It is easy to get overwhelmed very quickly with the ways to finance your business.
The following is a simplified summary of different forms of funding that are available to startups of various stages.
All funding sources have pros and cons, and not all are appropriate or feasible for all businesses. We just want to give you a general overview of the topic of funding.
When you “pull yourself up by your bootstraps” you are doing something difficult, on your own, with limited or existing resources.
Bootstrapping is a minimalist approach to funding, and because that often translates into doing more with less, it can be a driver for creative solutions and ingenious ways to stretch resources.
It can also be mundane, such as continuing to work your day job to cover your expenses while you get your business off the ground.
When the money is your own, you maintain direct control.
There are no investors or lenders calling and expecting a return on investment.
In some cases, this kind of pressure can actually be good.
It can force startups to conform to a timeline that prioritizes delivering results and achieving milestones; however, a large factor in the decision to become an entrepreneur is the ability to choose one’s own destiny.
Additionally, bootstrapped businesses grow organically.
Without large amounts of cash on hand, decision-makers must be laser-focused on achieving profitability.
This focus comes at the sacrifice of fast growth, but it does mean that the business is less likely to grow too fast, consuming its runway at an unsustainable rate.
The glaring challenge in bootstrapping a startup is the need for personal funds that can be diverted into the business.
Although the business may not require outside funding at first, your personal bank account is the source of funding and—as many of us are painfully aware—that money is not bottomless.
It is very possible that when bootstrapping your business, you could go into personal debt.
On the business side of things, bootstrapped businesses are always scrambling for resources.
Not just cash, but the advantages that cash can purchase—
- inventory, etc.
As a result of being cash-choked, bootstrapped businesses grow slowly compared to other funding models, and the lack of resources in critical early stages may lead to a risk-averse culture.
When startups recoil from the risk they often miss growth opportunities and can lose a healthy appetite for change—something that is absolutely critical for startup success.
Bootstrapped companies can also suffer from inattention. When you have to spend time working with other jobs, the time you have to grow your business gets pushed to nights and weekends.
At some point, your venture won’t be able to grow without your devoting your full time and attention to it.
Family, Friends, and Fools (FFF)
As one might expect, approaching friends and family for startup funding is a delicate situation that can get messy quickly.
Friends and family are self-explanatory funding sources.
Fools are something of a joke—the joke being that because startups have a tendency to fail, only a fool would invest his or her hard-earned money in an unproven business.
This type of financing has a much lower threshold of access than other methods covered here.
While your credit history and personal history certainly should be considered when friends and family loan larger sums of money, elements of personal relationships will often make friends and family more inclined to help and sympathetic to your cause.
That is not an excuse to bleed these people dry—they are your friends and family, after all.
Don’t ask them for more than they can afford to lose, and think of their needs every step of the way.
When soliciting friends and family for funding, don’t be shy about demonstrating the amount of your own money that you have already sunk into your business.
Ask for specific amounts of money and tie those funds to specific milestones.
Go above and beyond to offer friends and family a formal agreement as well as a handshake deal.
Tie debt repayment to the success of your business, or better yet, offer debt that is convertible into equity.
This is an overlap of the work and personal portions of your work-life balance triangle, but that doesn’t mean that the work portion should have to damage the personal side of things.
As an entrepreneur, always be thinking about the ways that you can grow your social network—you never know who might become a key initial investor in your venture!
On the other hand, giving out equity in exchange for funds, while very common, creates valuation issues and must be done thoughtfully.
For example, if you give away 10 percent of the company for a $10,000 investment, you’re implicitly valuing your company at $100,000. If you need additional funding later, and you give another 10 percent for $5,000, your company is valued at $50,000.
Which is right?
Too many competing claims on the assets of a company could scare away potential investors in the future.
If you have friends or family with deep pockets and substantial business acumen, great!
They are the people you should be chatting with first.
More often than not, however, personal networks include a mix of different people from a variety of backgrounds.
This means that your FFF financing may come from nonprofessional investors who themselves do not come with connections to suppliers, customers, or others within your industry.
Additionally, the money from FFF sources may not come with any more tangible strings than debt or equity funding, but there are invisible strings attached.
It can be tough to initiate and maintain conversations regarding money, and there is added pressure not to lose the money of people you care about.
