Starting a thread regarding capital raising for small-medius enterprises (SMEs) and start-ups. I will be sharing my experience and utilizing some discussions in my executive MBA capstone, "Strategic Response of Philippine Start-ups to Post COVID-19 Pandemic Economic Downturn."
First, I think its important compare and contrast SMEs and start-ups. Start-ups are organizations formed to search for repeatable and scalable business models. It is different from SMBs in three fundamental angles: (1) growth intent; (2) funding methods; and (3) end visions.
(1) Growth intent refers to the scale set by the management. Start-ups aim to identify the right business model which can aggressively scale in a huge market. In contrast, SMEs operate in a small market that they may efficiently capture and serve. For example, an SME is a home-made peanut butter brand can only serve a small community, restricted to grow by the number of people producing it in a home, and the presence of similar products in other communities - hence the market is capped. Compare that to a start-up, let's say a SaaS which may be launched anywhere, which can service the entire globe, restricted only by capital.
(2) Funding methods also differ significantly, with start-ups acquiring major investments immediately, coming from founders' own money, founders' family and friends' money, angel investors, and/or private capital (venture capital (VCs) and private equity (PEs). SMEs on the other hand typically get their capital from founders' own pocket, family and friends, small business loan, and grants/support.
(3) End vision is a point of differentiation, where SMEs in general are aiming for self-sustaining and long-lasting business compared to the temporary outlook of start-ups, where founders are expected to exit at some point in time, most commonly through IPO or buy-out via M&A. The temporary outlook of start-ups is anchored on the nature of the business itself, which is that start-ups are early versions of huge enterprises.
Owners/founders, in order to kick-off their business, invests time and effort, and of course capital, coming from their own pocket, and/or from their family and friends. Funding beyond this will be different for SMEs and start-ups.
For SMEs, because of the market size limitations, the multiple on invested capital (MOIC) and other return metrics are simply not attractive for private capital markets. Does this mean that SMEs are on a disadvantage? I say no. SMEs represent a significant majority of all businesses in any country in the world, and can demand grants and other support from governments to boost economies. In 2023, Indonesia pushed regulations on cross-border sales as it was deemed to be detrimental to the SMEs, forcing TikTok to acquire Tokopedia to continue its operations and growth in the country. In addition, SMEs focus on self-sustaining and long-lasting business, making them an enticing client for traditional banks.
Start-ups funding on the other hand is different. Under the assumption that there is a huge market to gain, sometimes blue ocean market, they race to capture it. Accelerating idea validation, enhancing go-to-market, and quickly establishing business moats. This results to taking of huge risk, big capital, and promise of high return. If the owner/founder can immediately get the needed support from professional funds better, but normally capital after that of founder and family and friends starts with an Angel. Angel investors, generally are high net worth individuals who value goes beyond the capital infusion - including, market credibility, industry expertise, and network. Professional funds like VCs generally comes in once the idea has been validated, injecting capital at early-stage, buying low and expecting to exit high.
VCs are funds coming from multiple investors, referred to as limited partners (LPs) and managed by general partner. Same structure applies to PEs, who typically has lower risk appetite than VCs and comes in at late stage funding rounds. Funding rounds are split into multiple stages (seed, series A), representing the maturity of the business. As start-ups are normally a burning platform, constant infusion of capital is needed until they achieve self sustainability. Each funding round results to somewhere between 15% to 30% in equity dilution. In between rounds, cash flow concerns may arise resulting to the need of mezzanine financing, typically through a simple agreement for future equity (SAFE) or convertible note - I personally prefer the former, having zero interest and therefore no additional bleeding. Alternative financing such as venture debt (catch is it has higher interest and there is equity warrant) may also be available.
In all of the financing above, owners/founders need to carefully review the fine print. You may want to consult an advisor and/lawyer, especially on liquidation preferences, dividends, most favored nation (MFN), veto, ROFR and other clauses that give privileges to your capital sources.
How about you? What are your experiences in financing (or bootstrapping) SMEs and start-ups?
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Joscel Delos Cielos CMA, CSCA
Vice President
Caloocan City
Philippines
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