Bridging the Gap
Tools to solve the Cash Gap (when money goes out before money comes in)
Many growing companies are limited—to hire, buy inventory, advertise, etc.—by their access to capital. However, most don’t qualify for traditional debt, nor are they ready to sign on for the “all or nothing” hypergrowth required by venture capital.
The absolute best source of funding is revenue from customers, but founders usually have to pay expenses before customers pay them.
This is the cash gap.
The gap exists even if the business has extremely low overhead– like SaaS and services where the costs are primarily talent and platforms. The gap can grow faster if the business requires physical inventory. A growing company can go out of business just as quickly as a shrinking company. Even a company with 90% margins and growing fast will cease to exist if it can’t fill the cash gap. $1M arriving in two weeks doesn’t pay $1k due today.
To grow without dying, founders must find sources of funding that can be used before they collect the better capital– aka revenues.
So how do you bridge the gap?
Traditional funding sources are debt (from banks) and equity (from investors), but only about 18% of small companies qualify for bank debt, and a tiny fraction (~0.5%) of companies have the potential for hypergrowth that equity requires.
A large gap remains where most founders figure out how to “bootstrap” using whatever assets they happen to have—savings, credit cards, friends, family, home equity, etc. This funding is truly a luxury for those with the means or connections and dramatically limits access to entrepreneurship.
The good news: We have seen a lot of innovation in this space from two directions.
The cost of starting a business has dropped dramatically
The models for providing capital have evolved beyond the typical debt-equity structures
Let’s run through a few of the latter.
Debt requires a very low failure rate for the funder. Too many unpaid loans and the lender will lose money, be unable to access more capital to lend, and fail. So, this structure requires the lender to focus on the security of the loans.
Traditional debt is backed by “current assets”
Debt security requires a “healthy” company, meaning consistent cash flow that can pay the bills, and collateral, which a lender can acquire to make them whole if the loan isn’t paid.
Lenders avoid taking the risk that an asset will increase in value– that’s where investors live. Collateral is usually an asset that is valuable now.
Lenders look back, and investors look forward.
Assets recognized by traditional banks include cash and real estate—these are relatively easy to access or turn into cash to cover the loan. The government also regulates the banks, limiting who they can lend to and what assets they can recognize. (This explains the meager 18% mentioned above.)
As you would expect, equipment financing or inventory financing is secured with those respective assets but will typically not loan on 100% of the value. For example, if a piece of new equipment is $100k, a lender may fund 70-80% of that value. The other 20-30% is a downpayment, so if it all goes wrong, the lender has a better chance of getting whole by reselling the equipment.
Other alternative lenders recognize different assets. Factoring uses short-term assets related to the sale of goods to make loans ahead of time: Invoices (paid upon delivery), Shipping paper (paid upon shipment), and Purchase Orders (order contract).
These loans are riskier and more expensive but sometimes make more sense than taking on a longer, less expensive loan.
A simple example: A customer will pay you $10k in 30 days, but you don’t have the product in inventory and need to make the purchase first. You have 60% margins ($6k), so it might be worth paying $1k (10% of $10k) to finance it and make $5k. But if you are “hoping” to sell $10,000 worth, and that takes six months, 10% per month eats all the margin. The timeline matters just as much as the cost of the capital. (More on that here.)
The key is to align long-term assets with long-term financial tools– and the same for short-term assets and financial tools. If you need to eat lunch but aren’t carrying cash, you won’t take out a 3-year loan; you would use a credit card.
Side note – Merchant cash advance tools are in this category. But they aren’t usually connected to a specific short-term asset and are some of the most misused, over-marketed financial tools on the market. Not because the financial tool is inherently extractive, but because it tends to be misused. Founders get sucked into funding longer-term needs with a financial tool designed for very short-term needs (15-60 day cash gap)– like using a credit card to buy a car.
Bridging the gap = redefining “assets”
Most of the innovation we see from lenders is creating tools to measure the value and risk profile of different categories of assets, expanding where debt tools can be applied.
If the purpose of the funding is to make capital available in advance of customers providing revenue, then it makes sense to look at what drives that revenue. That’s an asset. By defining the specific assets that lead to revenue, you can measure the risk of that future revenue and, therefore, the value of that asset. For example:
Subscriptions – PIPE, Founderpath, Capchase, etc.
Paid advertising – Clearco
Real-time sales data – Stripe, Shopify
All of these take into account the company’s current health (as a bank does) but expand the reach of debt by analyzing more of the tools driving future revenue and profits.
Based on the value of a future transaction, an investor puts money in and expects money back at a later date with a return. This return isn’t secured with physical assets and typically costs more because they take a short or long-term risk of losing all of the investment.
Traditional Equity is based on a “future exit”
Founders and investors can have wildly different ideas of what the company can be worth, dampening the likelihood of investment.
An equity investor counts on the company’s future value to exceed the present value. More specifically, they expect to multiply the original investment by maintaining enough ownership share when the owners are paid in a larger future transaction.
The time frame between investment and “exit” is typically a long cycle with (hopefully) multiple increases in valuation. Each new investment agrees to a higher valuation… at least that’s the plan. Eventually, the company sells, IPOs, or becomes irrelevant to the investor.
Side note: One innovation that increased alignment between founders and investors and created more equity opportunities was “kicking the can down the road” with a convertible note. There is no need to debate over a company’s value immediately– other investors will determine that later. Although this begins as debt, it is designed to convert into equity when future investors agree on a valuation (a “priced round”). The investor would be disappointed if it never converted to equity.
Bridging the gap = changing the timing
Innovation on the timing of an exit—and what exit means—has created more opportunities for equity transactions.
Even the required transactions that create the return for investors are becoming more accessible by designing in smaller, faster exits. For example, TinySeed invests with the intent to make smaller but a higher percentage of “wins.” Sureswift, Tiny Capital, MicroAcquire all enable smaller exits instead of all-or-nothing.
This math is bridging the gap by allowing high-growth companies to succeed for the investor without requiring the company to achieve “unicorn” status.
Hybrid financial tools are all structured to optimize for variations in both asset type and timing. They rely less on traditional assets than debt does; while valuing a future asset like equity without depending exclusively on an ultimate exit transaction.
Mezzanine - Debt with an equity upside (more significant transactions)
Founder earnings (SEAL - Shared Earnings Agreement)
Income (CISA - Convertible Income Share Agreement)
Profit with a conversion (SPACE - Shared Profits and Collaborative Endorsement)
Redeemable Equity - Structured to be re-purchased by the company
Convertible Revenue-based Equity - This is how Capacity Capital invests.
Our fund invests in exchange for a right to equity, but that equity right can be redeemed back through a revenue share. This aligns us with the founder and gives them true optionality to raise more capital, drive to a big exit, or grow fast while maintaining their ownership and control.
The flexibility of these models helps overcome one of the timing problems of a “one size fits all” funding approach that drives growth at all costs. The Startup Genome Report noted that premature scaling was the primary reason for failure in the 3,200 startups they studied. Seventy-four percent that failed due to premature growth took on two to three times more capital than was necessary.
There are far more options available for funding line-of-sight growth opportunities. An entrepreneur can consider more than just the traditional funding mechanisms that require already having assets, personal wealth, or a hyper-growth business model.
Be sure to match up the uses and sources to fit your business. If you have any assets to leverage, you may have more tools to fund the cash gap than you may realize. There are tradeoffs to these decisions, and choices limit your options, so make sure your funding decisions align with your vision.
You should choose funding just as carefully as when you select your team. Different types of funding fit different roles in your growth, just as each team member does. Take the time to understand specific gaps and find the right financial tools to bridge each gap.