It’s easy to give birth to ideas but actually starting a business requires cash. A lack of adequate start-up capital is one of the biggest reasons that new businesses fail, second only to the horrible miscalculation of selling something nobody wants.
But what you sell is amazing! There’s no doubt. So the question of how to fund your fledgling enterprise is critical. Here’s what you need to know to decide which of the most common funding strategies is best for you and your business.
See Those Straps On Your Boots? Pull ’Em Up
SELF-FUNDING is the answer for the vast majority of businesses when they are starting out for reasons that will become clearer as we move through the other funding options below. Self-funding, also known as BOOTSTRAPPING, isn’t necessarily the method entrepreneurs prefer but it’s the default when they don’t have a choice.
Don’t worry if you don’t have a choice. Bootstrapping can be a good thing. When you’re bootstrapping, not a cent can be wasted. That forces entrepreneurs to slow down and choose wisely. Some of the most important start-up capital entrepreneurs spend is their time. It’s always crucial to allocate time wisely, but especially so when bootstrapping.
When you’re playing with someone else’s money, it’s easy to move fast—way too fast. You can get into a lot of trouble hurtling in the wrong direction before you’ve clarified and tested the core of your business model.
Another advantage of bootstrapping, and one that can prove extraordinarily valuable down the road, is that you keep all your equity and maintain control of your business.
“You Just Call On Me, Brother, When You Need A Hand”
FRIENDS & FAMILY are the next most common way to raise funds, and they are usually a supplement to the first most common. In fact, 95 percent of start-up funding comes from either BOOTSTRAPPING or FRIENDS & FAMILY. But leaning on your loved ones can be dangerous ground if you don’t make the right arrangements.
The people closest to you, who know and trust you more than anyone else, are the most likely to believe in your vision and have faith in your ability to execute it. But borrowing from them has the potential to spoil those relationships, especially if everything doesn’t go as planned—and even when things do go as planned or even better than planned. Sometimes you can’t win even when you win.
There are lots of ways to mitigate this downside risk, and take every precaution to do so. Entrepreneurs should be more creative when structuring a loan from family or friends. Opt to make the loan a high-interest convertible note, or offer equity in the business by devising dynamic equity splits that take into account the value of their contribution.
Regardless of how you structure the loan, don’t skimp on contracts. You must have contracts, drafted by a lawyer, even with—maybe especially with—your family and friends. Whether things go very well for your business or very poorly, you’ll need extremely clear and detailed contracts. Hire a professional who will unify everyone’s expectations, for the short term and long term, from the very first day.
The Wisdom Of The Crowd
CROWDFUNDING is a relatively new source of capital for start-ups, made legal in 2012 through federal legislation commonly referred to as the JOBS Act. It’s also one of the fastest growing funding sources, and can be a great way to get a product-driven business off the ground.
A crowdfunding site like Kickstarter or Indiegogo is a portal through which supporters can donate money to your start-up. To attract as many funders as possible, businesses typically offer incentives, and tend to offer bigger and bigger incentives for larger donations—anything from T-shirts to getting the new product for free when it launches.
A crowdfunding campaign often functions as a platform for supporters to preorder the product before it exists. According to market research conducted by the domain company Panabee, crowdfunding works best for products related to technology, gaming, and design.
The downside is that you’ll lose about 5 percent of the money that the crowdsourcing website raises, as well as money for credit-card processing and other fees. What might make that worth it is that crowdfunding can be a great way to test demand for your product before you’ve invested too much capital in building it. Sometimes the capital raised through crowdfunding is sufficient for building the minimum viable product (MVP)—and suddenly you have the funding, product, and momentum you need to launch.
Crowdfunding can also function as part of a broader marketing campaign. For that reason, it’s best if you’re drawing on the expertise of an outsourced chief marketing officer (CMO) to design and launch your campaign as part of an initial marketing strategy. You want a powerful campaign that will establish a community of cheerleaders for your product that will also form a strong preliminary customer base.
Time Is Worth More Than Money—But You Still Need Money
A SMALL-BUSINESS GRANT is not free. You pay with your time.
The application for small-business grants is tedious, with no guarantee of success. Still, it’s a funding source that’s available to select start-ups that most entrepreneurs don’t consider.
If your business is building something that the federal government might consider a public good—something in education, medicine, and certain kinds of technology—it might be worth the effort to run a quick search through Grants.gov. There could be a funding source that’s well suited to your business.
