As an investment manager, I sit down daily with innovative companies seeking capital. For example, I talk to them about business strategy, the valuation of their company and possible funding structures. This always involves discussing the different forms of capital and what the advantages and disadvantages are. In this article I tell more about the 3 most common forms of capital and what my experiences with them are.
What forms of capital do we often encounter?
The type of capital a company needs depends very much on the type of business and the stage they are in. In general, loans, equity and convertible loans are the most common.
A loan appears on a company's balance sheet as debt capital. Most loans are provided by banks. The amount must be repaid within a certain period of time, and as an entrepreneur, you pay interest on the money you borrow. So the amount you have to repay is ultimately higher than the amount you borrow.
Banks want assurance that they will get back their investment. That's why banks often hold entrepreneurs personally liable. For example, they must put up their house as collateral. If things then go wrong with the business, the bank can sell the house and thus recover their investment.
For companies in the startup phase, getting a loan is often difficult. There are simply too many uncertainties, so a bank often does not have the confidence to see their money back.
Not even at NOM. Or is it?
In a nutshell, NOM does not originate loans like the bank does. This form of capital does not fit the stage at which we usually enter. The time-to-market is often still too long, so an entrepreneur usually has to start repaying before he books sales. This creates pressure on cash flow, which is negative for business growth.
We do provide subordinated loans. These are loans where we do not ask for guarantees. We show that we have confidence in the company, which also sends an important signal to banks. With a subordinated loan we take a risk, but we also strengthen the company's guarantee position.
Sometimes we get a call from a bank. They have an application for a € 500,000 loan, but see that the company can only guarantee € 350,000. We then step in with a subordinated loan of € 150,000, so that the entrepreneur can continue to grow. I expect this working method to increase in the future.
Another way to get capital is to sell some of the company's shares. In this way, you trade a piece of control of your company for capital to continue growing. This has advantages and disadvantages.
The advantage is that you are not liable for losses greater than the capital you have paid into the company. In addition, you share the risks of an investment with the co-shareholder. On the other hand, you do have to share profits with the other shareholders. The biggest disadvantage that many entrepreneurs experience is the fact that they lose some of the control over their company. Usually the fact that they get capital to continue growing outweighs this.
Investors often request preferred shares. With these, they try to hedge additional risks, for example with a veto right. Or they ask for additional economic rights. It is important for entrepreneurs to pay close attention to which rights they are giving away when selling shares.
Share deals at NOM
When we at NOM participate in a company, we often do so through a share transaction. When we join companies at an early stage, there is often little value created yet. That makes a discussion about the value of the company difficult, complicated and time-consuming. An entrepreneur usually looks at what his company may be worth in a few years and bases the stock price on that. We take the risk today and reason the other way around. In fact, the company can often deliver the predicted growth only with the help of the intended investment.
For many early growth stage companies, equity deals are relatively complicated. Negotiating the company's valuation is always a tricky issue, which takes a lot of time. In addition, selling shares takes a lot of time and money anyway. For example, investor control and rights must be negotiated, and a participation and shareholder agreement must be drafted.
Convertible loans are becoming increasingly popular in the startup phase. A convertible loan starts as a regular loan, where repayment obligations and interest payments can be suspended. The repayment and interest is then credited to the total loan. Investor and entrepreneur together determine one or more times when the loan can be converted to equity. For example, when a new investor joins or when a certain turnover is achieved. The convertible loan is the perfect middle ground between loans and equity deals.
As an investment manager, I am enamored with convertible loans. It takes the sting out of discussing business valuation in equity deals and is much quicker to settle. Also, the investor's rights don't have to be discussed so extensively yet; that will come at the time of conversion. At that time, if all goes well, the company will also be worth more. That simplifies the discussion about the valuation of the company. Because we invested at an early stage and thus took a risk, as an investor you often get a discount on the then current share price.
The convertible loan is also interesting for the entrepreneur himself. His investment is available sooner because this form of loan can be arranged quickly. In addition, it is also nice for the company not to have to endlessly discuss the value of the shares and the rights of investors.
I therefore understand very well why this form of capital is so popular with startups in America. I am therefore not surprised that this method is increasingly being used by Dutch startups. In any case, I will not hesitate to suggest the convertible loan if this is the best option for investor and entrepreneur.
In this white paper you will learn:
- What you have to deal with when you start working with investors
- Differences and similarities between bank funding, subordinated loan and equity capital
- In what ways NOM as an investor can help you
Please note that this whitepaper is only available in Dutch at the moment. We are in the process of translating this whitepaper.