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Non-dilutive funding: why is equity so important?

We often hear that during a fundraising round, the leverage effect comes from the equity raised. That is (almost) false... So, what is this famous leverage effect actually based on? On the level of your equity, the magic word for banks.

So, what exactly is equity and what is it used for? We’ll explain everything!

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Equity: what’s that?

Equity is the long-term financial resources that belong to your company. You can think of it as your company's undistributed financial reserve. It is important to measure your equity level to properly manage your company's financial health. Without wanting to give a boring accounting lecture, here is a quick refresher on what makes up equity:

Equity = (share capital + reserves + retained earnings + net income for the year + investment grants)

How should this formula be interpreted?

We can see that equity mainly comes from shareholder contributions (capital) and profits generated by the company.

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Why is this capital listed on the liabilities side of the balance sheet, just like debt?

A quick reminder: a company belongs first and foremost (at least from a legal standpoint) to its owners (the shareholders, in the case of a corporation). Equity therefore represents, in a way, the company's "debt" to its shareholders. For example, in the event of a company liquidation, the amount of equity will be returned to the shareholders (in the case of liquidation due to insolvency, equity is very often negative... and the shareholders lose all their contributions). In short, we can see that equity reflects your company's financial value and help assess its financial health and solvency.

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Why increase equity?

Based on the formula above, it is clear that the very essence of equity fundraising lies in the need to increase equity to offset losses. This is typical of the start-up model (and all innovative businesses in general), which are designed to operate at a loss to prioritize innovation and hyper-growth. In fact, it is often said that a start-up is no longer a start-up once it becomes profitable.

And what does that imply? That you no longer have to dilute your equity by raising equity capital to boost your shareholders' equity, but can simply capitalize on your positive net results. And that is the jackpot! Why? Because it means no more equity dilution and founders who own a larger share of their company!

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The importance of profitability

Indeed, during a start-up's early years, there is significant cash burn and value destruction (at least from an accounting perspective) linked to the investments made, which results in negative net income (Expenses > Revenue). This makes it impossible to be profitable in the early stages. So, at this point, how do you find money to fund your operations? One solution is to raise funds to increase your equity and maintain a healthy financial position. However, these rounds are often equity-based. The problem? This means that capital is diluted between investors and founders.

So, the goal is profitability! Because the sooner you become profitable, the sooner you can take on debt without necessarily having to raise equity capital on the side! This also reduces the pressure on your equity and helps maintain your company's financial health. After all, the goal of a business is to be profitable and create value (Revenue > Expenses), right?

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The risks of negative equity

You are often told how to raise funds, but rarely what happens when you don't have any. As mentioned earlier, equity is an indicator of a company's financial health. It serves as a guarantee for creditors. What does it mean to have negative equity? It’s not when it falls below 0, but when it falls below half of your share capital and reserves.

The calculation for the undercapitalization test is simple:

A = Share Capital + Share Premium + Reserves

B = Equity

C = 50% x A (undercapitalization limit)

→ If B < C, you have negative equity and the undercapitalization limit has been exceeded!

‍This can explain why banks are hesitant during a debt raise. If, for example, you hear BPI tell you that they cannot fund you because your company has the status of “company in difficulty,” it is precisely for this financial reason.

Indeed, when equity is negative, it means the company no longer has the means to fund its own operations and that the company's long-term financial health is compromised. If you cannot even fund yourself, how can you expect to pay back someone else?

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What happens if equity is negative?

The Commercial Code requires holding an extraordinary general meeting (EGM) when shareholders' equity falls below half of the share capital. During this EGM, and within 4 months following the approval of the annual accounts, the company's legal representative must consult all shareholders at a general meeting. Two options are then available:

1. Dissolving the company.
2. Continuing operations to rebuild healthy equity that complies with the law (i.e., positive), with a deadline of the closing of the second fiscal year following the EGM.

For this second option, the goal is to inject liquidity back into the company or to become profitable quickly enough to offset this drop in equity. This can be achieved in several ways:

• By carrying out a capital increase through cash contributions or capitalization of reserves.
• By generating profits to become profitable enough to absorb the losses.
• Or by carrying out a capital reduction motivated by losses.

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The relationship between debt financing and equity, aka Gearing

Since equity reflects your company's financial health, it is what banks use to assess your borrowing capacity. The balance to maintain between debt and equity is important; this is the well-known "gearing" (level of debt relative to equity). This is why it is important to maintain a reasonable amount of equity. What does this mean for banks? That the company taking on debt is able to meet its financial obligations.

Example:Most BPI financing remains within the limit of half the level of equity, i.e., 50% gearing. What we observe for start-ups is that they can obtain bank financing that respects a gearing ratio ranging from 40% to 60% (depending on the business model and potential collateral).

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Optimizing your gearing

As you can see, gearing is a key element for banks. The challenge is to make the most of your debt capacity to minimize the dilution of your capitalagainstoptimize your financing by using debt as a growth lever ! Be careful, however, not to over-leverage; the goal is not to generate revenue exclusively dedicated to repaying your debts. It is always a question of balance.

So, what does it take to optimize your gearing? Provide collateral to the banks!

• The HaaS models (Hardware as a Service) can help push gearing higher, given that there are assets for the bank to seize in the event of a payment default (Example: Long-term vehicle leasing).
• Another tool is leasing. This does not appear as debt (on the balance sheet), but it impacts your income statement (financial rents as an expense), which allows you to increase bank financing without impacting your gearing.
• Forming a banking syndicate to share the desired financing package among several lenders can minimize their individual exposure to your company, ultimately allowing for a larger total facility (and thus higher gearing).
• A profitable company, with a proven, solid business model, also provides a relevant guarantee for the bank, which will be reassured by the company's ability to repay the loan.

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In short, as you can see, equity is essential and must be properly preserved! At Super Capital, we can assist you with both your equity fundraising (VC fundsagainstAngel Investors) and your non-dilutive financing strategy to activate growth levers tailored to your needs. So get in touch with us!

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