A Big Bet On A Small Thing
SMALL-BUSINESS LOANS often sound attractive at the outset but the banks’ requirements tend to dim the glimmer in entrepreneurs’ eyes.
Banks are in the business of making low-risk loans, and there’s nothing low-risk about a business that has zero sales history. This means banks generally only make small-business loans backed by collateral. These loans are also difficult to get (fewer than 100,000 are made each year) unless you have great credit, significant resources, or substantial equity in your home that you’re willing to wager on your business.
Difficult doesn’t mean impossible, though, and if you’re approved for a loan, you’ll enjoy the relatively low interest rates. If you pursue this route, make sure you’re specifically seeking a Small Business Administration (SBA) Loan. The SBA has special programs designed to help launch small businesses, and is a far better option than other types of loans.
There are also a variety of businesses and consultants that specialize in helping start-ups land funding from banks and credit unions. They’ll know the universe of options available, and they’ll understand how to leverage specific features of your business. If no bank funding is available, they may also be able to match you with a loan from a nontraditional lending institution. That would come with a higher interest rate, but it might be worth it.
Do You Believe In Angels?
ANGEL INVESTORS & VENTURE CAPITALISTS expect most of the businesses they invest in to fail. They also expect a few of them to make money rain from the sky.
This funding source, which is slowing down, is not available to the vast majority of start-ups because such investors are only interested in companies that have the potential to produce heavenly returns. Only 0.05 percent of start-ups receive this type of funding. That’s just one out of every 2,000. These types of investors are looking for something that’s scalable and could be the next Facebook. That means a local coffee shop—even if successful by local coffee shop standards—will never make the cut.
The types of companies that can win this sort of funding tend to be tech start-ups or other companies that are completely product-driven or have a similarly scalable and high-potential model.
If your business is in a position to attract this type of funding, think twice before pursuing it. Venture capital and angel investments are by far the riskiest funding source for an entrepreneur. It’s the opposite of a bank loan. An angel investor might hand you a mountain of cash but it comes with a formidable cost.
In exchange for taking such a big risk, investors take equity in your company and often a seat (or multiple seats) on your board. Those things only become valuable if you’re hugely successful and, at that point, you’ll be rich—but it can also get you fired from the very company you founded.
Investors care about their investment, not you. When a company becomes successful, it’s not uncommon for investors to use their power on the board to fire the founding CEO and replace that person with someone more seasoned, since the skill set necessary for running a big company is very different from that of founding a start-up.
If that doesn’t scare you off, here’s some basic background on venture capital.
First, let’s clarify the difference between an angel investor and a venture capitalist. Increasingly, the line is blurred but, generally, the venture capital field consists of firms specializing in specific industries that make large investments in companies that have at least an initial track record of success. They’re looking for businesses that have already proven their product-market fit and the scalability of their business model. Angel investors are often former entrepreneurs who tend to be willing to make investments of varying size in companies that have no track record.
Accessing funding from either a VC or an angel investor is extremely difficult but there are a couple potential paths.
The first is to start by self-funding, perhaps supplemented with capital from friends and family. Bootstrap long enough to prove product-market fit, or at least to sufficiently establish the right side of your Business Model Canvas. Then you land an angel investor and use that capital to prove the scalability of your business model in order to attract a “Series A” round of funding from a venture capital firm.
Alternatively, you could pursue an accelerator program like the one offered by the seed funder Y Combinator. This program accepts a few dozen businesses at a time, and then Y Combinator provides those entrepreneurs with a living stipend in addition to a crash course of best practices delivered by highly successful entrepreneurs. Once you’ve “graduated” from Y Combinator, doors in the venture capital world swing open.
Sound great? It is. First, though, they have to admit you.
The winning applicants tend to have a strong team of founders—often with a pedigree education from somewhere like Stanford or the Ivy League—and/or a strong track record of successful start-ups under their belt, plus an amazing idea that could potentially be worth millions, if not billions.
Venture capital and angel investments are dangerous, complicated, and expensive means of securing funding for your business. For a select few, though, it’s the only way to fly.
One (or two) of these funding sources — whether its bootstrapping, friends and family, crowdfunding, a small-business grant, a small-business loan, an angel or venture capital — is right for your start-up, and making the right choice is crucial to your long-term success. And if you need a little help keeping track of your expenses and budgets in the process, download our Expense Tracker to keep your cash flow in clear view.