Whether you’re running an early-stage start-up or a dynamic scale-up, building the right capital stack for your R&D is crucial. But what is a capital stack, why is it important, and which steps can you follow to build one that’s right for your business? We’ve pulled together the information and tips you need to help answer those questions and create a solid funding strategy for your business now and into the future.
Understand the capital stack
Capital stacks are part and parcel of investing in real estate. But they’re equally important for investing in R&D. This holds true for start-ups, scale-ups or the innovation programs of established companies. Put simply, the capital stack refers to the different capital types and capital combinations you can use to invest in projects – R&D or otherwise. Financially savvy innovators use their capital stack as the foundation stone of their R&D investment strategy. Capital stacks are inextricably linked to start-up runways and the exponential growth trajectory of scale-ups. That’s why it’s vital to keep your capital stack top of mind. A correctly crafted capital stack is the difference between your R&D and business racing ahead or falling at the first hurdle.
The funding smorgasbord
You can use three main types of funding to build a capital stack fit for your R&D: assets, debt and equity. Let’s take a closer look at each.
Assets are resources of value that your business either owns or controls and can use now or in the future. Examples can include a founder’s personal savings that they invest in their business; property owned by the founder and business; company equipment; sweat equity (the unpaid work founders frequently undertake to grow their innovation and business); retained earnings and government grants. Many founders use assets alone to grow early-stage businesses in a process known as bootstrapping. As your R&D program progresses, you may also create intellectual property assets such as patents, which are intangible assets that can positively influence your company’s future growth prospects and value.
Debt comes in all different shapes and sizes. In a nutshell, debt is loan capital that your business repays with interest.
Secured debt is a liability where borrowers use their assets as loan collateral. Business finance is commonly secured against the residential or business property owned by founders and their companies, business vehicles or savings, inventory or even accounts receivable. If a business and loan amount is large, lenders may require a featherweight or a general security agreement. Creditors with these security agreements are first in line for repayment if a company enters administration, followed by lenders with other types of secured loans.
Unsecured debt is a loan that isn’t secured against collateral. It carries a personal liability for borrowers instead. Unsecured debts sit at the bottom of the food chain if a borrower defaults. So creditors with secured loans are further up the hierarchy and ahead in the repayment queue. When it comes to secured and unsecured debts, a key takeaway for borrowers and lenders alike is that you give to get. The surety that collateral bakes into secured debt lowers the risk for lenders and costs for borrowers. But on the flip side, security-free loans come with a higher risk and price tag. Borrowers pay more interest, and lenders face elevated risks from defaults and bad debts.
Peer-to-peer lending is debt-based crowdfunding. Platforms, for example, Australian small business lender Prospa, connect borrowers to capital and lend businesses up to $150,000 as an unsecured loan. Companies can borrow between $150,000 and $500,000 on a secured basis, but conditions apply. You must show you’ve been trading successfully for several years and meet additional eligibility criteria relating to turnover and loan terms. With secured and unsecured peer-to-peer lending, business borrowers benefit from lower interest rates, compared to those offered by established banks, faster approvals and avoid diluting their businesses.
Traditional banks and alternative financiers have secured and unsecured business loans. Buy Now Pay Later businesses such as Zip offer unsecured business loans of up to $500,000, and long-established players, such as ANZ, can supply unsecured funding with no maximum ceiling for eligible businesses. Secured borrowing from traditional lenders, such as banks, often involves risking big-ticket items such as your house or business premises. But this is often not the case with alternative financiers. At Radium Capital, for example, we don’t think like a bank. With Radium Advances of up to $1 million your pending R&D tax incentive (R&DTI) refund is the only collateral we require. And if your business requires larger advances of $1 million and above, Featherweight or General Security Agreements are required.¹
A bank or business overdraft is where your bank lets you access credit on your transaction account. The overdraft amount is pre-agreed, and interest, fees, and charges apply. Overdrafts can be unsecured or secured, with amounts over $50,000 usually requiring collateral as surety for the credit advanced.
Business credit cards
Available from banks or directly from credit card providers, business credit cards offer unsecured financing. Many cards require the holder or business owner to assume personal liability. But some providers will allow you to place the liability with your business. Credit cards are not a quick fix for a new or early-stage business looking for capital. While there are exceptions, eligibility rules typically require you and your business to have good credit scores, to have been trading with a valid ABN, for at least 12 months, have an annual income of over $75,000 and be registered for GST. In addition to the annual fee of a few hundred dollars, business credit cards can charge annual interest rates of over 20% on outstanding balances.
