Grant

As it is the most straightforward, we will begin with grant funding. By a grant we mean any source of capital that makes no financial claim on a business, in return for providing the funds. This includes everything from grants offered by national and international organisations as well as foundations, to prizes and awards offered by start-up competitions, as well as donation-based crowdfunding campaigns.

The amounts that organisations grant to businesses vary widely – from thousands to millions of dollars. Most common grants, how- ever, tend to be on the smaller side, typically under N$100k (US$6k). This makes them most appropriate to early-stage start-ups and entrepreneurs, or more established entrepreneurs seeking capital to ease cash flow constraints.

Typically, organisations making the grant will put out a call for applications, inviting interested start-ups to pitch their ideas. Appli- cants will need to show how their business or idea is relevant to the grant. A judging panel narrows down the field to several finalists and the winner or winners are chosen from there.

While organisations 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 that the money is being used for the intended purpose – during and after the grant has been disbursed. Some organisations release grant payments in stages, to ensure that the company is working towards its stated goals.

Advantages

• ‘free’ money in the sense that there is no equity or interest to pay
• funders have little influence in the day-to-day operations of the business

Disadvantages

• little support besides funding – thus it is hard to grow networks or get targeted mentorship

• long applications

• post-funding reporting is sometimes extensive

• grant makers can be inflexible in accommodating start-ups that need to pivot from one business strategy to another

Debt

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 subject to an agreed- upon interest rate.

Debt funding can come from various types of funders, including banks, peer-to-peer crowdfunding, impact investors, development finance institutions, microfinance institutions, and others.

As start-ups need to pay interest on their loans, typically in monthly instalments, debt financing is best suited to more mature start-ups with stable cash flows. The amount of funding that an entrepreneur can expect to borrow depends on two factors. First, the organisation he or she is turning to – a bank or impact investor will be able to offer a larger loan than a microfinance institution. Second, the size of the loan will depend on how much debt the start-up will realisti- cally 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.

In order to apply for a loan, start-ups will need to show a business plan and financial projections; these are meant to explain how the borrower plans to repay the debt.

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 loan, the higher the interest rate a lender will charge, as a premium for taking on the extra risk. The rates are also determined by the central bank’s prevailing interest rates in the country. This is because government debt (bonds) are considered virtually risk-free, so the bank has no incentive to lend money to a riskier enterprise at a rate that is lower than what the government is willing to pay on its bonds.

In case of default, lenders get 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 investments.

Advantages

• no need to give up ownership in the company
• management maintains full control of the company

Disadvantages

• often lenders will ask for collateral

• interest payments can be difficult to make for cash-strapped start-ups

Debt financing can come in two forms: secured and unsecured loans. Secured loans are a financing instrument in which the entrepreneur offers some asset 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 bor- rower defaults on the loan, offsetting some of the risk for the lender and thereby reducing interest rates. Unsecured loans do not have such protections for the lender and therefore have higher interest rates.

Equity

Equity financing means an investor puts money into a start-up, in exchange for a portion of the company’s shares. This means the investor becomes 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 N$100k (US$6k)) injections of capital from family members or angel investors to large deals financed by private equity firms that run into millions of dollars.

Prior to making an investment, 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 poten- tial 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 mod- els showing growth projections, competitor analysis, the proposed approach to marketing, and more.

Equity is the riskiest type of financing for investors, as the funders stand to lose their entire investment should a company fail.

Advantages

• no interest and capital payments to pay back

• investors have an incentive to be as helpful as possible: mentorship, advice, connections

• allows for long-term planning as equity investors do not expect to receive an immediate return on their investment

Disadvantages

• sometimes there are misaligned time horizons – start-ups building for the long-term, while investors want to exit quickly

• control mechanisms can mean entrepreneurs have less control of their business

• equity investors expect to receive a return on their money and the amount of money paid to the partners could be higher than the interest rates on debt financing

Mezzanine

A Mezzanine is a hybrid instrument and refers to financing that sits between equity and debt (hence the name) and combines aspects of both types. It is popular with some investors because it shields inves- tors from certain risks associated with pure equity investment, while still providing an upside if a business becomes highly successful.

There are various types of mezzanine financing, including subordi- nated debt, convertible notes and equity kickers. These are often combined into a single financing facility. The degree to which an investor is willing to be exposed to risk will dictate the amount of equity upside versus debt, for which he or she will negotiate. Con- vertible notes (also known as convertible debt) are quite popular globally, especially for early-stage start-ups. There are several rea- sons why investors and entrepreneurs may want to issue convertible notes instead of debt or equity. For the investors, it provides a level of protection in case the money is used in a fraudulent way – they have the right to pursue the debt issued (typically this is at a 0% rate, so they will attempt to recoup their investment).

For entrepreneurs, who expect their company’s equity to be worth more in the future, issuing a convertible note is likely to minimise their share dilution. Both investors and entrepreneurs are also likely to benefit from kicking the can on valuation to a later point, when an institutional investor comes in. While convertible notes can be difficult to understand, the key thing to keep in mind is that the amount an investor puts in as debt will be converted to equity at a later point to be defined in the contract. The share price will deter- mine how many shares that funding injection will be converted to.

To give a very brief example: a founder and an investor agree to a N$500k (US$30k) convertible debt at a discount of 20%. This means that when the company raises money in the next round, the early investor is able to purchase shares at 80% of what they are worth. If, for instance, the shares are priced at N$10 each (US$0.60) in the next round, the investor will be able to purchase them for N$8 (US$0.50). That means instead of buying 50,000 shares at N$10 each (US$0.60) for the N$500k (US$30k) lent in the convertible note, the early inves- tor will actually be able to purchase 62,500 shares (50k/80%).

There are other considerations and clauses that can be agreed upon, including a valuation cap. An in-depth overview of convertible notes is outside the scope of this guide, but there are plenty of online resources, books and individuals who will be able to walk entrepre- neurs through the complexities of that.

Advantages

• it mitigates risk for investors, meaning better funding terms than straight equity

• it can delay the valuation of a start-up which is imprecise in early-stage companies

• even though the owner loses some independence, he or she rarely loses outright control of the company or its direction

Disadvantages

• entrepreneurs may need to make regular payments to funders

• it can be overly complex and expensive to arrange

• agreements may include restrictive covenants