What Is Non-Equity Funding? 8 Alternative Investment Types To Get Funded Without Giving Away Equity

You’re a startup founder and you need an investment?

But you don’t want to give up too much equity of your new business?

After all, what’s the use of building your own business if other people end up owning most of it?

Fortunately, there are alternative funding options that can entice investors while minimizing the equity stakes they take.

This way, you can strike the balance between securing capital and maintaining control over your startup's future.

Let’s look at how that works.

1. Dividends

Dividends are profit-based cash distributions.

Once a quarter or once a year, your startup pays out some cash to investors:

A previously agreed percentage of your profits.

The catch:

You need to be already making profits.

Or to convince your investor that you will be in the near future.

If you have a business plan that shows a good potential for profits about 12 to 18 months down the road, a patient investor may agree to take less equity and accept dividends as part of your deal.

That way, you can reward them without diluting your ownership.

And there’s another problem that a dividend agreement can help you solve:

As strange as this may sound, some investors don’t care as much about profitability as about ownership.

Ownership can serve other purposes:

1. control of your company’s direction,
2. control of market players & competition,
3. co-owning intellectual property or patents,
4. co-owning technological advances, and
5. access to high-class talent.

Investors see all these side benefits.

What’s worse:

Some investors have a very hands-off approach, expecting 9 out of 10 startups they invest in to fail.

Their attitude is just to lean back and wait.

Then, when 1 out of 10 makes it big, they become active.

If you don’t need the investor’s active support, that’s not a problem.

But if you depend on them making introductions to future business partners, clients, their network of consultants, mentors, tax advisors etc., then you want to get active now.

You want to steer their focus towards the benefit of profitability, and dividends can be a good tool for grabbing that focus.

After all: No profit, no dividend payouts.

But dividends are not a part of every investment contract.

Because they pose some difficulties, especially for early-stage startups.

Beware of these issues:

1. Dividends only make sense if you have a reliable and near-term path towards profitability. At an early stage, many startups don’t.
2. Every cent you pay out in dividends is a cent not spent on marketing, product innovation, building a team of top-notch professionals, etc.

Here’s how to get it right:

Weigh your options carefully.

Luckily, now you know the options exist.

So, you’re one step ahead.

Build the costs and the timing of dividend payouts into your business plan and financial projections.

And make sure they don’t conflict with your ability to invest in marketing, product development, building a great team, and so on.

2. Revenue-sharing agreements

Revenue-sharing agreements offer investors a percentage of future revenues in exchange for upfront funding.

This is similar to dividends, except that the focus is on revenue instead of profits, so it completely bypasses your costs (which are 100% your burden to carry in this type of agreement).

This kind of agreement only makes sense if you have a very controlled and relatively small cost structure.

It can sometimes be easier to persuade an investor to take a revenue-sharing agreement (rather than dividends) because you’re de-risking them:

They share 0% of the risk of a ballooning cost structure as you grow exponentially.

Beware of these issues:

1. When will the payments of revenue-percentage start? (The sooner, the greater your risk. The later, the more difficult to convince the investor.)
2. When will they be paid out? (Certainly not forever, right?)

Here’s how to get it right:

Build the costs and the timing of sharing revenue into your business plan and financial projections, and make sure it hinders neither your path to profitability nor your growth.

If you’re clear on that, it can be a good tool to argue for giving away less equity.

3. Royalty-based financing

In this arrangement, investors provide capital in exchange for a percentage of your startup's future revenue or profits.

But unlike dividends or revenue-sharing agreements, royalty-based financing is usually structured as a loan, which means you will need to repay the investment over time.

The good thing:

It leaves your equity intact.

Also, royalty-based financing always has a clear limit:

Payments only continue until a specific return on investment (ROI) is achieved. This ROI is the most important lever, the condition you need to negotiate well.

Beware of these issues:

1. Royalties for which product lines? (Don’t say “all,” since there’s always the possibility that you develop new, very lucrative product lines, but without help from this investor.)
2. Royalties for which geographic regions? (Again, don’t say “all.” There’s a chance you’ll enter new, lucrative regions or countries, but without help from this investor.)

Here’s how to get it right:

Set an appropriate ROI and give away royalty rights to as few products and regions as you can.

Throw in a goodie or two, for example, one extra upcoming, exciting product or service that looks like it will generate good income.

Or a nearby region the investor is personally interested in or sees good potential for.

As a rule of thumb:

The more exciting and the less risky it feels to your investor, the better the conditions you can negotiate.

4. Strategic partnerships

Sometimes, a large company or multinational corporation stands to benefit from your product or service.

What if they became your investor?

A strategic partnership with a large corporation can provide your startup with access to resources, expertise, and distribution channels.

You can leverage their existing infrastructure, customer base, and brand reputation to drive growth.

All without the need for equity funding.

Instead, these investors can earn money through revenue-sharing, licensing fees, or other mutually beneficial arrangements.

That’s why it’s worth exploring this option and researching potential alliances you can forge with established companies in complementary industries.

Beware of these issues:

1. They might want to buy you out at some point. Don’t let them hit you over the head with that suddenly, but be open to discussing it while avoiding a hostile takeover.
2. You’ll be more dependent on one major player, to the detriment of exploring opportunities with their competitors.

Here’s how to get it right:

When you pitch to them, highlight the synergies between your startup and their company, emphasizing the value each party brings to the table.

