Here are some practical strategies and financing tips on the scale-up path.
Over the past decade, more start-ups have been founded and funded in Australia than ever before. Rather than taking the well-trodden path to investment banks, consulting firms and large corporates, many of Australia’s brightest school leavers and graduates are choosing to pursue their entrepreneurial dreams. Similarly, seasoned executives are increasingly taking what they have learned from their corporate careers and launching their own businesses.
However, the entrepreneurial journey is rarely a smooth one. The revenue that start-ups initially generate is usually both low and unpredictable. As the cash received from customers is usually less than the cash needed to pay for staff, marketing and other overhead costs, founders need to invest their own money and raise equity from investors to build their businesses through this start-up phase. Seeking external investment in a start-up business likely begins with family and friends and may progress to seed and VC investors. While founders don’t love the resulting dilution in their ownership position, most accept it, as without it, they can’t continue their entrepreneurial journey. For many, raising equity is their only option.
Once through this start-up phase, founders face a new set of operational challenges. Scaling a business is not usually a linear process. As revenues grow from low to mid-single digit millions at 20-50% p.a., so too do operations, which brings rising staff costs. The costs of growth, such as ongoing product development and marketing, also grow. It can take many years before a start-up gets to the point of being financially self-sustaining, where revenues are able to cover both fixed and variable costs. Businesses at this stage of their evolution are what we call a Scale-up at GCI Leap Capital.
However, while start-ups have relatively few choices when it comes to financing, scale-ups have significantly more options. They can continue to fund growth through the traditional routes of raising equity or convertible notes (debt by name, but really equity in disguise). Or they can choose not to raise at all, grow more slowly as a result and simply reinvest any profits that they do make back into the business. Increasingly, they are also able to raise debt. There are a number of “use cases” for scale-up debt. We have outlined some of these below.
Adding fuel to the fire
Many scale-ups have attractive unit economics with proven channels for finding new customers and well understood pay-back periods. The challenge is to continue to finance the acquisition of new customers as cost effectively as possible as the payback, while well understood, is often a year or more in coming. Funding this “gap” out of operating cash flows alone often results in significantly slower growth. However, financing customer acquisition through equity can be very expensive in the medium term. As such, taking a loan to fund spend in proven customer acquisition channels can be an attractive option that means founders do not need to sacrifice their growth ambitions, whilst managing their ownership positions.
Bridging to an inflection point with minimal dilution
- Breakeven and financial independence: For founders, an equity raise when breakeven is in sight can be the most painful raise of all. It results in permanent dilution of their ownership at a point when their business is so close to achieving financial independence. In this instance, founders can use debt to get them through to breakeven and being financially self-sufficient thereafter.
- An equity raising at a significantly higher valuation: When a business is growing fast, it is always tempting to delay a capital raise because its valuation is growing each month in line with its revenue. A founder will always be tempted to think, “If I just wait another few months, then I will get a higher valuation and will dilute less.” However, there are risks with this strategy too as the business’s cash runway will also be shrinking with each passing month, growth may slow and that expected future equity raise may take longer than expected – or worse, fail altogether, leaving the business in danger of running out of cash. A small loan that bridges to the next equity raise can mitigate these risks while allowing the founder to continue to drive growth ahead of a raise in several months’ time at a significantly higher valuation.
- An equity raising with a different set of target investors: Some equity investors have minimum thresholds that need to be met before their mandates allow them to invest in a business (e.g. a minimum ARR or a minimum equity cheque). In the case of a minimum ARR, a business may need to continue to invest in order to achieve this threshold with their preferred equity partner. Raising equity now from a different investor just so that they can get ready to raise further equity at a later point will often result in an unpalatable level of dilution for many founders. Instead, they can take a loan now in order to have the capital required to grow to meet the thresholds of their preferred long term funding partner.
Expansion into new geographies or launching new products
Many scale-up businesses want to accelerate their growth through launching new products to sell to their existing customers or by taking their existing products into new geographic markets. Businesses at this stage are often generating solid revenue from an existing product in their current market. However, their core business is not yet producing the required cash flow to fund the launch of a new product or expansion into a new market. While equity is the right option for a start-up launching a new product to market, for a scale-up business, it can feel too expensive for founders and existing shareholders. Again, a loan can solve this problem so long as cash flows from the existing business can service the loan that enables the expansion into new products and markets that will likely be loss-making for a period of time.
Small bolt-on acquisitions
It is quite common, particularly amongst software start-ups, for founders to build a good product but not manage to scale it successfully. This can be because of a lack of funding or an inability to find cost effective sales and marketing channels. In some case, more established scale-up businesses operating in adjacent markets can acquire the assets of these businesses. They can then sell additional product(s) through established channels to their existing customer base. If they cannot fund these acquisitions through their own cash, they may be able to do so through a loan.
As the many start-ups that have been launched in Australia move into their Scale-up phase, we would encourage them to think expansively not only about their growth strategies but also their financing strategies. This will ensure that when these businesses do scale into sustainable, profitable, growing enterprises, the value that will be realised by their founders and shareholders will be reflective of the effort, blood, sweat, tears and risks that they have taken to get there.