ImpactAlpha, May 13 – One defining outcome of the pandemic: a boom in entrepreneurship.
A record five million businesses were started in the U.S. last year. Many are sole proprietorships but many are hiring and more want to bring on employees. Women and immigrants and entrepreneurs of color are leading the wave of new business starts.
The kicker: venture capital and commercial banks back less than 20% of all new businesses.
Call No. 42 explored alternative financing structures for startups and small businesses that are changing the trajectory of entrepreneurship and community wealth. Key question: Is the term “alt-capital” still appropriate when such instruments reach as much as 80% of the market?
Weighing in were Kim Folsom of Founders First and Wefunder’s Jonny Price, along with Astrid Scholz of Zebras United and Armillaria, Ron Boehm of BOMA Investments and Andrea Armeni of Transform Finance.
That the dominant venture capital model is not appropriate for most businesses was undisputed on The Call. One problem, of course, is access, particularly for diverse founder-led businesses. Funding decisions made by a few and underwriting practices dependent on collateral leave much of the early business market without funding.
Another is that expensive equity capital may not be what businesses need to expand. Longstanding forms of debt finance – working capital, inventory finance, factoring, trade finance, even revenue-based lending – are being applied to a very large underserved market.
To bridge the funding gap for diverse entrepreneurs Founders First deploys revenue-based finance, which allows firms to raise capital by pledging a percentage of future revenues up to a cap. More than 63% of Founders First’s funding has gone to female founders, and 63% has gone to founders of color.
Revenue-based financing, “is a much more flexible source of funding that doesn’t rely on the individual’s personal financial credit,” said Founders First’s Folsom. “It looks at the strength of the business and the cash flows associated with that.”
Equity crowdfunding, in which founders can raise from friends and family, fans and customers, is expanding who and what gets funded.
“Power shouldn’t be concentrated in the hands of millionaires and VC funds,” said Price of WeFunder, which is trying to rebrand crowdfunding as community rounds. “Everyone should be able to vote with their dollars on which businesses in their communities or in cause areas that they care about get funded.”
Companies with a Black or Brown founder last year received roughly one third of the half a billions dollars raised through online startup platforms such as Wefunder and Republic, compared to just 2.6% of venture capital overall. If we’re “lowering the barriers to entry, and creating millions and millions of new angel investors who are women of color in Tennessee, where I live, then we should be able to get more capital flowing to founders that look like them,” says Price.
Financing that serves the majority of businesses is patient, flexible and allows founders to retain ownership, said Ron Boehm of BOMA investments.
“We started basically asking people, ‘What do you need for the short term?’,” said Boehm. “And for a number of years, we did a lot of working capital,” for solar, seasonal goods and medical devices. “We help people bridge that gap between the time they have to pay for manufacturing or production and the time they actually got paid by their customers.”
As entrepreneurs began requesting longer term capital, Boehm would ask, “Well, are you planning on flipping your company? Because that’s the typical way a venture investor looks at getting their money back?” And most of them said, “Well, of course not. We’re in this for the long term.” Boehm and colleagues began using flexibly redeemable preferred stock, which acts much like revenue-based financing but each payment is part dividend part equity redemption. The structure allows investors to exit the investments over time and leave ownership with the founder.
Real businesses focused on growing revenues rather than raising rounds have been called zebras, as opposed to unicorns, the popular term for companies valued at $1 billion or more. Zebras are often too early for the banks or not aggressive enough in growth profile for venture capital.
“There’s a need for patient and responsive, early and growth stage capital,” said Schultz of Zebras Unite. Schultz is excited about the rise of crowdfunding as well as new alternative capital funds and capital innovators, like Founders First, using a variety of debt, equity or hybrid and mezzanine structures. Also on Schultz’s radar: A revival of centuries old governance structures in the form of cooperatives and mutual aid organizations.
Though interest remains high, the systemization and socialization of alternative capital sources has not yet led to broad adoption, said Armeni of Transform Finance, which has been studying the mechanisms for years. “That has not happened.” Armeni points to a lack of patience and willingness of investors to try something new and put up with the additional diligence and legal structuring costs.
One possible path forward, says Armeni, is matching the capital requirements of the alternatives to the structure and design of the enterprise itself. Alongside the rise of alternative financing structures has been the growth of more alternative enterprise models, such as steward ownership, purpose trusts and multi-stakeholder cooperatives.
ImpactAlpha’s David Bank called it a parallel economy. “Different kinds of structures getting funded by different kinds of structures,” said Bank. “And emerging are new players on both sides of it that may not have even been participating in the previous market.”
That parallel market could be four-times as large as the 20% that’s getting funded by venture capital and commercial banks. That’s not a niche or alternative market. It’s a huge opportunity, Bank said, “to really change the trajectory of who gets to build wealth and who gets to build companies.”