What is quasi-equity and how can it benefit fast-growing early stage companies
Every entrepreneur dreams of watching their sales explode. They’ve launched a great product and are starting to get traction with customers. The future looks bright.
But now, they need money—typically for sales and marketing—to execute on the next phase of growth and make it over the hump to the promised land of profitability. They might have used up their personal resources and investments from family and friends, and they recognize that their new needs extend beyond their existing shareholders and capital providers.
In this situation, traditional lenders will tend to refuse to lend to the business because it doesn’t have collateral or positive cash flow. What to do?
Quasi-equity loans offer flexibility
“These entrepreneurs are often frustrated because they feel no one appreciates what they’ve achieved,” says Robert Duffy, Vice President, Growth & Transition Capital at BDC Capital. “Traditional lenders are usually uncomfortable taking on that kind of risk.”
That’s where unconventional types of loans can come in, such as quasi-equity financing. Quasi-equity loans offer flexible repayment terms with no need for specific assets as collateral or a history of profitability. Here’s how they work.
Based on projected cash flow
A quasi-equity loan is given based on a company’s future cash flow projections. Even if your cash flow is negative right now, you may be eligible for quasi-equity financing if your business has started to get customers, is growing quickly and expects to generate positive cash flow in the near term.
It’s more suited to companies in that situation than mezzanine financing—another type of unconventional loan. Mezzanine financing typically requires a record of positive cash flow.
Cost depends on performance
A quasi-equity loan’s cost is typically a combination of a fixed interest rate and a variable component, tied to the performance of the business, such as a royalty based on revenue.
Lower cost than equity financing
Due to the lack of security and early stage of the business, quasi-equity financing is more expensive than a traditional business loan. A lender typically targets a return that falls in between the cost of senior debt and equity.
But quasi-equity is still cheaper than equity financing, a typical source of money for cash-hungry young businesses. Equity investors usually demand a high return—30% isn’t unusual—to compensate for their risk.
No ownership dilution
Unlike equity financing, a quasi-equity loan typically doesn’t require dilution of your ownership stake.
Quasi-equity financing involves tailor-made repayment terms, with a typical duration of two to eight years. Commonly, no principle repayment is required for the first year or two. Options can also include balloon payments (repaying the entire loan at the end of the term) and cash flow sweeps (partial repayments when extra funds are available).
“The idea is to allow you to keep more cash in your company during the critical first few years,” Duffy says.
4 lessons from fast-growing start-ups
Quick growth can put a lot of stress on an early-stage company’s finances. While sales are expanding, piles of cash are flying out the door for equipment, inventory and staff. Meanwhile, receivables can take a long time to come into the business. Cash crunches aren’t unusual.
BDC Capital studied over 100 fast-growing start-ups to find out how they succeeded. Here are four lessons we’ve learned.
1. Use “what-if” scenarios
Most start-ups try to forecast expected revenues and expenses. But such forecasts are notoriously unreliable.
“Forecasts are incredibly important and we recommend that management spends the time necessary to plan and align the expectations of shareholders with those of lenders, employees and other important stakeholders,” Duffy says. “But a lot of forecasts aren’t useful because they lay out one or two specific scenarios. It is difficult to predict the future with accuracy, especially for an early-stage business.
“It’s very common for a company to encounter unanticipated issues and for revenue not to grow as projected. Most businesses haven’t figured out what they will do if that happens. They keep spending according to the ‘plan’ on an assumption of growth, and then they run out of cash.”
Companies often get caught in a difficult situation, Duffy says. They don’t want to cut costs for fear of negatively impacting their growth prospects or valuation. But as a result, they keep burning cash in a way that is unsustainable.
Instead of relying on forecasts that attempt to predict the future, Duffy suggests imagining a number of what-if scenarios—for example, slower-than-anticipated sales or higher sales—and working out how they’d impact cash flow. Then, if revenue growth is slower than expected, you’ll already have an idea of how hiring and other spending increases will be affected.
2. Tie spending to milestones
Don’t recklessly spend money if your growth or finances are off track. “You can’t execute the next step in your plan if the first step didn’t work,” Duffy says. “It might seem obvious, but we see this mistake repeatedly.”
Instead of tying spending to a possibly unreliable forecast, link it to milestones in your growth plan—for example, net income targets.
3. Stay focused on your finances
Staying on top of your finances may seem like another no-brainer, but a surprising number of companies fail because they don’t give it the importance it deserves.
“A lot of business owners are detached from their financial reality,” Duffy says. “They often see a financial plan as just a necessary evil and don’t link operational decisions to the reality of their financial situation and cash position.” Duffy suggests that business owners not abdicate any of their responsibility in this area. “Don’t assume that your finance team or advisors have a better handle on this issue than you.”
4. Approach lenders early
Once you have your first repeat customers, consider your coming financing needs. Many businesses make the mistake of waiting until they need financing before exploring options. That can put a heavy strain on the management team and may result in other priorities being ignored as they attempt to raise financing. Instead, approach lenders well ahead of time to explore your options.
Find out more about BDC’s quasi-equity financing and other customized financing solutions.