creative problem-solving tailored to your company's goals.  Free online legal forms may be a starting place, but they are rarely perfect for any one particular situation.  Be thoughtful and flexible, and proceed with care as you finance your business.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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