Traditional vs alternative finance
Ask any founder, and they’ll tell you how hard it is to access financing from banks. And if you’re at an early or non-revenue stage or you aren’t turning a profit, then it’s nigh on impossible to meet the lending criteria of traditional financiers. That’s why alternative finance is a lifeline for many new ventures. So if you haven’t already done so, it’s an avenue worth exploring.
Some forms of finance have elements of debt and equity, for example, convertible and mezzanine debts.
Convertible debt (also known as a convertible note or convertible bond) is a simple short-term loan. It can either be converted into shares once the company reaches one or more pre-agreed milestones or repaid as capital with interest. Convertible notes don’t tend to be exchanged for shares with controlling rights. So founders can keep control of their companies and avoid deterring potential investors such as Venture Capitalists (VCs) that will seek a say in how the business is run and don’t want to navigate other investors with controlling rights.
Mezzanine debt is an unsecured loan or subordinated debt. It can include bonus payments and warrants linked to the value of the business, which benefits and potentially increases the return for lenders. And if mezzanine debt holders default, instead of chasing their capital or joining a list of unpaid creditors, lenders can convert the debt into equity which then takes precedence above all other shareholders. The net effect is that if bankruptcy occurs, the mezzanine lender becomes the company’s controlling shareholder.
In brief, when it comes to your business, equity equals ownership. So if you raise equity capital from external investors such as Business Angels, Angel Syndicates or VCs, remember that you’re trading ownership of your company and your share of tomorrow’s profits so your business can have capital today. There are different types of equity. But common equity and preferred equity are the crucial ones when it comes to building your R&D capital stack.
Common equity is also known as common stock or common shares. Investors with common equity only receive dividends after preferred equity investors have been paid and are last on the list of creditors (behind the preferred shareholders) if the company becomes insolvent. However, these shareholders have voting rights included as standard, so they have a say in how the business is run.
Preferred equity is also known as preferred stock or preferred shares. While voting rights don’t come as standard, preference shareholders are top of the list when it comes to dividend payouts. They’re also prioritised over common equity holders if a business goes bust. So it may come as no surprise that both Angel Investors and VCs usually want to be preferred equity holders in exchange for the capital they invest. VCs tend to add conditions to their preferred equity, for example, voting rights, as VCs are often hands-on and want their investments to deliver exponential growth at break-neck speed. VCs (and Angel Investors) may also include an option to convert their preferred stock into common stock because situations can arise when this is financially advantageous.
How to make your R&D capital stack up
Now you’re armed with the building blocks for your R&D capital stack, how do you build the best one for your business? We recommend using four key metrics to analyse your options. Try to think of each portion of the capital stack as layers that ebb, flow and interact, rather than distinct types of capital you need to make decisions about in isolation.
The stage your business has reached is a crucial consideration, as is your company’s growth journey so far, and the direction you want it to take in the future. Consider if any of your previous funding decisions could limit what you do in future. If that’s the case, address any issues head-on. Be realistic about the type of capital your business needs to move forward. If you need to scale up rapidly or have capital-intensive R&D, debt and assets will only take you so far.
Each type of capital comes complete with its own set of risks. Choose the levels of risk that make sense for your business type and stage. Then weigh up the environments where you operate over the short, medium and longer-term.
Different types of capital have different costs. What can seem cost-effective financing for your business now could prove costly in future years and vice-versa. It’s fair to say that there’s an inverse correlation between the cost of capital and the borrowing risk for your business. With that in mind, view the pros and cons of your capital costs through the risk lens.
The time it takes to receive funding varies from capital type to capital type. That’s why it’s vital to build your R&D capital stack as soon as possible, so your cash flows smoothly and your capital reserves keep your R&D programs pumping.
A balanced approach
It’s vital for your company to work with business and financial advisors to ensure you have the right blend of capital to maintain your runway for the next 12 -18 months. Getting the right advice on your ratio of debt to equity is time well spent and will help you successfully steer your company on its growth journey. Whatever stage your business has reached, having quick and easy access to non-dilutionary R&D capital that’s cash-flow friendly can contribute positively to your capital stack. Radium Advances do just that by letting you access your R&DTI refund early. Contact one of our friendly R&D finance experts today, or see some of our client success stories to learn more about what we do and the different businesses we help.
- Typical terms for Radium Advances: Advances < $100k: Signed director guarantee; Advances $100k – $1million: First ranking charge over R&D refund only; Advances >$1 million: Featherweight Security Agreement or General Security Agreement ** Radium Capital is a specialist R&D financier. We recommend you seek the advice of business and financial advisors to determine the most suitable capital stack for your business.