Showcase how they’d benefit even more by letting you address all market players and not restricting you to their business ecosystem.

5. Convertible notes

Convertible notes, a.k.a. convertible bonds are debt instruments that can be converted to equity.

Debt is like a loan with interest payments, equity is a form of ownership.

Convertible notes start off as debt.

That means your startup pays interest on them.

If you sold $300.000 of convertible notes with a 4.25% yield (interest), you’d pay $12,750 annually.

One advantage:

Debts are tax-deductible in most countries, which can benefit you and the investor (indirectly, by seeing you succeed), so it’s a win-win.

Then, at an agreed time, the notes can be converted to stocks, i.e.: equity.

This shows the second advantage for your startup:

You can delay equity dilution until the conversion takes place.

This can mean 3 to 5 years of holding on to more ownership.

Beware of these issues:

1. Upon conversion, ownership dilutes suddenly. Keep that on your radar.
2. Be careful how the conversion triggers are defined in the contract. (At what point and given which conditions can or must the investor convert?)

How to get it right:

For investors, convertible notes are a way of de-risking.

They limit the downside risk:

Investors are receiving interest payments, so can’t lose 100% of their investment, as they could with pure equity ownership.

In exchange, investors should receive less of the upside opportunity:

Negotiate well, and you can limit the equity cost of this type of investment.

6. Convertible preferred stock

Convertible preferred stock is a hybrid financing instrument that combines debt and equity features.

So it’s unlike convertible notes, which can never be debt and equity at the same time.

The “debt feature” of convertible preferred stock is that it pays steady dividends.

The “equity feature” is that it represents ownership but with different conditions than common stock.

Convertible preferred shares are usually priced higher than common shares.

For example, at $10 per share versus a common starting common share price of $3.

They come with a fixed “conversion ratio.”

That’s the number of common shares one convertible preferred share can be traded for at the request of the shareholder.

So, as the common share price climbs to 3.50 and then 3.75, trading one for three will give the investor an immediate profit:

$10 < 3 x $3.75 = $11.25

This allows investors to benefit from future equity appreciation while providing your startup with initial capital.

And it allows you to negotiate for giving away less equity in lieu of these future opportunities.

Beware of these issues:

1. Convertible preferred stock should not include voting rights. Make sure it doesn’t.
2. Sudden high volumes of conversion can affect your common stock value.

How to get it right:

Clearly define the triggering events for conversion in the contract.

For example:

An initial public offering (IPO) or acquisition by a large corporate.

Plan ahead for how the trigger and the conversion will affect your startup’s and your personal finances.

Ideally, this event will be an excuse to pop a bottle of champagne or a few dozen!

7. Exit strategies

By outlining clear exit strategies, such as an IPO or acquisition, you can appeal to investors who are looking for a defined timeline to realize their returns.

This approach assures them that their investment will eventually yield a profitable exit, reducing their dependence on equity ownership.

Beware of these issues:

1. After the exit it may become more difficult to retain control of all executive decisions. Be ready to give up some control.  
2. Some IPOs have forced reshuffling of management teams, and this can lead to internal strife, or – worst case – losing your job.

How to get it right:

Be ready for the loss of control, or don’t exit.

Be honest with yourself:

Do you want to run this company in “your own way” for another 20 years, or did the road to success take its toll and you could do with a break?

Find an outside coach or mentor to reflect what you really want, to step away from it mentally and get a fresh perspective.

Then make the choice that’s really in your own best interest.

8. Employee compensation

Investors care a lot about the talent and expertise driving your startup's success.

Some investors may want to take an active role in your company if they believe they have some valuable skillset that would benefit your startup.

You may find that it’s mutually beneficial to negotiate about this role and compensation for the work they’ll do as part of their investment package.

They could get a board seat or take an advisory position.

I’ve even been involved in a case where an investor became the interim COO.

Beware of these issues:

1. One more decision-maker on board means one more (possibly conflicting) opinion to contend with. If you want to execute fast, too much time spent in discussions can be a real drag.
2. You need to know this investor very well. No shooting from the hip in this kind of deal. Getting the wrong person so deeply involved in your day-to-day decision-making can cripple a startup, so be careful about who you let in.

How to get it right:

Introduce this investor to the team.

Get their opinions.

Do an anonymous survey.

If the investor is ok with that, you’re dealing with a confident person – a good sign.

Spend personal time.

This is your investment into getting to know who you’re dealing with.

Get them to meet your friends and ask them what they think.

If you’re unsure, hire professional assessors or do a personality traits test.

Your investor should be fine with this if they really want to become a constructive member of your team

After all, it goes both ways.

Maybe they’ll see it as an opportunity to get to know you better, too.

Conclusion

Exploring the following 8 non-equity funding options can help you strike a balance between securing capital and maintaining control over your startup:

1. Dividends
2. Revenue-sharing
3. Royalties
4. Strategic partnerships
5. Convertible notes
6. Convertible preferred stocks
7. Exit strategies
8. Employee compensation

By tailoring your approach to each investor's needs and goals, you can create win-win scenarios that attract funding while holding on to as much equity as possible.

The best thing to do is to openly communicate the potential benefits of these alternative funding options to investors:

1. de-risking
2. aligning interests and goals, and
3. greater cash gains when you achieve shared goals.