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Four ways to fund a start-up

18 Apr 2018

Matthew Cohen outlines the advantages and disadvantages of different funding options for companies seeking to transform innovative materials into material rewards

Conceptual image of a person holding a magnet and attracting cash to it
Different ways of funding start-ups offer their own advantages and disadvantages (Courtesy: iStock/kentoh)

There is no one right or wrong way to grow a company. Every start-up’s journey will have unique twists and turns, and although venture capital (VC) gets a lot of attention as a means of helping entrepreneurs obtain outside funds, it is hardly the only game in town. In fact, in most situations, VCs are not the optimal funding source for early-stage companies commercializing novel physical science innovations – and I say that even though I am a VC investor at a firm that supports companies doing just that. The numbers back me up: according to the crowdfunding platform Fundable, fewer than 1 in 100 start-ups are funded by angel investors and about 1 in 2000 (0.05%) are funded by VCs.

But if VC (probably) isn’t going to help your company grow, what will? Broadly speaking, external funding sources fall into four groups: grants, strategic partnerships, equity investment and debt. This list omits profits, which is perhaps the best funding source of all: when your business’s growth can be supported organically by reinvesting the profits you make from selling your product or service at a positive margin, you don’t need to bother with external entities. However, many start-ups simply cannot grow completely organically, or they want to grow faster than organic growth alone allows, at least at the outset. Therefore, external funds are often required to push a technology out of the lab.

Each external funding option has advantages and disadvantages, as well as a time and place, in the commercial journey of an advanced materials start-up. Let’s explore these in more detail, in an order that roughly aligns with how companies pass through commercial stages.

A grant to get started

Grants are often the funding source of choice to take a great idea or lab result and turn it into a bona fide start-up company. To keep things simple, when I refer to “grants”, I am also lumping in other non-equity, non-strategic-partnership funding sources. These include university business plan competitions such as the Rice Business Plan competition at Rice University in the US (the world’s richest and largest student start-up competition) and grand challenge-type programmes like the Carbon XPRIZE – a $20m global competition sponsored by NRG COSIA to mitigate or reduce CO2 emissions. Many grant programmes have a geographic component, so depending on where you are, you might want to consider applying for Horizon 2020 (EU), SBIR/STTR (US), ARPA-E (energy-related innovations in the US), or SDTC (Canada) funding if you want to commercialize a physics-based, hard tech innovation – and this is by no means an exhaustive list.

Just as in academia, grants for start-ups are competitive, and the granting body may restrict how you can use the funds.

Early in a company’s gestation, grants are a great way to bring in enough money to advance an idea into a prototype product, validate a market hypothesis, or perform additional technical development. Not only are they typically designed for early-stage and high-risk, high-reward propositions, they also don’t require you to give up any ownership or control in your company. Typically, the intellectual property – patents, trade secrets or process knowhow — developed with the support of a grant remains the company’s sole property.

Another advantage of grant funding is that companies become more valuable the closer they get to commercialization and reduced technical risk. Thus, the longer you can wait to raise outside capital, the more favourable the terms of that capital will be for you and your founding team. Hence, grants represent a good way to increase a company’s value in the eyes of a potential investor or acquirer.

The downside of grants is that, just as in academia, grants for start-ups are competitive, and the granting body may restrict how you can use the funds. Oftentimes, expenses such as marketing activities, patent legal costs and capital expenditures cannot be funded by a grant. Another word of caution is that grants are often not directly aligned with the vision, mission or strategy of a start-up. Their influence can be defocusing for a founding team, and the monetary support they offer must be weighed against the time and effort required to apply for them and comply with their terms. VC investors often avoid start-ups with an “SBIR shop” mentality as it can be hard to change the company culture into a high-growth, product-focused business.

A final challenge is that some grant programmes require the company or other investors to put up matching funding. In some circumstances, however, this can be a good way to use a small amount of outside equity capital to bring in a larger amount of money. From an investor’s point of view, this is a form of free leverage: it means that our investment buys more for our money than a traditional venture round of funding.

Howdy, partner

Start-ups are typically good at developing novel out-of-the-box solutions and nimbly pivoting and refining their approach. However, scaling up manufacturing, creating a channel to the market and/or developing the requisite trust in your (currently) no-name brand are often not a start-up’s strong suit(s). No one wants to reinvent the wheel, though, so at this stage, smartly crafted win-win partnership agreements can really help accelerate product development and market launch. Furthermore, a collaboration with a large, established company in your target market or supply chain can help validate the market’s interest in what you’re developing. For physics-based entrepreneurs, capital efficiency is the name of the game: most investors don’t have the appetite or knowledge to play in this space, so utilizing strategic money is a great path to a successful venture.

We almost always encourage start-ups to engage with strategic partners from an early stage.

Strategic partnerships can take various forms, and the devil is always in the details. However, two of the more popular strategic partnership funding models for a physical science start-up and a large company (“BigCo”) are non-recurring engineering (NRE) funding and joint development agreements (JDAs). While the nomenclature may vary, NRE typically refers to a one-time payment or a series of milestone-tied payments from BigCo to start-up that help the latter design, develop and test a new or improved product. JDAs, on the other hand, usually involve BigCo paying a start-up to develop a tailored solution that fits BigCo’s specifications and ties into a particular market; common design elements where each company pays their own expenses; and innovations that fall outside of the defined scope of the JDA, but which the start-up created while developing a solution on behalf of BigCo.

