If you’re interested in non-dilutive funding, chances are you’re the owner of a small or middle-market business looking to fund your company’s next big growth initiative.
For one thing, you may not want to dilute your control over your business’ future or profits due to lost equity. At the same time, traditional bank loans are hard to come by with the more strict regulatory environment. Banks today tend to favor bigger enterprises — ones that have sufficient cash flow, collateral, credit, or a favorable debt-to-income ratio.
Thankfully, private firms, business development companies (BDCs) and wealthy investors have more than met the call of smaller and mid-sized companies. Alternative lenders provide highly flexible funding arrangements — like non-dilutive financing — that allow businesses of all stripes to grow.
In fact, as of 2018, 40 percent of private credit managers were lending to companies with EBITDAs under $25 million.
The result? Even modest-sized operations can tap into a larger line of capital than ever before. Meanwhile, asset managers are able to raise even larger funds, allowing them to address unmet borrower needs.
That brings us to one of the most popular forms of alternative financing: non-dilutive funding. Below, we’ll discuss what non-dilutive financing is, the forms it takes, and how it can work for your company.
What is Non-Dilutive Funding?
Non-dilutive funding refers to any capital a business owner receives that doesn’t require them to give up equity or ownership. For many, non-dilutive funding is the prerequisite step to getting their startup, small business or full-fledged operation off the ground.
Contributions from donors, tax credit programs, vouchers, grants, competitions, and even family constitute forms of non-dilutive capital. Non-dilutive funding is often considered most helpful during the establishment of a company, yet businesses of all sizes rely on it at different stages of growth.
During the initial growth phase, companies want to ensure that they can keep building equity, which makes non-dilutive funding a vital tool.
Of course, just because the owner doesn’t relinquish any shares, doesn’t mean the funding comes with no strings attached. Similar to how some loans accrue interest, specific grants can incur additional restrictions, oversight or other organizational costs.
The federal government’s Paycheck Protection Program (PPP) in response to the coronavirus pandemic is a recent and particularly timely example of non-dilutive funding. Companies applying for the loan were fully forgiven if at least 60 percent of the amount was used on payroll. Moreover, businesses that fell short were granted a loan maturity of two years and an interest rate of one percent.
Dilutive vs. Non-Dilutive Funding: What’s the Difference?
As you can likely guess, dilutive funding (or equity financing) means an entrepreneur has to cede a portion of his or her ownership in order to secure capital. Invariably, dilutive funding requires a willingness to sacrifice some control over the company’s direction as well as a cut of the future profits.
With dilutive funding, businesses are called to think long and hard about the type of investors they attract. Investors may be willing to take on high risk, yet their primary goal is to receive quick returns and then make an exit. Many investors require quick growth over a short period of time, regardless of whether the business can comfortably scale.
Commonexamples of dilutive funding include selling shares to angel investors or venture capitalists in a round of funding. Angel investors typically require a return of 25 percent from fledgling companies with unicorn potential, while venture capitalists typically focus more on companies believed to demonstrate long-term growth potential. Well-off investors, investment banks, or non-traditional financial institutions can all provide venture capital, in addition to managerial or technical experience.
Businesses that lack access to traditional capital markets or bank loans sometimes seek out venture capital, though it’s worth remembering that venture capitalists do get a say in company decisions due to the nature of the loan.
The Benefits of Non-Dilutive Funding for Entrepreneurs and Businesses
At the startup phase, running a business can be incredibly challenging. Perhaps a lack of experience or minimal credit history makes it difficult to break into traditional loans. Or perhaps the owner lacks industry connections to trustworthy investment sources. No matter the reason, companies may find that it’s an uphill battle to secure sizable capital with few strings attached.
Non-dilutive funding is especially attractive for new companies since owners retain full control of their own enterprises. Owners never have to worry about the whims of venture capitalists, angel investors or other financiers.
Owners that are confident in their own leadership, with a firm grasp of the company’s long-term objectives, are especially committed to retaining full control. Moreover, external investors will not reap future financial gains through non-dilutive funding.
During this sensitive phase, founders can expect to spend three to nine months securing the capital they need to grow. New companies often fall prey to unattractive loan arrangements, believing that they’re unable to secure a better deal.
Not only does non-dilutive capital ease the strain, it offers owners a chance to net more favorable funding arrangements since the investors are less worried about generating a large return. Non-dilutive funding agents are attracted to the sustainability and longevity of the business, which much more closely aligns with the business’ goals.
One Cleveland, Ohio startup owner emphasized the critical importance of understanding non-dilutive funding options in an article for Entrepreneur Magazine. If he had stuck to a combination of dilutive and non-dilutive funding during the first phase of growth, he would have raised $3.2 million for 29.3 percent of the company, rather than raise $2.3 million for 42.2 percent of the company.
Moreover, he would have been able to sell his shares later at a significantly higher valuation, allowing him to raise an added $900,00 and own an additional 12.9 percent of the company.
Different Types of Non-Dilutive Financing
Non-dilutive funding can take many forms. Common types include crowdfunding, loans from family, licensing, product royalties, tax credits and other awards.
Grant awards, whether from governmental or non-governmental entities, are often the most prized form of funding, since they immediately allow the company to fund day-to-day operations, develop products, perform clinical trials and redesign marketing material.
Crowdfunding (raising small amounts of money, usually via online appeal, from several individuals) and family loans (revenue raised from relatives) are unpredictable and may incur a reputational cost, especially if they don’t work as the company owner expects.
