EF - 2. lecture - Sources of financing

Key Distinction: Source vs. Type of Financing

A type of financing is the instrument itself (equity, long-term debt, short-term debt). A source of financing is the partner that provides it (a bank, a VC fund, an angel investor). These are separate concepts. The right source depends on what stage in the firm life cycle the company is at. Approaching the wrong source for your stage will likely result in failure.

1. Bootstrapping

Bootstrapping means minimizing the need for external capital by securing resources at little or no cost. It refers to any method that decreases the external financing need. The name comes from “pulling yourself up by your own bootstraps.”

The core idea: every month you can postpone raising external capital, your business develops further, gets valued higher, and you give up less equity when you eventually do raise.

Examples:

• Omega Pharma (Marc Coucke) - started from a garage with personal loans of EUR 3,750 each, no wages, eventually sold for EUR 3.6 billion.
• PlentyOfFish (Markus Frind) - built from his bedroom, no employees for years, already profitable before he even learned what VCs were. Sold for $575M.
• Apple - Steve Jobs used a purchase order from The Byte Shop to convince Cramer Electronics to give him parts on 30-day credit. He assembled and delivered the computers, collected his money, and paid the supplier without giving up any equity.

Bootstrapping is not just for the early stage. Large mature companies also continuously try to optimize working capital and keep external financing needs low. Research shows that companies successful at early bootstrapping tend to grow faster and remain efficient throughout their lifespan.

Concrete bootstrapping methods:

• Start in a garage / work from home
• No wages or below-market wages for founders
• Partnerships with suppliers and customers (negotiate payment terms)
• Optimize the supply chain and payment process (customers pay immediately, you pay suppliers on 30-day terms)
• Use student workers or interim (= dočasný) personnel
• Generate early revenue through consultancy, contract research, or pilot projects before the main product is ready, prepayments from customers
  • referencing to the first lecture (doing pilot projects and other work can give you a solid track record which could help with dealing with investors later)
• Apply to foundations (Gates Foundation, Thiel Foundation) for non-dilutive grants
• Lease equipment instead of buying
• Minimize inventory and accounts receivable (same conditions for all customers and cease relationships with late payers)
• Coordinate purchases with other companies
• Use government subsidies where available

Why it matters so much: raising capital takes at least 6 months of networking, updates, and due diligence. If your company is only 6 months old, you have not had time to build any investor relationships. Bootstrapping buys you that time. When you do raise, raise enough in one round (with a buffer) so you are not back fundraising every few months.

Personal capital injection: investors care about whether you have “skin in the game.” How much you invest depends on your personal situation. A 50-year-old with a million in savings who invests nothing will face hard questions. A student entrepreneur gets more slack. In Belgium, around 40% of founders invest nothing beyond the legal minimum (EUR 1,000).

2. Friends, Family and Fools (3Fs)

This is patient and cheap capital. Your mother will probably not ask for her money back after two years. However, there are real risks:

• If the business goes bankrupt, it can cause relational damage.
• Family members who invest may overstep their role and start acting like they run the company (unsolicited advice at the dinner table, loss of autonomy).

Written contracts are essential, arguably even more so than with professional investors. The contract should clearly specify the terms, the rights and responsibilities of the investor, and the level of involvement/control. Convertible notes are often used in this context.

• What are convertible notes? It is a form of debt, which later converts into equity when the startup gets proper financing instead of repaying back with interests

This is not a permanent source of capital. Your grandmother can invest once, but she likely does not have dry powder for a second or third round. It is a one-time source, after which you move on to the next financing partner.

3. Incubators, Accelerators and Venture Studios

Incubator: provides shared office space, networking opportunities, mentoring, and access to shared equipment. It is horizontal (accepts any type of business), has no fixed program, and the duration ranges from months to years. The approach is hands-off and supports organic growth. Financial contribution is small or none, and compensation is usually none or a small fee (e.g. rent).