This disadvantage should not invalidate FFF financing for your business — many, many startups couldn’t have gotten to where they are without financing from friends and family — but it does mean that prospective entrepreneurs should tread carefully.
When considering FFF funding, I always recommend what I call the Thanksgiving Dinner Test.
Imagine your business doesn’t work out, and you end up losing all of your investor funding.
Would that ruin your Thanksgiving dinner, or would your family be okay with it?
Is the money you’re borrowing immaterial to them, or are you risking their entire life savings?
Think carefully about these questions.
Debt financing is the catchall term for efforts to raise capital that include taking on debt in some form.
Common sources of debt financing for startups include commercial banks and startup-specific lenders such as Kabbage.
Debt financing methods of raising capital allow businesses to retain control of their business—once the loan application process is complete and your loan is approved, the money is yours to do with it what you will.
This process can be completed relatively quickly, and, once approved, the money doesn’t trickle in.
It is deposited in one lump sum, which means it can be put to use right away.
Loan applications often require an extensive operating history, collateral in the form of hard assets, or both.
This immediately disqualifies many startups from being able to take advantage of debt financing.
The lack of historical data and sufficient collateral are often insurmountable barriers in the application process.
Not only do many startups not qualify for debt financing options, but the road to new-venture success is littered with stories of businesses that struggled to service their debt obligations.
This problem is not restricted to new ventures only; large, established corporations can succumb to the cash flow problems that taking on too much debt can create.
Equity financing is the practice of raising capital through the sale of ownership shares of a business.
It allows startups to raise money without suffering the constriction of debt obligations, but at the expense of sharing or diluting control of their business.
Angel Equity Financing
Angel investors are independently wealthy investors acting either individually or as a group (known as an angel network).
Angel investors are distinct from venture capital investors.
They both deal in equity financing, but angel investors are more willing to invest in early-stage startups rather than providing funding to accelerate fast-growth businesses.
This desire to “get in on the ground floor” makes angel investment particularly attractive for early-stage business.
The equity financing that angel investors provide is often advantageous to startups if a satisfactory deal can be reached.
Because angel investors can be less concerned with hitting short-term profit targets, they are often willing to work with startups to set them up for long-term success.
This may mean only providing just what the business needs instead of forcing faster, unsustainable growth or working with startups that are still in earlier stages of growth—the kinds of businesses that debt financing institutions and venture capital firms would never touch.
Additionally, despite the fact that angel investment is generally equity investment, not all angel investors insist on active control in the business.
The level of participation an angel investor has depends on numerous factors—the experience and temperament of the investor chief among them—but compared to venture capital equity financing, angel investors are often much less hands-on.
For angel investors who have industry expertise or a history of investing in a particular industry, another advantage they bring to the table comes in the form of guidance and advice.
If they are part of an angel network, they may also be able to set up introductions with other investors, mentors, or industry contacts.
Not everyone can become an angel investor.
The SEC requires that individuals who deal with unregistered securities (such as shares in a private company) must meet certain criteria to become an accredited investor.
These criteria include income minimums and a minimum net worth.
This means that if an angel investor should turn out not to be an accredited investor, your venture could be exposed to disruptive and costly legal consequences.
What about crowdfunding? Isn’t crowdfunding the same as finding numerous unaccredited investors?
Crowdfunding does not have to take place in the form of equity financing and often doesn’t.
It is common for crowdfunded startups to offer early access, exclusive rewards, or other perks in lieu of equity-sharing arrangements.
The legislation is also on the side of helping startups grow through the use of crowdfunding. The Jumpstart Our Business Startups (JOBS) Act of 2012 loosened the burden of SEC reporting on crowdfunded startups—new ventures can raise up to just over $1 million annually without registered securities.
Although many angel investors have some degree of industry experience, their investments may not always constitute “smart money.”
In the world of investment, smart money is money that comes from a source with a track record of making smart investments.
If your business is the recipient of smart money, congratulations—you demonstrated to the investor that you have what it takes to be successful and inspired their confidence.
The other side of the coin, however, is that if the money isn’t “smart,” the angel investor may not be able to help you make success-based decisions if he or she is a new investor or one with a limited track record.
Because angel investors are individual investors and often not professional investors, experience, track record, and expectations can vary wildly from one “angel” to the next.
