November 10, 2022

Growth Capital: What You Didn’t Know, Advantages, Disadvantages, And More

Growth Capital: What You Didn't Know, Advantages, Disadvantages, And More

Struggling to understand what growth capital is and whether it's the right option for your business? Read on; we've got your back.

Imagine you've spent years working to bring your business idea to fruition. You've estimated the product market fit, built a sizable customer base, and established a steady revenue for your company. Now, foreign expansion is on your mind- but debt isn't an option, and you're relatively mature for a venture capital-backed company.

What's the first funding option that strikes a chord with this scenario?

That's right - growth capital. Growth capital is ideal for high-potential, late-stage companies that need money for growth and expansion. But wait, we'll get around to that by the end of this article. Let's first take a look at what growth capital really is.

What is Growth Capital?

Growth capital (also known as growth equity and expansion capital) is a form of investment given to promising late-stage companies that need funding to take them to the next level. Companies that opt for growth capital are generally more mature than venture capital-funded companies. However, they may use this capital for a major upheaval, acquisition, aggressive expansion, product development or the like — essentially, to focus on better company growth.

Basically, growth capital is the "it factor" for late-stage enterprises with established business ideas and products but that still want cash to expand and diversify their operations. Many startups fall into this category before they go public.

These companies surpass the classic venture capital-funded growth stage. They are either on the verge of achieving a positive EBITDA or have already achieved EBITDA but need more investment to accelerate their growth.

Pro tip: EBITDA is the Earnings Before Interest, Tax, Depreciation and Amortization. EBITDA helps investors gauge a company's profitability and allows founders to ascertain their company's financial worth.

Source: Concept Financial Services Group

In business terms, it's safe to think of growth capital as the crossroads of Venture Capital (investments in risky but promising companies) and Private Equity (investments in mature companies with stable cash flow, traditional leverage buyout firms).

Growth Capital Examples

Growth equity deals tend to be smaller than leveraged buyouts (LBOs) but more significant than venture capital fundraising rounds. Although growth equity firms are free to invest in any sector they see fit, they have a propensity for the technology, SaaS, TMT sectors and a fair presence in the consumer/retail, healthcare, and financial services sectors.

Let's look at established companies that have opted for growth capital as their funding source, usually when they're beyond the Series C funding stage:

Duolingo

If you've ever had the urge to learn a new language, chances are you've come across Duolingo. This language-learning platform raised $35 million from Durable Capital Partners LP and General Atlantic- a growth equity firm. Duolingo needed this Series H funding to accelerate growth, expansion and work on R&D for new products, with a valuation of 2.4 billion dollars.

TCNS Clothing

In 2018, TCNS Clothing, a leading women's apparel company, acquired a $140 billion deal by TA Associates, a renowned player in growth equity firms. W, Aurelia and Wishful are the three brands that operate under TCNS, catering to females aged 25-40. The company seeks fresh capital for growth and expansion, and TA Associates offer solace as a minority stakeholder in this New Delhi-based company.

Fractal

Earlier this year, TPG, a prime global growth equity firm, invested in Fractal. When the need for scaling globally arose, Fractal, which provides advanced analytics and artificial intelligence solutions globally, landed a $360 million deal with TPG. Fractal aims to rise exponentially with this strategic growth capital.

Deliveroo

Deliveroo, a food-delivering business, recently received $275 million in funding. This London-based firm operates in a dozen countries across Asia, Europe, and the Middle East. Bridgepoint, a seasoned investor in the restaurant industry, and Greenoaks Capital, a long-standing investor, spearheaded this funding. The money was raised to support growth in both existing and new markets and investments in initiatives like RooBox, which provides restaurants with access to off-site kitchen space to meet the demand for takeout that their own kitchens are unable to meet.

Grab

When Softbank put $750 million into Uber competitor Grab in 2016, it was a growth capital investment. Softbank and other investors led the Series F round of funding. Grab currently operates in six South Asian nations, has 21 million app downloads, and employs 400,000 drivers. The funding was essential to concentrate on technology and effectively compete with companies like Uber, particularly in Indonesia. Among its future endeavours is improving its algorithms in driver efficiency, mapping data and technology development, demand forecast, and user targeting.

Which Companies Should Look for Growth Capital?

