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There are many options companies can take when looking for funding, which they will need at various times during its growth. Debates in the boardrooms of startups usually hover around whether to go for dilutive or non-dilutive funding.
Each comes with its own set of advantages and disadvantages and they each work or hurt the founders in various ways depending on circumstances and depending on what goals and risks the founder wants and is willing to take.
Any investment that reduces the value of the company shares – primarily through the issuance and sale of new shares – is a dilutive investment. This has been the traditional route for startups, particularly in the tech industry.
This approach offers multiple advantages, namely, in that it secures funding for the business, while also allowing an investor to own a portion of that business in the hopes of gaining financially as the business grows, either through dividends or through a potential sale of those shares (or exit from the company) down the road for a higher valuation.
Depending on the type of shares being issued to the investor and the amount bought, this also offers the investor some say in the management of the company.
For the founders, they run the risks of having their shares diluted – giving them a smaller piece of the pie, and depending on the type of shares issued and the size of the stake offered, this could also dilute the founder’s control of the company.
At the same time, the investor is taking a risk by investing in the company, particularly if it is in its early stages. Startup failures are the norm, with a staggering 98% of startups failing in their first five years – long before the usual time it takes for the investor to see a return on that investment. That is why venture capital firms exist: to pool large quantities of investor capital and hedge against the fall of the majority of.
Deciding which strategy to go with will be greatly determined by the business size, needs, financial, capabilities, circumstances and timing. The ideal outcome for an owner is to obtain the largest possible valuation for the business.
While valuations are impacted by the business’ growth, management, financial results, and operations, outside factors such as investor sentiment, the macroclimate, bubbles, and the interest rate environment play a huge role is determining their access to and the availability of funding.
This can be seen in the 2001 collapse of the tech bubble, which happened after a period that had seen investors pour massive amounts of funding into any tech startup regardless of their economic viability at higher and higher valuations.
That coupled with historically low interest rates and the innovations coming out of the tech industry at the time, rapidly drove demand from investors to buy shares.
At higher interest rate environments, and times of economic downturn, investor funding usually dries up, making it difficult for businesses to get good valuations for their companies.
Non-dilutive funding – as the name suggests – is when a business obtains funding without having to see the ownership stakes of the shareholders reduced or diluted.
Non-dilutive funding is a broad term that covers a whole slew of possible transactions. This includes taking on debt in various forms, including business loans from a bank, personal or credit card loans, leasing of equipment or even venture debt – where a VC firm that has obtained equity in a startup provides it with a loan that would be repaid in a fixed amount of time.
Non-dilutive funding also comes in other forms such as the sale of company assets, grants from the government or other donors, or crowdsourcing. They also include revenue sharing models, whereby a loan is paid off through a share of the expected revenues.
The main advantage of non-dilutive funding is that business owners will not need to give up any equity to obtain said funding, allowing owners to retain control of the company. Loans also do not come with a set of milestones. The capital is injected, and the company is free to do with that loan what it sees fit, provided interest payments are made.
High interest rate debt could be a huge financial burden, especially on a company that has just started operating.
That’s if a small business can even obtain a loan, as financial institutions typically hesitate to take a risk on a nascent company.
Access to grants is also very limited, as well as highly competitive with many businesses competing for a proportionately small pool of funding.
Read more about: Saudi Arabia's SMEs Financing Programs
It's worth noting that in times of slow growth, investor funding dries up, driving demand for companies to seek alternative forms of funding, including non-dilutive.
This is currently happening in the MENA, where almost half of the USD 4 billion raised by startups in 2023 came from debt. Debt taken on by startups tripled over the previous year to USD 1.7 billion, whereas total funding rose only by 1.7%, according to Wamda’s Investment in MENA Year in Review 2023.
The primary factors that goes into considering debt is whether rates are low or high and whether the business itself is showing traction or is performing financially. Existing shareholders in well-performing companies will be more likely to favor taking out loans they know they can pay at favorable rates and avoid dilution.
Inversely, when interest rates are higher, companies usually shy away from taking on debt, unless favorable terms at convenient scheduled payments are worked out with creditors.
Know more about: What are the different types of crowdfunding platforms in Saudi Arabia?
Disclamer:
The post is for educational purposes only and the Firm does not directly or indirectly provide these services. Funding Souq KSA is regulated by the Saudi Central Bank (SAMA). This communication is not directed at or intended to be acted upon by any Person in the DIFC.
