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Tapping external funding sources

Access alternate financing beyond traditional bank lending to achieve sustainable growth across various stages of the business life cycle


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“What does it take to convert a brilliant idea into reality? Funding! Instinct has led many an adventurous entrepreneur to the closest bank in the hope of securing much needed finance; however, this trend is becoming a thing of the past. Let’s find out why?


In most cases, entrepreneurs and SMEs’ do not have the required collateral, consistent cash flows, or financial stability that banks require to grant loans. What they have is a unique idea, a burning passion, and an acute focus to succeed. This is when angel investors, startup platforms, venture capital firms, and private equity funds are invited to the party; to perhaps chart a path for mutual success”.


In our thought piece last month, we discussed how to optimize internal funds by managing our cashflows.

In this article, we analyze popular funding options available to startups such as Angel funding, Venture Capital funding, Crowd funding, Leveraged Buyouts, and how they can assist an early-stage business to grow exponentially.

Statistics reveal that less than 5% of businesses survive the growth phase as a result of a lack of access to funding. This indicates that it is the businesses that are classified as early stage that desperately require access to finance and early-stage businesses are those that are within the first 2 stages of a business life cycle (phased out as launch, growth, shake-out, maturity, and decline)



So, what should startups be looking for - Equity funding or debt funding?

Funding could be done through either debt or equity or a combination of both with various covenants and conditions put in place to safeguard the mutually agreed interests of both parties.

Typically, bank lending is the most common source of external finance for many SMEs and entrepreneurs, who lack access to equity funds and as a result are heavily reliant on traditional debt, cash flow and investment needs. While it is commonly used by established businesses access to traditional bank funding is a challenge to SMEs, newer, innovative, and fast-growing companies, as

External Debt funding generally comes with steep interest rates and the interest rate is generally reflective of the risk profile of the company, which is higher for those at an early stage with the product or service yet to be tested and the unknowns significantly higher. The repayment of this interest component can result in cashflow constraints, restricting the growth trajectory of an early-stage business. On the other hand, equity investors request part ownership in the business, while negotiating an exit strategy to realize their investment at some point in the future along with substantial capital gains. Higher returns are expected for incremental risk taken.

Hence, it is important for a business to figure out its expected optimal capital structure, (the combination of debt versus equity funding) since taking on more debt would mean higher costs, yet diluting ownership in exchange for immediate funding which does not entail an immediate interest or capital repayment, however, would have long term repercussions.

Various funding options can be mapped against the business life cycle to determine some of the best practices and provide insights on how businesses can realign their finances.

Businesses require different forms of external funding for different stages of their life, and this can help jump-start businesses and take growth to the next level, achieve economies of scale, and generate a leveraged return. It also has drawbacks in terms of dilution of ownership & the loss of control. Some of the more popular sources are listed below.



Angel Funding requires a higher level of compensation

Angels are generally wealthy individuals or retired company executives who invest directly in small firms owned by others. They are often leaders in their own field who not only contribute their experience and network of contacts but also their technical and/or management knowledge.

The funds that angel investors provide may be a one-time investment to help the business get off the ground or an ongoing injection to support and carry the company through its difficult early stages.

One such platform is the Angel Fund initiated by the Lanka Angel Network (LAN) backed by 100 Sri Lankan professionals and entrepreneurs. At times, angel investors have unrealistic growth expectations and heavily dilute promoters early on, reducing their incentive to grow the business. Recently, Hatch’s HERCapital fund was established to pioneer a gender-smart funding scheme in Sri Lanka and will empower early-stage startups through a well-structured program that includes mentorship and financial support.

Since angel investors are typically wealthy individuals, it’s not uncommon for business owners to want to seek them out for funding. So, how do you find angel investors? There are online angel investment networks, professional social networks like LinkedIn and local business organizations that can connect a company with Angel Investors. However, it is vital to have a solid business plan as Angel Investors want to make sure that there is a strong potential for success before investing in a company.


Businesses require different forms of external funding for different stages of their life, and this can help jump-start businesses and take growth to the next level, achieve economies of scale, and generate a leveraged return. It also has drawbacks in terms of dilution of ownership & the loss of control. Some of the more popular sources are listed below.

Angel Funding requires a higher level of compensation

Angels are generally wealthy individuals or retired company executives who invest directly in small firms owned by others. They are often leaders in their own field who not only contribute their experience and network of contacts but also their technical and/or management knowledge.

The funds that angel investors provide may be a one-time investment to help the business get off the ground or an ongoing injection to support and carry the company through its difficult early stages.

