Fundraising is a critical milestone for Startups as they begin their journey through their corporate lifecycle. While the need for capital, how to accesses it, and where to access it differs depending on the stage of the company, building the right foundation is what all successful Startups have in common.
There are various sources of funding that Startups can tap into, starting with one’s savings, to finding support from family and friends, to angel investor networks, all the way to Venture Capital, Private Equity Funds, Financial Institutions, and others. It is important to keep in mind; however, each step of the way requires a set of pre-requisites that are necessary to have smooth access to the type of capital that matches the need of the Start-up.
To begin, there are basics that one needs to keep in mind and prepare for before commencing to raise capital:
- Generate a bold and plausible idea: Solve a problem! The starting point of a great venture is to identify a problem, a pain point, or a gap. Once a problem is identified, explore the various solutions in which you can solve that particular problem. Then, once you have a solution figured, develop it into a product or a service.
- Identify the group that will benefit from your product or service: demand is found where the solution for the problem is found. As you turn your solution into a product or a service, identify those who will benefit from it. They could be individuals, entire communities, companies, or others, those are who will adopt your solution and be willing to offer monetary value to what you are offering.
- Research and Consult: Once the group is broadly identified, do some research. Learn more about the group you identified, study how your solution fits well with the needs of this target group, and more importantly, don’t forget to translate the data you collect into numbers. Map those you wish to learn more from, those with knowledge who can help you develop your product or service further, and spend time researching about products or services that may be similar to your solution, this will help you create a value proposition and help you differentiate yourself from others.
- Begin networking: Reach out to people. Depending on the sector or market your product or service fits, advice is available to guide you on how to further build a solid solution, establish the right management style, and support you navigate through the various market dynamics. There are various gains from networking, most importantly, it will help you remain relevant to the most recent updates in the market, open doors of opportunity, support you in forming partnerships, provide you with valuable links in the industry value chain, and possibly, help you raise capital. There are various options for networking, for example, social events, workshops, conferences, and relevant network memberships.
- Build a great team: A successful venture is driven mainly by a team that can grow through challenges, finds solutions to difficulties, and complement one another in skill, knowledge, character, and more importantly vision. Choose your team carefully. This does not mean that it will all go smooth as you progress, be mindful that change may be needed from time to time. It is critical, as you build your team, to think of how to retain them. Your strategy of team retention is a plus when you grow to raise capital.
- Create an early version of your product or service and test it: You don’t need to wait until you have a final version of your product ready before you reach out to your target customers. Develop your product or service gradually, starting with an early version that you can share with your friends or target clients. This will help you build a product or a service that fits. Build further as you receive feedback and tweak your solution, this will not only help you save time and resources but may also generate early traction.
- Consider an incubation or an acceleration program: You’re not alone. There are professional agencies that exist to support a Startup like yours. While some are different from others in the types of services they provide, the majority of incubators and accelerators may provide mentorship, early support in terms of access to network, office space, appliances, and sometimes various funding opportunities. Incubators and accelerators may also differ in the types of Startups they accept for their programs. Make sure to research and reach out to them for more information. A list of incubators and accelerators in Sudan could be found in Chapter 5.
- Gain traction for your product or service: At this stage, you are comfortable with your product that you are ready to test it in the market. A critical milestone in a Startups’ journey, is to be able to validate its solution by demonstrating that a set of customers are willing to pay for your product or service. This stage where you gain traction is usually referred to as a Minimum Viable Product (MVP). The number of customers you gain, users, or even page viewers, depending on the numbers you generate according to the sector where your product or service exists, is proof that your solution has a market. This is an early indicator for potential investors that your product is viable enough to be funded.
- Do your homework and prepare well: Have well-developed documentation regarding your venture. This includes but is not limited to, a forward-looking business plan and projections model, financial data about your company (a clear and simple financial model could help), and a good presentation about your company, its vision and mission, your product or service features, the market, and more importantly, your team. It’s important to remember, the quality of your material plays a significant role in the way an investor perceives you.
- Right before you raise funds: Understanding your capital needs and the needs of your targeted investors is crucial. Successful fundraising depends on how well you’re aware of both your needs and the interests of your targeted investors. Therefore, do understand how your venture aligns with the interests of the investors you approach. Remember, investors have different needs and different approaches to investing, spend time and study their needs and interests. Moreover, Think of your own capital needs. Successful businesses know what they need and when. Spend time to understand your current and future capital needs.
- Raise funding to grow further: Once you have tested your product or service and gained traction, and also understood your capital needs and the investors you wish to attract their support to your venture, reach out and pitch your venture. Understand, however, that investors are critical in examining and measuring the balance between the various risks associated with your venture against the returns you could potentially generate over time and the returns they would usually seek. In addition, keep in mind that your growth potential is another important factor that they would assess. Moreover, they would examine the team driving your venture, and your strategy to retain your core staff, and how you add new ones. They would also ask you about the uses of the funds you are asking, and how and in what do you plan to use them. Be prepared to provide them with realistic and measurable answers. Lastly, know what you are offering in return for the funding you aim to receive, think critically, and examine additional value an investor could bring besides capital. More importantly, keep in mind not to give away too much of your company as you may need to raise more capital in the future.
