Capital-Hungry Startups Should Consider This Alternative to VCs.
By nature, startups are hungry for capital.
That’s simply a fact of life in the high-growth, high-risk, high-reward segment that is technology. For that reason, these fledgling, upstart tech companies are powered almost exclusively by venture capital and private equity, firms with the deep pockets, market savvy, and connections to make (or break) a startup.
To say that startups live in fear and reverence of these investment firms is an understatement. Yet these promising, early stage companies shouldn’t limit themselves only to VCs, whose generous funding always come with strings attached. Instead, they should seek alternative sources of investment to help power their growth. Doing so could uncover more steady (if smaller) sources of capital, and moreover, could even help the average person get in on the action.
Where should startups with traction turn? Try business development companies (BDC), for one.
What is a BDC?
Before we get into the benefits of a BDC-startup partnership, it might be helpful to understand exactly what a BDC is. At its simplest form, a BDC is just a firm that invests in small- and mid-sized businesses in the United States (what we call the lower middle-market). Like other, larger investment organizations, BDCs use shareholder money to generate income, turn profits, and grow their portfolio companies.
BDCs didn’t arise out of the vacuum. Instead, they were a response to the Investment Company Act of 1940, an important series of regulations put into place after the stock market crash of 1929 and ensuing Great Depression. The Investment Company Act limited the number of people (and companies) that could invest, thus drying up the amount of money going to smaller, growing businesses.
As a result, Congress passed the Small Business Incentive Act of 1980, which created the BDC. This had two effects: first, smaller, middle-market businesses (which earn annual revenues ranging from $10 million to $1 billion, and employ anywhere from 100 to 2,000 workers) could get a source of funding. This niche, though long neglected, is actually extremely critical to the nation’s overall economic health. In fact, middle-market companies are responsible for approximately one-third of all revenue in the US -- quite a large segment to leave out in the cold. Since the recession, these companies also grew twice as fast as the economy as a whole, making them a key driver of economic recovery.
Next, BDCs also democratized investing. Think of them as open-source venture capital, because they are open to all investors, not simply a handful of wealthy individuals. Equally important, BDCs, by law, cannot invest more than 25 percent of their assets into any single business (or any one sector).
Why would a BDC work for my startup?
As a tech entrepreneur, you may nod and yawn at this information. After all, while BDCs seem fair and transparent, they’re far more important to investors, rather than entrepreneurs. What can BDCs offer a startup with some promising initial successes?
Plenty, as it turns out. First, even giants like Google and Facebook began their lives as middle-market companies and grew from there. It’s important to note that not every startup can grow into one of the next big tech companies. Even if your goal is to be acquired (and thus win a handsome payout for your blood, sweat and tears), you’ll need to hit a tipping point before you are bought by a larger company. In the interim, you should certainly consider BDCs.
Moreover, venture capital is in decline, at least in the United States. Since 2015, VC firms have closed far fewer deals (and funded far fewer startups) than in previous years. In the first quarter of 2016, funding fell 25 percent to $13.9 billion from Q4 2015, with a high of slightly less than $20 billion; this was also the biggest decline in startup capital since the dot-com bust.
Even where it is available, startup capital is increasingly becoming harder to come by. As the Chicago Tribune notes, the decline in startup funding isn’t due to a lack of funds; VCs are on track to make the highest profits on record since the ‘aughts, raising some $1 billion each at companies like Accel Partners, Andreesen Horowitz, and Founders Fund. Big-name investors simply pooled their capital in a small handful of large, early investments. Needless to say, this means more intense competition for fewer slots.
Besides, venture capital can be hard to come by -- especially if your startup isn’t based in the traditional (and rising) tech hubs across the nation. In cleantech, for instance, investment is concentrated in four metro areas (San Francisco, Boston, San Jose, and Los Angeles), making three out of four solely in one state.
Yet this trend isn’t restricted only to renewable energy; instead, overall venture capital has become more restricted by geography. One study by Citylab and the Martin Prosperity Institute shows that VC activity takes place mostly in four or five major hubs. Top takers are San Francisco with $23 billion, New York with $7.5 billion, and San Jose (Silicon Valley) with some $6.7 billion.
BDCs are a great source of alternative funding.
In short: startups who have gained traction (and had a tantalizing taste of success) need funding to grow and to realize their goals. Yet VC is only becoming increasingly inaccessible. Moreover, BDCs are a very stable, sensible choice -- particularly for startup founders who are accustomed to high degrees of volatility, uncertainty and instability.
In addition, BDCs have few secrets. Rather than trading ridiculously complex financial instruments like mortgage-backed securities or credit default swaps, BDC trades must be disclosed in SEC filings -- and traded on the open market without restrictions or fees. That way, startup founders don’t have to worry about any dirty laundry on the part of BDCs; everything is in the open, for all to access via the SEC.
Stability is a huge selling point. By law, BDCs are limited from taking on more debt than they can handle -- and even if they wanted to, a BDC cannot acquire your company. Unlike banks, which have a maximum debt-to-equity ratio of 10-to-1 (this means they have ten times as much debt as they have equity), BDCs are forbidden from surpassing a maximum debt-to-equity ratio of 1-to-1. Though there has been a push to increase the ratio to 2-to-1, note that this is still far lower than the standard ratios of banks and other financial institutions.
Related: 4 New Ways to Self-Fund Your Startup
Even if you have traction, it’s tough to be a startup today, given the historic decline in venture capital and consolidation of funds. There are fewer opportunities to win capital (and more competitors locked in the same race). As a result, startups should seriously consider business development companies (BDCs), a stable, little-known financial vehicle. Not only are BDCs open to the general public, but they’re also solid by design. BDCs are unlikely to fall into the same trap as big banks during the Great Recession, nor are they likely to engage in the sort of hostile takeover and backhanded trading that seems to accompany high-growth, high-reward companies.