Know the right funding model when seeking investors for your business

Ask most entrepreneurs what is their biggest challenge, and there's a good chance they will list access to investment and funding at the top.

That's particularly true in many of Africa's biggest entrepreneurial markets too.

In a survey released by the Entrepreneurs' Organisation (EO) South Africa earlier this year, for instance, nearly half of South African entrepreneurs said they don't get enough funding from the public or private sectors.

Another survey released by East Africa Com, meanwhile, had 59 per cent of East African entrepreneurs list a lack of access to investors as a significant business barrier.

Similarly, a 2021 EFInA report found that 70 per cent of Nigerian startups and scale-ups struggled with access to finance post-Covid-19.

As important as improving access to that funding is, it's almost as critical that entrepreneurs identify the funding models best suited to their business needs.

The wrong funding model can, after all, mean that entrepreneurs end up over-diluting their equity in the business or taking on too much debt. But what do those funding models look like? And what advantages does each model offer?

Debt vs equity

One of the first distinctions that all entrepreneurs should understand is the difference between debt and equity-based financing.

Debt-based financing involves borrowing money, usually at interest, from lenders. For some businesses, that may mean borrowing from traditional financial institutions such as banks.

Others may instead go to private lenders. Regardless of how well or badly the business performs, the lent money must be paid back. That said, it does ensure that entrepreneurs retain a greater degree of control over their businesses.

Equity financing, on the other hand, involves selling ownership shares (equity) in the company to investors, such as shareholders or venture capitalists.

While it doesn't create an obligation to repay any money, it does mean that entrepreneurs end up with a reduced stake in the business. And because they're part owners, they may not have a full say in how the business is run.

Choosing whether to take one approach or the other (or a combination of the two), largely depends on a company's financial situation, risk tolerance, and its desire to maintain control or share ownership with external investors.

Beyond the basics

Beyond those basics, most organisations that offer funding will provide a range of funding models. These include, but are not limited to:

Senior debt finance: Senior debt is a company's highest priority debt that must be repaid first during bankruptcy. This kind of financing is typically secured against some type of collateral (the company's physical assets, for example) although it can also be unsecured. In the event of bankruptcy or if the loan goes into default, the collateral of a secured senior debt facility may be sold to cover the debt. Unsecured senior debt holders can file claims against the company's general assets.

Unitranche finance: Unitranche finance combines the various forms of debt held by a business into one loan. Under this form of financing, the borrower pays a blended interest rate and has a predictable repayment schedule that can be tailored to the borrower's needs. Unitranche financing can enable medium-sized companies to access financing that would be impossible to get from a bank.

Second lien finance: Second lien debt is secured debt that ranks equally for payment with senior debt and shares the same security package. Second-lien loans are not debt subordinated to first-lien loans, only on the capital pledged to secure the loan. This means that in the event of bankruptcy, the second lien ranks behind senior debt in receiving proceeds from shared collateral.

Mezzanine finance: Mezzanine finance is a hybrid form of financing that includes aspects of debt and equity-based funding. In addition to being used for expansion or recapitalisation, mezzanine finance can be utilised to acquire other businesses, for management buyouts, and to minimise dilution of equity. Companies usually consider mezzanine financing to finance business goals when they have reached their senior debt borrowing ceiling or want to preserve future senior debt capacity.

Choosing the right model

Knowing what these various models entail and what they're used for should go some way to helping entrepreneurs figure out which one is best for them. That said, it's worth breaking it down a little further. When deciding on a model to pursue, entrepreneurs should consider their capital needs, risk tolerance, how much (if any) ownership and control they're willing to give up, the cost of the capital, and the negotiated terms offered by the lender or investor.

If the business has relatively low capital needs, for instance, a traditional bank loan or senior debt may be the best option. On the other hand, if the business is on an aggressive growth trajectory, it may be more inclined to take on a more high-risk form of funding such as mezzanine finance.

Fortunately, businesses aren't on their own when it comes to making such choices. A good lending or investment institution will work with the company to figure out the best funding structure for it. Even with that assistance, however, it's still important that the business undertakes a thorough financial analysis, interrogates the terms of each financing option, and makes a decision that aligns with the company's goals and risk profile.

The writer is Corporate Communications Manager at Norsad Capital