Accelerator: provides all of the above plus funding and more intense support services (accounting, financial planning). It is vertical (focused on a specific niche or theme), runs a structured program of 3-6 months, and takes an equity stake (typically 5-10%). They aim to actively boost growth. Some are sponsored by corporates (e.g. KBC in Belgium sponsors an accelerator hoping startups later become banking customers).

Key examples:

• Station F (Paris) - the world’s largest startup campus, 34,000 sq meters in a converted railway depot, ~1,000 startups per year. Alumni include Hugging Face and Mistral. Big corporates like Microsoft and L’Oreal pay to be present for scouting.
  • https://www.youtube.com/watch?v=DxSijOqyHz8
• IMEC (Leuven) - world-leading in chip design, 84% survival rate for their startups (3-4x normal), 29+ exits.
• Y Combinator - the most successful accelerator globally. Over 100 companies worth $1B+. 2-3% of accepted companies become billion-dollar companies. Alumni include Stripe, Airbnb, Coinbase, DoorDash.

Every incubator/accelerator has a different business model. Some want equity, some charge for office space, some are free. Compare them carefully.

Venture Studios are a newer concept. A venture studio generates business ideas internally, builds an MVP, tests for product-market fit, find early customers and then recruits external entrepreneurs to run and scale the company. The studio retains 30-80% of equity. They do not have a set timeframe (unlike accelerators) and reportedly have higher success rates. Example: the Moderna vaccine was developed in a venture studio context.

4. Crowdfunding

Crowdfunding matches entrepreneurs with many small investors through an online platform. The entrepreneur applies to the platform, investors sign up and commit money. Capital is held in escrow until the funding threshold is met. If the threshold is not reached, all money goes back to investors.

The key differentiator from other sources: instead of 1-3 investors, you have potentially hundreds of small investors. This requires a platform to manage administration.

Four types of crowdfunding (in increasing complexity):

• Donation crowdfunding - investors get nothing back. Pure goodwill. Platforms like GoFundMe and Kiva.
• Reward crowdfunding - investors receive a product or perk. Example: Star Citizen (video game) raised $250M+ on Kickstarter by offering better in-game items. Antwerp Brewing Company gave investors a free pint for life and their name on a brewery wall. Jaswig (KU Leuven spin-off) sold 175 standing desks via Kickstarter. Most academic research focuses on this type.
• Debt crowdfunding - investors lend money at an interest rate (e.g. 15%) for a fixed term (5-7 years). Very large amounts can be raised. In practice, professional investors often dominate, which somewhat contradicts the “crowd” idea. Example: Balls & Glory raised EUR 125,000 in 40 seconds via lending-based crowdfunding. Platforms: Funding Circle, Zopa.
• Equity crowdfunding - investors receive shares. Still underdeveloped in Europe due to diverging national regulations and legal complexity. An EU-wide passport has been discussed for 10+ years without resolution (it would enable all crowfunding services to operate under the same rules). In crowdfunding deals, the investor typically gets less equity (under 20% in ~60% of deals) compared to business angel deals (~30%).
  • the most developed equity funding is in Asia-Pacific region by far

Advantages:

• Extra financing source that democratizes entrepreneurship (no need for existing investor networks)
• Instant market test - if nobody invests, your product likely lacks demand
• Generates early-stage customer feedback
• Can raise capital with no or limited dilution (in non-equity types)
• Wisdom of the crowd effect: many individual decisions can collectively produce an accurate valuation
  • which is often much precise than the best single decision

Disadvantages:

• Often limited investment amounts; raising millions is difficult
• Hard to pick the right platform (many new, low-quality ones exist)
• Legal constraints - for equity/debt crowdfunding in Belgium, raising over EUR 100,000 requires FSMA approval and an expensive prospectus (updated rules: no prospectus needed if total < EUR 300,000 and max EUR 1,000 per person per project)
• Reputational risk: 75% of campaigns deliver products late, and failed campaigns are public
• Exposes ideas to copycats
• Only works well for B2C products that are easy to explain; complex B2B products are a poor fit
• Lack of experienced investors means limited ability to support the venture beyond cash