Considering the advantages and disadvantages, you may be asking yourself how likely it really is that your venture can court and successfully close an angel investment deal.
Angel investors have traditionally been associated with Silicon Valley tech startups, but today that is largely a misconception.
Angel investors exist in a wide range of industries and regions.
In fact, a 2017 study by the Angel Capital Association found that 63 percent of angel investors are based outside of the major metropolitan areas of San Francisco, New York, and Boston.19
Angel investors look for a winning team, a completed business plan, a risk-conscious founding team, and a business that is built on a solid foundation of integrity (angels who can’t trust their startup partners get cold feet quickly).
Companies like AngelList20 are tools for startups and angel investors to connect with one another.
Corporate Partner Equity Financing
In some strategic partnerships, it makes sense for one company to benefit from an equity stake in its partner.
From the perspective of a startup, nothing is better than partnering with an established company that can confer instant brand recognition and access to new customers, new partners, and new resources.
In his 2013 title, 101 Startup Lessons: An Entrepreneur’s Handbook, author George Deeb outlines a strategic partner equity deal he was part of when National Geographic purchased a 30 percent equity stake in his adventure travel website iExplore.
National Geographic was able to leverage the travel-experience-based offerings of an emerging adventure travel website (emerging because the deal took place in the year 2000) as a complement to their natural-world-focused publication.
In return, iExplore received a quick boost in recognition by association with the historic publication, along with marketing and promotional support.
National Geographic was incentivized to keep iExplore afloat—they had skin in the game to the tune of 30 percent.
Critically for iExplore, the initial support that National Geographic provided was able to be parlayed into other investor support during a period of financial uncertainty.
If National Geographic believed in this startup, that was good enough for other investors.
The story of National Geographic and iExplore is a good example of an equity-based partnership and how it can be an asset for larger corporations as well as a boon for well-positioned startups.
As Deeb elaborates, it is also a cautionary tale. The deal was made before a post 9/11 slump in travel spending, and at a time when iExplore had cash to spend.
As sales declined, iExplore found that they needed cash on hand to adequately take advantage of the marketing and promotional considerations they had negotiated as part of the deal.
Deeb’s synopsis of strategic equity partnerships? The devil is in the details!
Established companies have deep pockets, and a well-structured strategic partnership has the potential to completely change a startup’s future.
The equity stake that changes hands gives the larger, established company a deep incentive to encourage the success of startup partners and integrate them into the completion of strategic objectives.
This focus on the future has other short-term benefits as well.
Large corporations are always on the lookout for ways to reduce their tax liability, and an equity financing strategic partnership can be chalked up as a tax-advantageous loss.
Corporate partners may apply less pressure to be profitable right away, unlike with debt financing funding options or venture capital firms.
The National Geographic and iExplore deal from the previous example is a summary of a summary.
The account glosses over numerous back-and-forth meetings, extensive negotiation, and a significant amount of work on the part of the startup.
That deal went through, but Deeb makes no mention of other deals that had been proposed and fell through, or how long the process to come to an agreement took.
Together, this commitment of resources—specifically time and energy—can be a drain on resource-strapped startups, only to end in a deal that falls through.
Not only is the strategic partnership process a lengthy and bureaucratic one but consider that not every corporation is looking for a startup to take a chance on.
Short-term tax benefits aside, your startup has to offer a concrete benefit to a potential corporate partner and demonstrate that not only can you deliver on your end of the bargain, but you can stay in business long enough to do so.
Keep in mind as well that the issue of control is ever-present in equity funding arrangements.
Corporate partners will often push to align your priorities with their strategic objectives as a condition of the equity deal and may even ask that they place personnel on your team.
Concessions like these can culminate in a greater loss of control than some founding teams anticipated, and for many entrepreneurs can represent too high a cost to pay for the capital they need to grow their venture.
Venture Capital Equity Funding
No source of startup funding has captured the popular imagination and romanticized the role of the modern entrepreneur more than venture capital.
Like angel investment, venture capital comes in the form of private equity.
Unlike angel investment, venture capital is normally only accessible by ventures that conform to a general template.
Specifically, those who are out of the initial stages of unproven demand, but not at the stage of organizational maturity where growth slows and revenues can level off.