One such platform is the Angel Fund initiated by the Lanka Angel Network (LAN) backed by 100 Sri Lankan professionals and entrepreneurs. At times, angel investors have unrealistic growth expectations and heavily dilute promoters early on, reducing their incentive to grow the business. Recently, Hatch’s HERCapital fund was established to pioneer a gender-smart funding scheme in Sri Lanka and will empower early-stage startups through a well-structured program that includes mentorship and financial support.

Since angel investors are typically wealthy individuals, it’s not uncommon for business owners to want to seek them out for funding. So, how do you find angel investors? There are online angel investment networks, professional social networks like LinkedIn and local business organizations that can connect a company with Angel Investors. However, it is vital to have a solid business plan as Angel Investors want to make sure that there is a strong potential for success before investing in a company.

Venture Capital is ideal for early-stage financing, expansion, and acquisition funding

Venture capital (VC) is a form of private equity and a type of financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. Venture capital generally comes from high-net-worth investors, investment banks, and financial institutions.

In more sophisticated markets venture capital and private equity help bridge this gap. Here the equity gap is so wide that entrepreneurs are forced to depend on retained profits and bank borrowing for growth.

Venture Capital is the most suitable option for funding a costly capital source for businesses having large up-front capital requirements which have no other cheap alternatives. Software and other intellectual property are generally the most common cases whose value is unproven. That is why; Venture capital funding is most widespread in the fast-growing technology and biotechnology fields.

The first step for any business looking for venture capital is to submit a business plan or a pitch document. If interested in the proposal, the VC firm typically performs due diligence, which includes a thorough investigation of the company's business model, products, management, and operating history etc. Once completed, the VC firm will pledge an investment of capital in exchange for equity in the company which usually ranges from 25%-50%. These funds may be provided all at once, but more typically the capital is provided in rounds. The VC firm then takes an active role in the funded company, advising and monitoring its progress before releasing additional funds.

In addition to capital, VC provides valuable information, resources, and technical assistance to make a business successful.

On the flip side, the autonomy and control of the founder is lost as VCs become part owners of the business. The VC process is generally lengthy and complex in nature, considered as an uncertain form of financing, the benefits of which can be realized in the long run only.

There are various exit options for Venture Capital to cash out their investment such as through an Initial Public Offering (IPO), a promoter buyback, Mergers and Acquisitions and usually, by means of a sale to another strategic investor.

Among notable transactions in the VC space, global technology platform Zilingo acquired Sri Lanka-based startup nCinga Innovations for LKR 2.8 billion (USD 15.5 million). Venture Capital fund BOV Capital, the lead investor in this landmark deal, gave a 300% return to its global investors, which resulted in the distribution of funds of up to LKR 380 million.

Lanka Ventures PLC (LVL), BOV Capital, Bluestone Capital, Emerald Sri Lanka Fund - NDB-ZEPHYR Partners, Acuity partners and Ironwood Capital Partners are among some of the leading Sri Lankan private sector VC providers. Meanwhile, in a recent article, Bank of Ceylon has also expressed its intention to establish a Venture Capital Fund with an estimated allocation of Rs.10Bn to invest in the IT, Export-oriented and Import Substitution business segments on a priority basis.

Both angel and venture capital financing are generally done in rounds:

New venture financing begins with a first concept that is self-funded or through generous contributions from friends or family until it breaks even. Seed funding options are also available at this point including crowdfunding, which can be explored as an alternative.

However, rapid growth can be achieved when venture capital or angel investors, or a combination of both, invest through funding rounds. The first round of funding is typically used to set up a product in the market and take the business from the growth stage to the next phase of expansion.

Later funding rounds would be needed when the company is proven and needs to expand by hiring more staff, penetrating new markets, or even considering acquisitions. These rounds will take the company from the expansion to maturity stage in the business life cycle.

The mezzanine round is in fact an intermediate round and is recognized as bridge financing shortly before a company goes public. Having reached its maturity stage, it can consider mergers, acquisitions and listing on a stock exchange through an IPO.

This may also signal the exit stage for venture capitalists who intend to capitalize on their investment gains and repatriate profits back to their fund’s investors. The startup investment journey for early-stage investors would have completed its full circle by then.

Crowdfunding 

Crowdfunding brings together – through social media and online platforms – small sums of capital from many individuals to finance a new idea or venture. Crowdfunding and peer-to-peer lending aren’t right for every firm, but if a business plan appeals to investors, it becomes a useful funding source.

Crowdfunding through established platforms supplies much needed access to accredited investors and the public. It is an efficient way to attract investors, especially in the first phase of a business.

Secondly, with minimal commitment, a creator gets the opportunity to confirm and refine a product or service offering in line with the saying ‘the wisdom of all is greater than the wisdom of a few.’