Here is an example. Let’s suppose a large steel producer signs a JDA with a thermoelectric start-up on a project to recapture and utilize waste heat from their industrial processes. During the JDA, the start-up develops a manufacturing improvement that reduces the cost of producing its industrial waste heat recovery modules by 60%. However, this improvement also applies to the combined heat and power systems that the start-up is developing for a residential market. Typically, this improvement IP, as it falls outside the scope of the JDA, is solely owned by the start-up. Hence, innovations that result from JDA funding often have important spillover effects for the start-up company’s technology platform as a whole.

The next question, of course, is how to find a suitable partner. Even if you have identified a BigCo that would benefit from partnering with you, locating the right person to speak to within their 10,000+ employee organization can be surprisingly difficult. This is an area where VC firms like Pangaea can be helpful. Our limited partners (that is, the investors in our funds) include many of the world’s leading material, chemical, industrial and electronics companies, and because we’ve been investing in advanced materials companies for over 15 years, we have developed a good network. Based on this experience, we almost always encourage start-ups to engage with strategic partners from an early stage. Assuming the agreements can be crafted in a mutually beneficial way, we believe the myriad benefits (including de-risking product development, obtaining market validation, help with creating a channel to market, identifying a potential future acquirer and, of course, the cash) outweigh potential downsides such as giving up a slice of the pie or scaring off competing strategic partners.

A stake in the game

Photo of Matthew Cohen

The equity investor mix includes high-net-worth individuals (typically referred to as “angel investors”); “angel groups” where several such individuals participate in deals together; “family offices” where managers invest an ultra-wealthy family’s money; venture capital and private equity firms. It’s hard to generalize about why these various entities would invest or pass on a start-up, but typically, equity investors want to “add fuel to the fire” to help a start-up build its operations and thus create shareholder value. This means that, all else being equal, this group of investors will eschew “science projects” where money is earmarked for fundamental R&D work in favour of start-ups where a capital infusion will enable rapid commercial expansion.

Most VCs are looking for a plausible path to obtaining 10 times their initial investment within three to seven years. If that sounds like a tall order, that’s because it is: most investments fall well short. However, if an entrepreneur cannot convince a VC that the addressable market is large enough; the “pain point” for consumers is acute enough; the team is strong enough; and a potential acquirer will pay a high enough price – well, we’re probably going to pass. Most business cases do not fit these stringent requirements, but this certainly does not mean that they should be abandoned. It just means that VCs aren’t the right choice for funding them (at least not right then).

Raising a round of venture capital speeds up the clock for a start-up. Venture rounds typically last one to two years, and if key milestones are not achieved within that time frame, it will be tough for that start-up to raise additional funds in a successive round. Venture money can solve some problems, such as shortages of working capital or funding for expanding a firm’s capacity, but it often cannot break down fundamental technical or commercial barriers – at least, not during the time frame of a funding round.

On top of this, the rate at which firms burn through cash typically ramps up after they get VC funding. This makes it more difficult for a start-up to reposition and pursue a different path or adjacent opportunity. In general, a round of VC funding means making a bet on a specific market opportunity. There may be pivots along the way, but getting the market opportunity completely wrong is usually a death sentence. For that reason, VC funding should come in when the start-up is ready to make a good, educated guess about the market, rather than just throwing things at the wall and seeing what sticks.  This is especially true for physics-based innovations. For example, a start-up company in this sector might develop a new semiconductor manufacturing process that can be used for silicon-based anodes in lithium-ion batteries, solar cells, thermoelectrics and non-volatile memory – a classic “platform” innovation. However, if they try to go after all of these opportunities simultaneously, it’s unlikely they’ll succeed with any of them. VCs want to see concrete progress on solving a major pain point in a large market, not just potential.

Venture money can solve some problems, but it often cannot break down fundamental technical or commercial barriers.

A final item to note is that when a start-up gets VC funding, its corporate governance and oversight can change almost overnight. Typically, a new board of directors is formed or an existing one significantly changed. This board will play a range of roles, including de facto “boss”. If the board believes things are not going well, or the CEO or key team members lack the skills necessary to increase shareholder value, it is the board’s fiduciary responsibility to supplement or even change the team. Even though the chances of a founder being fired from the start-up he or she founded are low, the mere possibility can be a very tough pill for an entrepreneur to swallow.

Indebted

The last source of funding for a start-up company is debt. Usually, this is more appropriate for later-stage companies with sizable balance sheets, revenue and purchase orders. While it may be possible for a pre-revenue start-up to take on debt, it’s a risky proposition. Terms around interest rates, payback periods, and penalties for missing repayment deadlines vary widely, but the last of these could include losing control of your company. Furthermore, debt holders are almost always senior to all other stakeholders and will get paid first if the company is liquidated or acquired. Some company-friendly, economic development debt programmes are certainly worth considering at almost any stage in a start-up’s life-cycle, but until a company can make good predictions about revenue amounts and timing, it’s tough to make traditional debt funding work.

The bottom line

Grants, partnerships, equity and debt are all valid options for funding start-ups. When considering which route to follow, it is worth remembering that venture capital and private equity are only appropriate for very specific subsets of early stage corporate growth. As such, VC won’t be right for most companies. However, for advanced materials start-ups that do fit the mould, we encourage you to consider getting in touch. Even if Pangaea declines to fund your venture – and that’s what we do most of the time – we always strive to assist. If we can provide feedback, introduce you to a potential partner, or even just stay on each other’s radar screens as you make commercial progress, we’re always happy to connect as you progress your innovations from the lab bench all the way through to global deployment.

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