Funding Instruments Overview
One of the first and most important decisions that entrepreneurs will need to make when raising money is deciding what type of capital they need. In this guide, we cover six (6) types of capital:
- Grants and reimbursable grants;
- Zero-sum coupon loans;
- Convertible Notes;
- Debt (loans);
- Equity; and
- Mezzanine (a mix of debt and equity).
One or a mix of these six (6) types of funding will apply to most entrepreneurs in Sudan, as well as other countries.
Grants and reimbursable grants
In principle, a grant refers to a type of funding that typically does not obligate the recipient to repay the funds or makes any financial claim on a business in return for providing the funds. This includes everything from grants offered by national and international organizations as well as foundations, to prizes and awards offered by competitions, as well as donation-based crowdfunding campaigns, and others. Grants are typically the most straightforward form of funding.
The amounts that organizations grant to businesses vary widely, ranging from thousands to millions of dollars. Most common grants, however, tend to be on the smaller side — typically under SDG 20 million (USD 50,000~). This makes them most appropriate for early-stage start-ups and entrepreneurs who are particularly at the ideation or pre-seed stage, or more established entrepreneurs seeking capital to ease cash flow constraints.
Typically, organizations offering the grant will put out a call for applications, inviting interested businesses to pitch their ideas. Applicants will need to show how their business or idea is relevant to the grant. A judging panel then narrows down the field to several finalists and the winner or winners are chosen from there.
While organizations that fund grants typically do not expect any sort of financial return (i.e., a stake in the business, or a promise of repayment), they will often check on the grantees to ensure the money is being used for the intended purpose, both during and after the grant has been disbursed. Some organizations release grant payments in stages to ensure the company is working towards its stated goals.
Nowadays, a reimbursable grant is a common type of funding instrument. Similar to a grant in terms of no financial claims or interest on a business in return for providing the funds, however, the amount of the grant funding provided may be repaid based on pre-agreed milestones for the Startup to achieve. Further, it is common as well that reimbursable grants may not include any financial triggers for repayment, depending on the mandate of those providing the grant, and no legal liabilities or obligations in case the Startup did not succeed further. It is commonly deployed in this particular manner to create discipline for Startups while not burdening them with liabilities at such an early stage.
- Free money in the sense that there is no equity or interest to pay.
- Funders have little influence on the day-to-day operations of the business.
- No obligation to repay and no legal liability in case the Startup is unable to reimburse.
- Little support besides funding – hard to grow networks or get targeted mentorship.
- Post-funding reporting is sometimes extensive.
- Providers of grants can be inflexible in accommodating start-ups that need to pivot from one business strategy to another.
Zero-sum coupon loans
A zero-sum loan for Startups has characteristics of both a reimbursable grant and a loan. Similar to a reimbursable grant in terms of no equity or interest to pay, and similar to a loan in terms of repayment schedule and maturity. It may also not require collateral which differs from a typical loan, however, the terms and conditions of a zero-sum coupon loan differ depending on the mandate of the investor.
- Provides flexibility for founders as there may not be any interest to be repaid.
- It may not require collateral.
- Long-term and flexible repayment schedule.
- May be limited and difficult to obtain.
- Extensive reporting.
Convertible notes or bonds
A convertible note is a form of debt (loan) that can be converted into equity at a specific time based on pre-agreed terms and conditions. It is a common funding instrument nowadays as Startups’ need for capital grows larger and sophisticated. Typically a convertible note converts into preferred stock shares in the company. In simple terms, investors, rather than receiving their funding back with interest, receive shares in the company. The way convertible notes are provided may differ from an investor to another, however, the most common are those investors who may have more appetite for risk but looking for a form of compensation in the future for the risk they took if the Startup grows to be successful.
- More space for founders as there are no control rights offered when converted to equity.
- Slightly faster to obtain depending on the investor.
- May be simpler in terms of legal documentation required.
- If Startup is unsuccessful, or no further equity capital is raised, the debt (loan) remains and it is repayable, thus may burden fragile companies beyond what they can carry.
- Might be complicated to deal with if founders are not aware or knowledgeable enough about future implications.
Debt financing is one of the most common ways to get funding. In simple terms, debt financing means an entrepreneur takes out a loan from a financial institution, which he or she promises to repay within a predetermined time period and is subject to an agreed-upon interest rate.
Debt funding can come from various types of funders, including banks, crowdfunding, impact investors, development finance institutions, microfinance institutions, and others.
As entrepreneurs need to pay interest on their loans, typically in monthly installments, debt financing is best suited to more mature businesses with stable cash flows and some forms of assets. The amount of funding that an entrepreneur can expect to borrow depends on three (3) factors. The first is the type of organization he or she is turning to, for example, a bank or an impact investor will be able to offer a larger loan than a microfinance institution. The second factor is the amount of debt the business will realistically be able to take on. Early-stage start-ups with no product and no customers, for example, usually cannot (and should not) borrow much, while more established companies with proven cash flows will be able to tap into larger pools of credit. The third factor is the type of collateral and/or guarantees available for a company.