Venture capital firms—the firms looking to invest their money in startups with high growth potential—adhere to a strict set of criteria when selecting which businesses to invest in, and they are known for passing on many more opportunities than they commit to.
The startups that do make the cut are expected to produce returns of 30 to 50 percent annually and are expected to cede large portions of equity, so much so that in some instances venture capital has been referred to as “vulture capital.”
If that sounds harsh, remember that venture capital firms are accepting tremendous levels of risk and writing very large checks.
Angel investment funds don’t always constitute “smart money,” but that is not the case with venture capital.
Venture capitalists are choosy—with the amount of money they are committing, they must be.
So any startup that secures Venture Capital backing also receives an automatic endorsement by association.
This endorsement isn’t unearned, either.
Venture capital firms have deep pockets, extensive connections, and no shortage of guidance for the startups they work with.
In many ways, the reputation of venture capitalists as kingmakers is not undeserved.
Some of the biggest names in ultra-successful startups couldn’t have gotten to where they are without large infusions of venture capital through multiple rounds of funding.
It is worth noting, however, that the vast majority of startups that reach success do so without Venture Capital funding.
According to a report from Empact and Fundable, a grand total of .05 percent of US startups are funded with venture capital.
Which is a minuscule number compared to the much larger number of US startups that receive angel investment funds: .91 percent.
As you can see, less than 1 percent of businesses receive either an angel or Venture Capital investing, so think very carefully about whether this is a reasonable and/or desirable goal for you.
As you may have guessed, the restrictive guidelines that venture capital firms adhere to mean that they pass over most startups.
In fact, venture capitalists may be so laser-focused on limiting risk that they only consider new businesses that have already cleared their first round of funding, or only work with startups that require funding to grow rapidly.
At any rate, venture capital firms aren’t writing small checks.
Many venture capitalists won’t touch requests for funds under $2 million—they are used to cutting high-dollar deals that have a high chance of paying out.
These big checks also come with big strings.
There is no venture capital arrangement that doesn’t involve ceding significant amounts of control.
Venture capital firms are notorious for stepping in to ensure their return on investment, going so far as to place key people on a startup’s board of directors.
What’s more, venture capital can dry up in an instant.
A firm can decide to pull their support if things aren’t going their way, resulting in a hit that many businesses will be unable to recover from.
The opposite of micromanagement and oversight can also be true.
If another startup your Venture Capital is funding begins to flounder or they are simply very busy, your startup may not receive the level of attention that you expect.
Call it a sign of the times, but an increasing number of businesses have called upon the masses in lieu of using what could be considered more traditional funding methods.
The startups that have seen tremendous crowdfunding success make it seem as though all your venture needs to do to gather all the money you need is to create a campaign on Kickstarter or Indiegogo and the dollars will start pouring in.
As with numerous other examples from the world of entrepreneurship, the high-profile successes eclipse the reality that many, many projects are chalked up as unsuccessful.
By Kickstarter’s own admission, approximately 36 percent of projects succeed.
There are many reasons for this.
Not all businesses, products, or campaigns are appropriate for crowdfunding.
Not all campaigns are executed according to crowdfunding best practices.
And there is no way to know if the entrepreneurs behind these projects had other issues with their businesses that may have contributed negatively to project success.
The biggest advantage of crowdfunding is money.
The whole idea behind the crowdfunding process is that a lot of small amounts of money can add up quickly.
These dollars can be gained in exchange for perks such as early access, exclusive bonuses, or VIP features.
These enticements would normally not work at all on professional investors, but because the average crowdfunding investor is nonprofessional and the sums of money are usually quite small, crowdfunded dollars can often be obtained without sacrificing equity or assuming debt.
The everyday people who commit money to crowdfunded projects aren’t just an ocean of micro investors—they are also regular people.
A crowdfunding campaign that fails to meet its goal or that receives lukewarm feedback can be a signal of a product or service that fails to meet a real need.
A campaign need not fail to produce insight, however.
There is no shortage of people on the internet who would like to offer their opinion, solicited or not.
A crowdfunding campaign can act as a dry run or a sort of stress test for a concept, product, or service.
Serving as a magnet for input and opinions, your campaign can be a valuable source of feedback.
Crowdfunding success carries different amounts of cachet with different types of investors, but the fact remains that it is an accomplishment to run a successful crowdfunding campaign.
