Startups Need To Avoid Taking Debt Amid Coronavirus Spread
Starting an enterprise is a difficult task as it requires countless sacrifices. These include physical and mental health issues associated with working long hours and missing out on important family events due to work obligations. But what worries most aspiring entrepreneurs these days is being stuck with an unsustainable level of debt during a global pandemic.
The unfortunate reality is many startups end up in failure, and this figure will multiply as the coronavirus (COVID-19) continues to force hundreds of millions of people inside their homes. Banks and lending institutions are less willing to take a chance on an entrepreneur’s idea which creates an unfortunate reality where startups struggle on financing.
Downfalls Of Debt Financing
Enterprises of all sizes from one employee to hundreds of thousands will always need easy and quick access to money in the best of times. But the first few months of 2020 have proven this is far from an ideal environment for enterprises to raise capital. The one person enterprise just starting and working from their basement doesn’t have the same ability to borrow compared to multinational behemoths.
Banks and financial institutions will be quick to demand startups and their founders pay large interest rates with punitive terms. From their point of view, it makes sense: the risk of default is much higher now due to the coronavirus and their fees need to correspond with the heightened level of risk.
Banks could be put in a position where they need to save themselves from billions of pounds of losses. And when big banks are very unhappy, they have the legal resources to make sure their money is recouped through any means, including seizing personal assets like a home.
Funding Rounds: A Partner In Success
Equity financing is the complete opposite of debt financing. Instead of signing off on a transaction in which the entrepreneur owes an institution or lender money, the enterprise owner owes a portion of future profits and other benefits as a new minority owner.
For example, an enterprise owner who developed a new software can sell a certain percentage of their entire operation to an investor. In other words, there is zero debt involved.
The first round of securing financing from an outside investor is referred to as a “Series A Funding.” The coronavirus certainly presents a new set of challenges, many of which can be overcome. For example, the advancement of video conferencing can replace face-to-face meetings.
However, an entrepreneur needs to plan wisely and seek an outside investor who is in a position to leverage their investment cash with relevant expertise or a network of professionals. Now more than ever, even the brightest and most motivated entrepreneur needs outside guidance and help to navigate through the coronavirus pandemic.
Again, the enterprise owner is trading a portion of the enterprise’s future profits in exchange for financing so a two-way relationship needs to be established. Private equity and other investors will become increasingly selective over who gets access to their cash. Entrepreneurs need to understand their enterprise and market inside-out to prove they are a winner.
If the enterprise fails, the entrepreneur isn’t financially responsible to pay back the investment since it involves no debt. The likelihood of the investor taking drastic actions like repossessing a car or home due to failure to repay is non-existent.
Assuming the “Series A” round is successful and the enterprise achieves a set of goals and objectives, it could reasonably justify a new round of investment, known as a “Series B.” Once it is evident that the initial success seen after the first round of financing can be replicated at a larger scale, it will be easier to attract new investors who will want to invest in a booming enterprise despite coronavirus-induced headwinds.
The first original outside investor may or may not partake in the second round of financing as there is no obligation to do so. They also may want to take advantage of what is likely to be a higher valuation to sell their investment at a profit. After all, they are in it for the money and nothing else.
Similar to the previous round of financing, a “Series B” investor is likely to make its resources available, including access to experts that can help expand the enterprise even more. The process of funding rounds typically ends after a “Series C” although it is not unheard of for enterprises to go as far as a “Series E.”
Beware Of Giving Up Too Much Control
While more common in later stages, the outside investor could be in a position to make exceptional demands, like a vote on key decisions or representation on the board of directors. The entrepreneur will need to carefully evaluate the pros and cons of each stage. But this could be seen as a sign that everyone’s financial interests are aligned as everyone wants to maximize profit
Each round of financing comes at a cost to the entrepreneur: a percentage of their enterprise. After owning 100 percent of the enterprise, an entrepreneur could find themselves outnumbered by outside investors.
Under a worst-case scenario, the founder of a company could be shown the door. The most notable example would be ride-hailing company Uber whose founder and CEO Travis Kalanick was forced to resign after clashing with powerful investors and individuals who were granted seats on the board of directors.
Even worse, outside investors flush with cash can take advantage of the coronavirus outbreak by imposing the types of demands which would be unheard of during a normal period. But at the end of the day, the entrepreneur could be left with no option but give in. This would be especially true if outside investors are holding on to their cash and waiting for an economic rebound. Each individual entrepreneur will be faced with a difficult decision to make, but would need to accept the new reality that the coronavirus has changed the way the world does business — and certainly not for the better.