Tax credits are deducted from the taxes your company owes, yet requires the business to spend funds up front. Qualified companies can secure either refundable or nonrefundable credits. The former allows owners to receive a cash refund after paying all the tax they owe while the latter is applied to income tax with a direct cash infusion.
Alternatively, vouchers are a form of government assistance that lets companies secure facilities, goods, services, or professional advice. Since vouchers are non-transferable, they don’t often have a cash value as they are secured under the company’s name. The funding is provided directly to the service provider on behalf of the recipient.
One popular form includes revenue-based financing (RBF), where investors provide companies with capital in exchange for a percentage of the monthly revenue as a return on the investment. The returns only continue until the initial capital amount plus any accrued multiple is repaid; most RBF investors expect to be repaid within four to five years of the investment, depending on the loan size.
Here are some other forms of non-dilutive funding:
Venture Debt
Venture debt is a form of debt financing that is only available to venture-backed startups. Small companies that aren’t in a position to give up equity or secure financing from banks turn to venture debt, allowing the company to take on debt rather than give up shares.
Importantly, this capital isn’t issued through venture capital firms. Instead, a specialized venture debt lender, such as a bank, hedge fund, private equity firm or business development company, provides financing.
Extremely successful companies, such as Uber and AirBnB, have a long history of accruing venture debt. The loans are structured similarly to medium-term business loans in that they are paid off within three to five years. Companies leverage venture debt to increase their own growth without requiring additional rounds of equity financing.
Venture debt is considered a great complement to equity; it’s especially helpful for those that want to extend the runway between funding rounds, finance a specific project, purchase equipment, or limit dilution. However, any company taking on debt should have the means to repay the loan since lenders can force the guarantor into bankruptcy in order to recoup.
Annual Recurring Revenue Lending
Annual Recurring Revenue, or ARR, refers to the value of a company’s subscriber base or the yearly value of a single subscription. Software companies, such as Spotify, Adobe’s Creative Cloud or Netflix, rely on the measure in order to evaluate their profits.
Alternative lending sources often evaluate SaaS companies based upon their ARR. In combination with the customer renewal rate, the ARR helps the lender determine whether or not they’d like to enter into a long term relationship with the company.
ARR lending is very similar to venture debt, allowing subscription-based services to maximize their returns without losing company ownership.
Structured Equity Products
Structured equity products are pre-packaged investment deals that include a mixture of assets linked with interest. The products are derived from securities, a basket of stocks, commodities, debt issuance, foreign currency or an 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.
Finding the Right Funding Provider
While many alternative lenders can get creative, business development companies (or BDCs) often provide the most charitable and flexible non-dilutive funding terms.
BDCs are organizations designed specifically to invest in small and medium-sized enterprises, whether the company is in the initial stages of growth or in distress. BDCs range from public to private institutions, and are set up to provide steady capital through a wide variety of funding options, such as equity, debt or a hybrid arrangement. With a shared focus on steady revenue growth, startup founders are not required to relinquish managerial control of the company.
Investors also find BDCs attractive. Since BDCs are registered as regulated investment companies (RICs), they are required to distribute 90 percent of their profits to shareholders. The result means above-average dividends that range anywhere from 8 to 14 percent. BDCs are also unable to exceed a two-to-one debt to equity ratio, allowing company owners to build sustainable funding arrangements.
Examples of non-dilutive funding abound. Recently, Google committed $175 million of non-dilutive funding to Black-owned businesses in order to promote diversity in corporate leadership. The move came in direct response to recent worldwide protests over police brutality in the Black community, demonstrating that non-dilutive funding terms work wonders for those coming from a wide swath of backgrounds.
Other modern companies have earned capital from a variety of government research grants, industry grants, foundations, and other industry partnerships. Among the many examples are those in the biotech industry, which are eligible for grants from such sources as the National Institute of Health (NIH), Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) programs.
This was the case with Mimetas, a company based in the Netherlands and Rockville, Maryland, which received SBIR funding and won a second grant from a local university. The grant later allowed that organization to initiate therapeutic RNA studies and the company plans to apply to the FDA.
Charitable grants are even provided through private industry. Two Alabama startups won a combined $150,000 from the Alabama Launchpad, an organization funded through several local businesses that seek to recruit promising enterprises. Two winners included MOXIE, a company dedicated to high-tech web-based solutions for industrial production, and Culture Compost, a firm that aims to reduce landfill waste through composting.
The Verdict: Is Non-Dilutive Funding Right For Your Company?
Fundraising is without question one of the biggest dilemmas CEOs face. As mentioned above, getting that funding from an angel investor or venture capitalist means that the founders will lose some equity and some control of the company’s operations and direction. That might not be as big a deal if the company’s valuation increases — always the goal, of course — leaving the CEO in a stronger equity position.
On the other hand, there is the issue of control — of having the final say in company decisions. That’s not a small consideration, and deciding which way to go often depends on what sort of company is doing the fundraising and where the business is in its growth cycle.
Software as a Service (SaaS) companies, for example, tend to show profitability earlier than other tech companies, and their annual recurring revenue makes them a great early fit for BDCs and others who offer non-dilutive funding.
Optionality is key. There are a number of funding opportunities available, and the best option will largely depend on the specifics of your organization, your preference surrounding equity, and what kinds of goals you’re looking to achieve.