If you can pull off one or more crowdfunding successes, that achievement alone confers instant credibility.
And, depending on the type of investor or funding you are approaching, it is not out of the question that you could have pulled in more via crowdfunding than you were asking for.
All of these aspects contribute positively to your request-for-funding pitch.
The JOBS Act of 2012 that made crowdfunding a viable option for startups was a boon for new businesses in that year and for several years thereafter.
At this point, the crowdfunding marketplace is crowded with startups who are clamoring for funds.
This doesn’t mean that crowdfunding is tapped out, but it does mean that businesses that are seeking funding do have to work for it.
That work may mean developing high-production-value presentations, waiting until you can increase the valuation of your business, giving more bonuses to your micro investors, or some combination of all three.
This feeds into the point that not all products or services are appropriate for crowdfunding campaigns.
First, crowdfunding is best for projects that require smaller (on average) funding commitments.
Second, products that aren’t sexy or eye-opening (despite being valuable) don’t do well with the nonprofessional investor class.
Additionally, if your crowdfunding campaign includes equity sharing, be aware that professional investors may be uncomfortable sharing equity with numerous inexperienced investors.
Crowdfunding is also a poor choice for businesses that need funds right now.
Fundraising campaigns can take months to produce results, though there have been exceptions.
The Small Business Administration (SBA) incentivizes small business growth in the US by offering low-interest loans for qualifying businesses.
These business loans are available through some banks and credit unions and benefit both the business owner and the lender.
For-profit lenders like banks are wary of risk, and this results in their denying many loans.
SBA loans, on the other hand, are backed by the Small Business Administration and reduce risk to lenders. If businesses default, the government pays off the balance.
These loans not only benefit new businesses by providing the funds they need at favorable interest rates but they also often have lower thresholds of acceptance—simply maintaining a good business credit score and adhering to the terms of repayment are often the only major criteria considered outside of your business plan and standing.
These loans are designed to get businesses up and running, help them establish credit and purchase equipment, property, or other items with the high initial cost.
Government-backed loans are not blank checks and they are not handouts. As with any other debt, your business assumes, keep in mind that revenue will have to be diverted to service the debt.
The SBA does not administer any loans or debt financing directly. Instead, the agency underwrites loans that are made available from participating for-profit lenders such as banks and credit unions.
Business Funding Stages
As noted at the beginning, the specific funding path that is best for your business is a product of the specifics of your business, where your startup is in its life cycle, and the options available to you.
It is beyond the scope of my experience to outline various funding strategies in detail, but generally speaking, think of funding in stages.
This stage of funding comes before your startup is up and running.
This money is used to
- further develop, test, and research your product;
- to overcome initial industrial barriers to entry (such as regulatory licenses or compliance issues);
- and to take care of the costs associated with getting started.
Often, bootstrapping and funds from friends and family are most appropriate for this stage.
The seed stage of funding is the point at which your business will need funding to keep it afloat until it is capable of generating its own cash flow, or it is ready for further investments.
This funding stage may be lumped in with the pre-seed stage, depending on the funding options available to you and the amount of money you need.
SBA-backed microloans, grants if your venture qualifies, and crowdfunding options are often most appropriate for this stage of funding.
First-round funding is often the first time a venture opens up equity to entice the investors to provide the funding needed to expand, or to reach a point where the startup can generate its own sustainable cash flow if that wasn’t achieved with seed funding.
Prior to this point, there often isn’t much to a venture to give it the level of equity that can be used as an enticement. This is the stage when many ventures turn to angel investors.
As the venture grows and looks to expand into new markets, create new products, or extend existing lines, more capital will be required for each of these activities.
The venture will have reached the point where it has proven that it can deliver returns, but this is also the point where large infusions of cash will be needed for the business to expand substantially.
At this point in a startup’s life cycle, it will be in a better position to be attractive to venture capital firms.
As a startup with a track record of success matures, it gains access to larger and more impactful forms of funding.
At this stage too, debt financing becomes more and more attractive, assuming the venture has the cash flow to service their obligations.
At this point, “going public” becomes a real possibility as a tool not only to raise capital but to allow venture capital firms to cash out. Another funding measure is mezzanine funding, a kind of mixed debt and equity high-value loan.