Companies wrapping up from the venture phase but still needing to fully mature, fall into the ideal category of businesses that need strategic growth capital. If you're wondering what a good growth capital company profile looks like or if the time is right for you to look for growth capital, fret not.

Consider the following scenarios to gauge whether it's the option you need:

Your company is churning revenues at a high rate
Your business is cash flow-positive, profitable, or going to be profitable
Bootstrapped company with no previous investment
Companies with a proven product or business model
You have a targeted use for the capital
You want to maintain control over the business and are unwilling to sell
The company may not be able to opt for debt financing and is too mature to choose venture financing
Growth equity investors also prefer companies with minimal leverage or no debt

It's also paramount to consider why you need growth capital and what targeted use you have for this capital. Commonly, founders need growth capital to:

Invest in building a team, sales, marketing, and operations
Launch products and services or enter a new market
Expand into new localities
Mergers and strategic acquisitions
Invest in creating new technology, facilities or growth before IPO
Provide liquidity to shareholders
Restructure the company's balance sheet so as to reduce debt

How Does Growth Capital Work

Growth equity is structured chiefly as a minority investment; investors seek less than 50% stakes in the company compared to majority interests, which take up more than 50%.

These late-stage companies may also opt for debt to acquire capital, but the repayments would place too much strain on their cash flow. So, such founders instead give up stock in return for financial backing from a growth equity fund.

This is why growth capital becomes an appealing alternative, particularly in economies where debt is scarce to finance leveraged buyouts or competition to fund young enterprises is fierce.

There is a continuum from venture capital investments through growth capital transactions to buyouts, and all private equity deals fall along that spectrum. In fact, it can be challenging to draw a clear line between a growth capital agreement and, say, a later-stage VC investment or a majority buyout that leaves the founders with strong capital interest and continued management obligations.

Compared to venture capital, growth equity has a lower holding period of nearly 3-7 years. This is because companies are more mature in growth capital stages, whereas VCs need more time (5-10 years on average) to snowball into a profitable company.

Moreover, for investors, growth capital is a moderate-risk investment. The target rate of return is roughly 30-40%, with 3-7x being the expected multiple of capital that is invested.

How do these growth capital firms get their returns, though?

Primarily, the ability of the company to expand its operations results in considerable revenue and profit growth, which becomes the source of returns for growth equity investments—these returns progress when the company approaches profitability or gets a strategic buyer.

Growth capital exits generally culminate in an IPO, company sale, or selling of shares to other investors.

So, whom do founders approach for growth capital?

Private equity firms, late-stage VCs, mezzanine funds, hedge funds, wealth Funds, and family offices are all growth capital providers. In addition, traditional buyout firms may also occasionally provide growth capital.

Some big players in this field (the significant growth capital firms with exponential track records) are TA Associates, Summit Partners, General Atlantic, Insight Partners, TPG Growth, Sequoia Growth and Spectrum.

Is Growth Capital the Right Option for You?

Here are a few points to ponder upon that will help you make a sound decision:

How much say do you wish to have in the day-to-day operations of the company
Whether or not you have a solid financial foundation to support the costs associated with investing in growth
Whether you need a cash infusion along with sound guidance or you simply need cash
The financial burden on your company, and perhaps on you personally
Whether you have an immediate need for the funds

Advantages of Growth Capital

There are a number of advantages to opting for growth capital.

For starters, proper growth funding allows companies to grow exponentially and work through any insufficiencies that hinder their growth.

Growth equity provides more than just financial backing; it also offers access to domain-specific knowledge and assistance that helps escalate profit margins.

Moreover, seasoned investors get the best of both worlds- since growth equity occupies a sweet spot between VC and PE. It also allows them to focus on working with middle-aged companies and build strategic growth plans.

Plus, in growth equity, the chances of a company failing are relatively less since, even in the worst-case scenario, the company may simply grow less than expected. It poses a moderate risk investment for investors and works out equally well for businesses to ramp up their scalability.

Disadvantages of Growth Capital

Since growth capital is usually in the form of minority investments, investors may not retain direct control over the company. Instead, they have to rely on the management team's potential for the operations and financials, which may not suit some of them.

Securing a growth capital deal is also highly competitive, time intensive, and, of course, there's the dilution that needs to be taken care of. Equity dilution is perhaps the utmost reason why founders may be hesitant to opt for growth equity, especially at the company's late revenue-churning stages.