In order to apply for a loan, entrepreneurs will need to show a business plan and financial projections, which are meant to demonstrate how the borrower plans to repay the debt. In addition, most banks may ask for a form of collateral that could be used as a guarantee in case of a company defaults on its loan repayments.
When taking out a loan, borrowers typically focus on two key aspects of the financing structure: the interest rate and the tenor (the time until the entire loan must be repaid). The interest rates are seen to be correlated with the riskiness of the borrower – the less likely he or she is to pay back, the higher the interest rate a lender is going to charge for taking on the additional risk. The rates are also determined by the central bank’s prevailing interest rates in the country.
In case of default, lenders get the first claim on any assets the business has, meaning this is typically seen as a safe financing structure from the lender’s side when compared to equity investment.
In countries where Islamic finance is widely adapted, loans are typically not provided in the form of cash and interest, but rather tied to the purchase of a commodity (the case for Murabaha) with interest tied to the overall price of the commodity i.e. the amount in which the commodity is purchased. Repayment in the case of the debt principal (the amount borrowed against the commodity) in Murabaha is mainly repaid in installments. Another common form of Islamic finance is Mudaraba and can be described as a profit and loss sharing contract into a commercial enterprise according to predetermined terms and conditions. Various other types of Islamic funding products are available in chapter 4.
- No need to give up ownership of the company.
- Lenders will often ask for collateral. In Sudan, it is only possible with immovable collateral, especially with financing from the banks.
- Interest payments can be difficult to make for cash-strapped start-ups.
- Requirements might be cumbersome for Startups at early stages, specifically that they may not have any form of collateral or the track record as a corporate as of yet.
NOTE: Debt financing can come in two forms: secured and unsecured loans. Secured loans are a financing instrument in which the entrepreneur offers some assets as collateral, making the loan less risky for the lender. This could, for instance, be a car or debenture over assets that the lender will be entitled to if the borrower defaults on the loan, offsetting some of the risks for the lender and thereby reducing interest rates. Unsecured loans do not have such protections for the lender and therefore have higher interest rates.
Currently, there are no debt financing instruments in place in Sudan from banks that do not require collateral. But there are several initiatives from international organizations to back the collateral by providing a form of a guarantee for financial institutions. There is a newly established risk transfer mechanism (Tayseer) that is also mandated to provide guarantees to financial institutions in place of collateral. This enables the partnering financial institutes to provide debt financing to entrepreneurs without or with moderate collateral (more information can be found in Chapter 5 – the Investor Directory). The eligibility for these programs is often tied to impact criteria based on the overall objectives of these programs.
Equity funding means an investor puts money into a start-up in exchange for a portion of the company’s shares, becoming a part-owner of the business.
Equity investment varies in amount, depending on the entrepreneur’s needs. It includes everything from relatively small (less than SDG 20 million or USD 50,000) injections of capital from family members or angel investors to large deals financed by venture capital or private equity firms that control up to millions of dollars.
Prior to investing, equity investors go through a detailed screening process, commonly referred to as due diligence. At this stage, they look at the potential for a start-up to grow into a highly profitable business. Most equity investors understand that the majority of start-ups fail; therefore, they look for growth potential rather than steady cash flows. Equity investors like to back tech start-ups because of their ability to scale with relatively low capital requirements compared to traditional brick-and-mortar businesses.
In order to receive equity investment, entrepreneurs will typically need to have an extensive business plan, with strong financial models showing growth projections, competitor analysis, the proposed approach to marketing, and more.
Equity is the riskiest type of funding for investors, as the funders stand to lose their entire investment should a company fail.
- No interest payments to pay back.
- Investors have an incentive to be as helpful as possible by providing mentorship, advice, and connections.
- Misaligned time horizons: start-ups building for the long term while investors want to exit quickly.
- Control mechanisms can mean entrepreneurs are less in charge of their business.
Note that SMEs are also eligible for equity funding, depending on the scalability of their business model. Investors base their decision on whether SMEs can grow into large enterprises and become a market leader in their segment.
Mezzanine is a hybrid instrument that refers to financing that sits between equity and debt (hence the name) and combines aspects of both types. It gives the lender the right to convert to an equity interest in the company in case of default. It is popular with some investors because it shields investors from the certain risk associated with pure equity investment while still providing an upside if a business becomes highly successful.
To raise mezzanine finance, a company must have a credible track record in the industry, consistent profitability, and a feasible plan for expansion through an initial public offering (IPO) or acquisition. Thus, mezzanine finance is used by companies that have a positive cash flow.
While there are similarities between the mezzanine and convertible bond instruments, mezzanine usually has equity participation that comes in a form of a warrant or an equity kicker (option) as conditional rewards based on specified performance goals, however, convertible note providers may convert all or a portion of their loan principal into equity with higher equity dilution than of equity provided with warrants. In addition, convertible notes have lower interests than mezzanine financing.
- Mitigates risk for investors, meaning better funding terms than straight equity.
- Can delay the valuation of a start-up, which is imprecise in early-stage companies.
- Entrepreneurs may need to make regular payments to funders. Can be overly complex and expensive to arrange