Efficiency is another benefit. The ability to centralize and streamline funding through a single streamlined profile will end the need to pursue potential investors individually. Also, there will not be requirements to meet investor requests based on individual preferences – as is the case for many startups, as their bargaining power is limited.

In terms of public relations, crowdfunding will enable startups and early-stage businesses to gain much needed visibility for their products or services through social media and other channels, and steer traffic to their company websites and other resources.

While crowdfunding was initially used to raise funds for charitable causes through donations, it is gaining value as a mechanism to raise equity to fund businesses – especially startups. Equity crowd funders will fuel ideas by supplying working capital in exchange for a small stake in the business much like in the case of angel investors.

Crowd Island, Tribefunds, FundMe Sri Lanka are some of the more popular crowd funding initiatives launched recently.

While loan-based crowdfunding requires licensing and registration from the Central Bank of Sri Lanka, equity crowdfunding is pursued per the provisions in the Companies Act. In fact, inequitable access to finance and innovations around ‘P2P lending’ have already been named in the government’s Vision 2025.

Leveraged Buyouts

An LBO is a transaction where a corporate is acquired using debt as the main source of consideration. These transactions typically occur when a Private Equity (PE) company borrows as much as it can from a variety of lenders (up to 70-80 percent of the purchase price) and funds the balance with its own equity. While leverage increases equity returns, the drawback is that it also increases risk.

“You borrow a lot of money to buy a company; and then you try to operate the company in a way that makes enough money to pay back the debt and get rich. Sometimes this works and everyone is happy. Sometimes it doesn’t work and at least some people are sad.” - Matt Levine, Bloomberg

There are four main LBO scenarios – viz. repackaging, split up, portfolio and savior plans.

  • The repackaging plan means buying a public company through leveraged loans, making it private, repackaging it and selling its shares through an IPO.

  • A split-up plan entails acquiring a company and selling its different units for an eventual dismantling of the enterprise.

  • Under the portfolio plan, there’s the acquisition of a competitor in the hope that the new entity becomes better through synergies.

  • And the savior plan is about the acquisition of a failing business by its management and employees.

Leveraged buyouts are a fantastic option that can help many small businesses on the road to success. However, only a few entrepreneurs and potential financiers truly understand the concept. Notable transactions in the Sri Lankan business landscape are the purchases of the controlling stake in Singer by the Hayley’s group and 28% stake of Asiri Hospitals by TPG group.

Regardless of how leveraged buyouts are viewed, they will always be a strong option for the smart investor and savvy private equity firm – provided there are funds to be lent.

While external funding options are conceptually available, it is important to understand the range of institutions active in the Sri Lankan entrepreneurship and early-stage business support ecosystem at various stages of the lifecycle of a business


Source: Ecosystem actors by category and business stage – International Trade Center


The support ecosystem in Sri Lanka is a collaborative arrangement through which institutions support entrepreneurs to combine their resources, capabilities, and products to offer a coherent, entrepreneur-oriented solution creating value and sustained business outcomes. Well-managed ecosystems improve the management of critical interdependencies to increase benefits or reduce costs.

As a nation, it is imperative that a strong and cohesive ecosystem is built to hone the necessary skills and empower young entrepreneurs & early-stage businesses to move into national and international platforms. Hopefully, this article will sharpen focus, spark debate, and delineate steps required to access alternate funding sources and make informed decisions to perhaps go public at some point via an Initial Public offering on the Colombo Stock Exchange or to partner with a Private Equity firm or strategic partner for long term growth.

For more information on the different types of opportunities such as preparing to list on the Colombo stock exchange, understanding concepts of Block Chain, Crypto currencies, Non-Fungible Tokens (NFT)s, check our article next month.



Sources


“New Approaches to SME and Entrepreneurship Financing” – OEDC, Feb 2015; “The_Impact_of_COVID19_to_MSME_sector_in_Sri_Lanka” – Sustainable Development Organization of the United Nations, May 2020; “Venture Capital” – Edupristine, May 2022; “Start-ups in the new normal with Angel Investors” Roar Media, April 2022; “Early Stage Valuations” KPMG, Q2 2021; "Startup Funding” LMD, July 2019; “Entrepreneurship support ecosystem in Sri Lanka”, International Trade Center July 2019; “SLASSCOM Start up report 2019”, Island of Ingenuity 2019; “Sri Lanka Startups Report”, KPMG 2019



About the Author

Taamara provides business advisory to the portfolio companies of the Sri Lanka@100 platform. He counts 13+ years of experience in Wholesale Banking, Investment Advisory, Treasury & Corporate Finance. He headed Payments & Cash Management (PCM) at Sampath Bank prior to working at NDB Investments and MAS Holdings.