Growth Capital: Are There Any Alternatives?

When founders want to raise capital, they tend to gravitate toward the most prominent options in the startup economy: equity financing, debt financing, or something that lies between the two. While we've discussed the ins and outs of private equity for strategic growth capital, debt financing, and revenue-based financing are also excellent options for raising growth capital.

Debt Financing

Debt financing lets business owners keep full control of their companies. The common forms of debt financing (or financial leverage) are bank loans, family and credit card loans, and bond issues. However, sometimes owners have to put up their own assets as collateral, and even then, it's usually for a minuscule amount. While the saving of equity (read as future profits) is a silver lining, debt financing demands collaterals and interests that you (as the founder) are solely liable for.

Revenue-Based Financing

Revenue-based financing is an alternative to growth capital fundraising wherein companies can raise funds by using a portion of their future revenue for instant capital. This capital is paid back in time as the income progresses.

For those skeptical of equity dilution or interest hassles, revenue-based financing emerges as a stellar option. For businesses that need to stock up on inventory or ramp up ad spending, again, revenue-based financing is a perfect non-dilutive alternative. This growth capital raising strategy does particularly well with Software as a Service (SaaS), e-commerce and technology companies.

How Can BridgeUp Help Companies Like Yours

Tomorrow's revenue, today. Sounds difficult, right?

Not with BridgeUp- which is a plain sailing revenue-based financing subset perfect for companies with a predictable revenue stream.

Debt and dilution have long been the evils of the startup fundraising game, and BridgeUp offers a way to escape the much-dreaded repercussions of these for founders. BridgeUp is industry-agnostic and suitable for any company that has a recurring annual revenue.

Enlisted investors make bids to buy a company's monthly recurring revenue contracts in exchange for the yearly value of the contracts. This annual value is provided to the company in advance. As a result, the business continues to receive monthly payments from clients, which it then uses to repay the investors. Result? You receive instant capital that can fund your growth needs rapidly.

As we always say, revenue is your best asset. Find out more about BridgeUp by calling us at +91-9819660287 or dropping a query on this form here. Let's scale. Together.

Frequently Asked Questions (FAQs)

Are growth capital and venture capital different?

Growth capital is the middle ground between venture capital and leveraged buyouts. Venture capital revolves around early-stage companies, which may be risky, while growth capital deals with late-stage companies with an established business model. As a result, the holding period, returns and risks in both these stages differ, although the lines are blurry.

What is a growth capital loan?

A growth capital loan is when a company seeks a loan to accelerate its growth. These loans are in the form of debt and have minimal to no equity dilution.

Growth capital loans consist of three documents: a loan agreement, a debenture, and an equity kicker. Loan agreements are conventional contracts between a lender and a borrower that govern the loan facility. The debenture establishes and recognizes the company's liability to the lender.

The equity kicker is described in detail in a warrant instrument.

What do growth capital firms do?

Growth capital firms pursue businesses with a steady business model, usually when they are too mature for VC funding but still need to be ready for an IPO or buyout. These established companies enable rapid revenue growth and mitigate the usual risks of fundraising as compared to VCs or angel investing.

What do growth capital lenders look for in companies?

Businesses with high gross margins, asset-heavy business models, strong momentum, and scalability with predictable and recurring revenues generally sit well with growth capital lenders.

How do growth equity deals take place?

Growth equity deals take 2-3 months on average, and it all begins by pitching your business concept and its financials to investors. A legal term sheet is then issued, followed by due diligence by investors and then cashing out the capital after the required legal work is carried out.

How are leveraged buyouts and growth capital different?

Traditional Leveraged Buyouts (LBOs) are often majority investments looking to buy out a company rather than invest in its growth. A typical debt-to-equity ratio for a leveraged buyout is 90% debt to 10% equity.

Because the assets of the targeted company can be used as leverage, LBOs have earned a reputation as a brutal and predatory commercial strategy. Conversely, growth capital tends to be a minority investment where investors wish to scale the company while remaining a minority stakeholder.

What companies do growth capital firms invest in?

Companies that are profitable or approaching profitability with a high growth rate, proven business models, recurring revenues, and residual value fit the bill for growth firms. While there is no strict rule for raising growth capital, founders opt for this funding strategy, usually after Series C funding.

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Zeus Dhanbhura

CEO at BridgeUp