Tips for successful crowdfunding:

• Have a clear strategy and deadline
• Create a prototype
• Select an active, reputable platform
• Spelling errors reduce success chance by 13%
• Include a video (~3 min); not having one decreases chances by 26%
• Provide benefits to the crowd
• Leverage friends and family as early backers (research by Mollick shows this is critical)
• Use social media actively
• Provide regular updates; lack of early updates reduces success by 13%
• Crowdfunding is hard work: 35+ hours/week for campaigns with goals over $100,000

5. Business Angels

Business angels are high-net-worth individuals, often ex-entrepreneurs, who invest their own money in early-stage companies. Example: Innocent Drinks was founded in 1998 with one business angel. By 2009, Coca-Cola paid GBP 30M for 10-20% of equity.

Key characteristics:

• Informal source of seed capital (own funds, not a managed fund)
• Hands-on approach and personal involvement
• Seek more than just financial return (fun, mentoring, staying active)
• Long investment horizon
• Investment size typically EUR 30,000 to EUR 1.5 million
• Personal fit with the business and industry matters a lot
• Approximately 18,000 active angels in the UK, 200,000+ in the USA

Types of business angels:

• Super angel - makes many investments, large network, well connected to later-stage investors, but time may be spread thin
• Domain angel - deep vertical experience in a specific industry, can validate ideas, but may be too proactive with advice
• Grouped angel - network of angels who co-invest
• Financial angel - invests from a portfolio diversification perspective
• “Sport fisherman” angel - invests for the thrill
• Foolish angel - does not really know what they are doing

Angel returns (UK data): the distribution is very skewed. Many investments return nothing, but the rare successes are large. Angels with prior entrepreneurial experience achieve better returns.

Advice on raising angel money:

• Try to raise from the most experienced angels possible, even if the financial terms are less attractive
  • “Give a fish to a man, you will feed him for a day. Teach a man how to fish, feed him for lifetime.”
• Well-regarded serial investors will not screw you because they know it compromises the company
• If struggling to raise at all, take money wherever you can get it
• Negotiate a convertible loan in early stages if possible
• Prominent angel investors help attract VC money later
• Be careful with large discounts on convertible debt if you need follow-on funding soon
• Avoid a large group of unsophisticated angels

6. Venture Capital

VC firms invest other people’s money (not their own) in unquoted companies, seeking capital gains on a medium-term horizon with active management involvement. They are independently managed pools of capital focused on equity or equity-linked investments in high-growth private companies.

Examples: Virax (biotech, first VC round of EUR 23.4M in 2002, later IPO), Airbnb ($9MfromSequoiaCapitalin2009),Slack($150M from Google Ventures in 2014).

Key characteristics:

• Invest someone else’s funds (limited partners provide the capital)
• Focus on larger deals: at least EUR 1,000,000, occasionally less
• Maximum investment often 10% of the fund size in one project
• Exit via IPO, trade sale, sale back to entrepreneur, or bankruptcy/liquidation
• Better at dealing with information asymmetries through specialization, syndication, and intensive monitoring (staged financing, board seats)

Types of VC investors (heterogeneous industry):

• IVC - Independent VC (US-style limited partnership)
• CVC - Corporate VC (affiliated to a non-financial corporation)
• BVC - Bank-affiliated VC
• GVC - Government-owned VC

They differ significantly in financial objectives, strategic objectives, and ability to mobilize resources.

VC return expectations vary by stage and geography. Seed/startup stage requires 31-55% yearly returns. Growth/expansion requires 21-35%. In practice, out of 10 portfolio investments, a typical VC might see 2 total losses, 4 break-even, 2 modest successes (5x), 1 good (10x), and 1 superb (20x). The portfolio return is driven by the outliers.

