There are several ways to finance a business. One of them is called “equity financing,” which is when the owners of the business give up a share of equity upfront to VC’s (venture capitalists) and angel investors in return for money invested. That causes “dilution” of the existing shares. In other words, the shareholders will get a lower return on their equity (ROE) because the value of their shares has been diluted.
After exhausting friends and family funding options, startup business owners and entrepreneurs will often turn to venture capital and equity financing to get to the next level. That seems less risky than taking on early stage debt that needs to be paid back, but it could have long-term consequences. There are advantages to debt and other non-dilutive funding that could (literally) pay higher dividends down the road.
What is non-dilutive funding?
Financing that does not cause dilution is called “non-dilutive” funding. Debt is one type of non-dilutive funding, but there are other means of financing that don’t require the dilution of equity. The list includes loans, venture debt, grants, licensing, royalty financing, vouchers, and tax credits. Non-bank financing is also known as alternative funding.
The common denominator with all these is that you don’t need to give up equity when fundraising. With debt, your firm will also be paying interest. Those interest payments are a liability that is added to the income statement after you calculate your EBITDA. Their existence will lower the amount of taxes you’ll owe because they decrease your pre-tax income.
7 types of non-dilutive funding
Equity financing causes dilution, but there’s no requirement to pay it back. Non-dilutive funding is often in the form of debt, so payback is required with interest. That can still be an advantage because interest payments could lower your tax liability. In some cases, non-dilutive funding does not require repayment. Review the list below to learn more:
1. Small business loans
Most people are familiar with the concept of taking out a personal bank loan. We do it to buy cars, homes, and to consolidate debt. Small business loans are different. The lender may check your personal credit score if you’re the point of contact for your company, but they’re more concerned with the company’s balance sheet and income statement.
The advantage of using a small business loan for funding is that you’ll have an extended period to pay it back. Loan terms are generally three to five years on small business loans, so it classifies as long-term debt. The interest payments are recorded as liabilities on the income statement prior to calculating the tax liability, which is an added advantage.
2. Venture debt
Venture debt is a type of loan available to companies that are already venture-funded. It’s offered by specialty banks or non-bank lenders and is typically used for equipment purchases that add to the asset side of the balance sheet. You’ll find venture debt listed as one of the many types of working capital funding your company can apply for.
Examples of venture debt include term loans for growth capital and accounts receivable financing, where companies use their outstanding invoices as a basis for funding. Lenders will typically offer one third to one half of a company’s total equity in venture debt with repayment terms ranging from twelve to forty-eight months. Interest rates vary.
Grants are the most appealing and the most difficult to get form of non-dilutive funding. Unlike small business loans and venture debt, grants do not require repayment. They’re most common in the non-profit sector, but there are grants for start-ups and small businesses that you can apply for through commerce organizations and the US Small Business Administration (SBA).
In the aftermath of the Covid-19 pandemic, the US and state governments made additional money available through grants to help small businesses get through the crisis. Much of that has been used up, but there are several programs available if you’re still struggling. Apply early and apply often. Government grant applications usually take several months to be processed.
Are your products, services, or processes something other companies might be willing to pay a licensing fee for? This is a creative way to raise non-dilutive capital. One of the more common examples of licensing is the use of popular cartoon characters in television commercials. The advertisers pay the creators for those.
5. Royalty financing/revenue-based financing
The recurring revenue generated from a licensing agreement is called “royalties.” Using that income to guarantee debt financing is basically the same process as using your company’s accounts receivables. Royalty rights can also be sold outright, providing an instant source of working capital, but depriving the company of a future income stream.
6. Vouchers and bonds
Vouchers and bonds are financial vehicles for raising funds that don’t require processing or approval by a third party. A voucher is essentially a “promise to pay” which can be offered in place of cash. A bond is issued in return for a specific amount of money invested. Instead of equity, the company pays interest during the bond term plus principle upon maturity.
7. Tax credits
Tax credits don’t add money to the asset column. They reduce the tax liability on the other side of the balance sheet and increase retained earnings, which equate to shareholder equity. We’ve included tax credits here because they’re non-dilutive. Tax credits increase return on equity rather than decrease it, so take them whenever you can get them.
Advantages and disadvantages of non-dilutive financing
The primary advantages of non-dilutive financing should be obvious. You don’t need to give up any equity in your company to get it and you won’t dilute the equity of your existing shareholders, leading to higher retained earnings and dividend payments. There are also tax benefits to debt funding such as interest payments reducing your tax liability.
The disadvantage is that in most cases you’ll be taking on debt. Loans, venture debt, and bonds are the most common types of non-dilutive funding. Grants are hard to come by. Licensing and royalties are only available to certain types of businesses. Tax credits come when they come. Most businesses choose either debt or equity funding.
How to know if non-dilutive funding is right for you
It’s time for some small business finance tips. First, let’s put on our “Accounting 101” hats and review how a balance sheet works. Assets are on the left. Liabilities and shareholder equity are on the right. To achieve “balance,” the two sides need to be equal. Check that first before we move on to the next part of this exercise: calculating ROE.
To calculate the return on equity (ROE), you’ll need the net income from the income statement. Divide that by the shareholder equity from the balance sheet. Here’s the formula:
ROE = (Net Earnings / Shareholders’ Equity) x 100
Why is this important? When you fund your company with equity financing, the ROE for your existing shareholders, including you, will go down. That doesn’t happen with non-dilutive financing. Figuring out which option is best for you starts with the ROE equation. You can use it to answer the following important questions about funding:
· How many shares are currently outstanding?
· What will the new ROE be if you issue new shares?
· Will shareholders be happy with your decision?
Public companies that dilute their shares too much can create a sell-off that could negatively impact share prices. Firms that take on too much debt could end up with limited working capital as they attempt to pay it back. Making the decision between the two is a balancing act, so start with your balance sheet. The numbers will give you guidance.
Ramp provides you with working capital to unlock and sustain growth
Ramp has a non-dilutive funding option for you called commerce sales-based underwriting. It’s designed for startups and growing businesses with an online shopping cart. Our platform connects to popular commerce platforms such as Shopify, Stripe, Square, Amazon, and WooCommerce. We use that data to secure you up to 30x higher credit limits on average.
Using sales-based underwriting with Ramp’s expense tracking software gives you more spending bandwidth through non-dilutive debt and can reduce your costs by giving you more control over spending and expenses. Best of all, you won’t need to give us equity in your company to take advantage of it.
Dilutive funding requires the company to give up equity in return for the funding, lowering the return on equity for current shareholders. Non-dilutive funding doesn’t require equity, but it may come in the form of debt which needs to be paid back with interest.
Everyone should consider non-dilutive funding as an alternative to equity funding. There are advantages and disadvantages to both, so they should each be considered carefully when the company needs additional funding.
When a company dilutes its shares, the shareholders get a smaller return for their investment. In public companies, this could cause a sell-off that could drop the share price even further.
Extra shares can be issued without dilution if a general resolution is passed by the shareholders and existing shareholders buy the new shares on top of their own. Non-diluted shares cannot be offered to new shareholders.
Ramp offers sales-based underwriting that can give you access to working capital when you need it. Ramp’s commerce-based sales underwriting is a type of non-dilutive funding since it gives you access to capital via credit – rather than in exchange for shares of your company.