Seed-stage VC is becoming more important. Some VCs specialize in seed rounds (e.g. First Round Capital, Volta Ventures), typically investing around $500k. Software companies can now get off the ground with limited funding thanks to open source, cloud services, and easier distribution. VCs invest early due to FOMO (fear of missing out).

How does Venture Capital differ from Private Equity?

• Private equity is investing in companies that are not traded publicly on a public stock exchange. Investors are buying the company not for strategic reasons (synergies, mergers, market shares), but for financial reasons (to gain more capital, add another revenue stream etc.)
• Venture Capital is a special type of private equity focused on investing in early-stage companies and start-ups (taking much higher risks for potentially bigger rewards)

7. Convertible Notes

Convertible notes are short-term debt instruments that convert into equity, commonly used in seed-stage rounds. Typical range: EUR 20k to EUR 500k.

The note automatically converts into preferred stock when a Series A round closes. The conversion terms have four key components:

• Discount rate (typically 20-30%): gives the note holder shares at a lower price than Series A investors pay
• Valuation cap: sets a maximum valuation at which the note converts, protecting the early investor if the company becomes very valuable
• Interest rate (typically 5-10%): accrues and is paid in additional shares upon conversion
• Maturity date (usually 24+ months): if no Series A happens, the note either auto-converts at pre-agreed terms or must be repaid

Example: Invest 100k, future valuation is 500k. Without discount, you get 20% (100/500). With 20% discount, you convert at 400k, getting 25% of the shares for the same amount of money. This is the reward for taking the risk.

• but, if the value of the company shoots very high, e.g. to 1M, the discount alone gives you 12.5% (100/800), which is worse for the investor, because he got smaller discount because of the higher valuation (than agreed)
  • that’s why the valuation cap is used, valuation cap of 500k means you still convert at 400k (after discount), getting 25% of the shares regardless of the current valuation
  • it essentially means that by valuation cap, the investor “locks in” his discount if the company is valued over agreed 500k
• there is also an interest for the time “waiting for the Series A”, e.g. 5 % interest:
  • Year 1: 5% × 100k = 5k
  • Year 2: 5% × 100k = 5k
  • Total: 110k converts, meaning bigger discount (instead of paying interests to the investor)

Advantages: simple to issue, no valuation discussion needed (postponed to Series A) - the “right” price is not set yet, entrepreneur retains control, potentially lower dilution, fairly standardized, multiple return components for the investor.

Disadvantages: does not incentivize investors to actively increase company value, may not benefit existing investors if the follow-on round is priced very high, limited investor rights (voting, control).

• with convertible note, the investor’s motivation does not have to be pleasing the company’s valuation, because then they will get smaller discount

8. Banks

Bank debt remains the most frequently used financing source overall (including for startups in Belgium as of 2019). However, availability for innovative startups is limited because banks require collateral that early-stage companies typically do not have.

Banks assess companies based on:

• Balance sheet and P&L history (problematic for startups with no track record)
• Guarantees and collateral (account receivables, inventory, equipment, real estate)
• Whether the business is generating cash

Key ratios for the bank (solvency ratios):

• total debt ratio = debt / total equity and liabilities
  • measures the ratio of what part of the company is made out of debt, the higher, the bigger financial risks, because debt comes with mandatory repayments regardless of how the business performs
• coverage of the total debt = cash flow (CF) after taxes / total debt
  • this answers a question: if the company would throw it’s annual cash flow at its debt, what percentage could it pay off?
  • if the ratio is 25 %, it would take the company to repay it in 4 years
  • no one expects it to be in 1 year, but if the ratio is too small, it signals a huge debt compared to the company earnings
• coverage of long-term debt payable within 1 year = cash flow (CF) after taxes / long-term debt payable within 1 year
  • long-term debt that needs to be paid within 1 year (soon), it’s no longer in the future
  • so this ratio answers the question: can this company’s flow actually cover the debt that is coming due right now?
  • if it’s under 1, it’s a red flag and the company would need refinancing, selling assets or raising new capital

Types of bank loans: account receivable loans, inventory loans, equipment loans, real estate loans.

Alternative lending sources exist (e.g. Funding Circle, government-backed startup loans like Startlening from PMV in Belgium).

Critical rule: never give a personal guarantee if you cannot afford to lose it.

9. Strategic Partners

Strategic partners bring more than capital. They can provide knowledge, distribution channels, complementary products, and market access. They can be customers, suppliers, or even competitors.

Examples:

• Facebook acquiring WhatsApp for $19Bin2014($4B cash + 184M Facebook shares) to capture a rapidly growing messaging platform
• Microsoft investing multi-billions into OpenAI across three phases starting in 2019

10. Government Measures

Government support is country- and region-dependent. Types of measures:

• Substitution: 100% publicly funded (e.g. Finnish Vinnof, Danish Growth Fund)
• Co-investment: government invests alongside private partners (e.g. Arkimedes, UK University Challenge Funds)
• Refinancing
• Risk sharing: government absorbs losses (e.g. Tante Agaath in NL, UK Regional VC Funds)
• Fiscal measures (tax shelters for startups/scale-ups, exemptions on withholding taxes)
• Incubation structures
• Loans and loan guarantees

Belgian examples: WinWinlening (fiscal advantage for 3F loans), Tax Shelter for startups and scale-ups, PMV co-financing and government guarantees, LRM and BAN Vlaanderen for VC/angel financing. During COVID (2020), one in four European SMEs used subsidized loans or grants, up from 10% pre-pandemic.

11. IPO (Initial Public Offering)

An IPO is for mature, larger companies needing significant capital. It provides publicity and increased reputation. Drawbacks: very costly for small firms, strict reporting standards, and exposure to market dynamics.

The IPO landscape has changed significantly. Private markets now offer abundant capital through late-stage rounds (Series D, E, F, G) at lower cost of capital than an IPO. Companies generally still want to be public for liquidity (for early investors, employees, founders), M&A currency, and growth capital access, but the traditional IPO process has become less attractive relative to private alternatives.

Choosing the Right Source: Three Key Questions

When evaluating which financing source fits your business, consider:

1. Risk of failure - how novel and young is the business? Does it own tangible assets that could be sold if it fails? Banks prefer low-risk, established businesses with collateral, just to be able to repay debt with interests without problems. High-risk ventures need equity investors who share in the upside.

2. Scalability - can the business multiply revenue with minimal incremental cost? VCs and angels bet on exponential growth. Banks do not share in profits and therefore do not value scalability the same way.

3. Understandability - is the business model easy for anyone to grasp? Equity crowdfunding works for simple, consumer-facing models. Complex, knowledge-intensive B2B models are better suited for specialized angels or VCs who can evaluate the technology.

Differences Between Key Sources

Internal finance gives maximum control but no risk diversification. Debt (banks) preserves control and offers fiscal advantages (interest is tax-deductible) but requires repayment and collateral. Business angels add value through experience and networks, invest their own money, decide fast, but offer lower legitimacy than VCs. Venture capital provides large sums, high legitimacy, and professionalization, but demands high returns, involves sophisticated contracts, and takes significant equity. Subsidies are essentially free or cheap money but come with restrictions on how funds can be used.

Approaching Investors: Practical Advice

• Do your homework: check references, CVs (investor’s partners), and track records of potential investors, websites and databases of investors
• Avoid cold calling; use warm introductions, use references
• Meet potential investors informally before submitting a formal funding request
• Keep (potential) investors updated on your progress over time
• Know their investment criteria (size, industry, geography)
• Use social proof: getting one great investor to commit helps convince others
• Be sharp in all communication (pitch deck, emails)
• Have a clear plan for what the funding will be used for