Did you know that running out of funding is the second-largest reason startups fail? And cost issues are the 5th one1.
With growing business expenses, it's easy to go bankrupt. You can see that if you want to have your own business with positive cash flow, you must know how and where to find money to get the company going.
Luckily for you, we have prepared a list of startups' most common financing methods juxtaposed with startup funding rounds.
You as a small business owner must understand the financing models and at what stage you can count on them. In the end, no bank will give you a loan if you only have an idea. Similarly, you will not ask your grandma for her life savings when you're already in round C, and your startup valuation varies from $100-$120 million.
Ready to find out how to boost your startup capital? Keep reading
NOTE: The article below and accompanying graph are simplified representations of startup funding stages, e.g., types of investors are not so strictly bound to each financing round. I made them structure the article and better get the overall message across.
TABLE OF CONTENTS
- Pre-seed funding: bootstrapping, family & friends, contests, grants, loans
- Angel Investors
- Incubators & Accelerators
- What is venture capital (VC)?
- How does venture capital funding work?
- VC: Advantages
- VC: Disadvantages
- Venture Capitalists vs. Angel Funders
- Private equity (PE)
- Going public: IPO
According to: https://www.fundz.net/what-is-series-a-funding-series-b-funding-and-more
Pre-seed funding: bootstrapping, family & friends, contests, grants
Sometimes startup founders have nothing more in the pre-seed stage than a concept. With no market research and product development, all you can count on is your own money. Don't worry; it's normal and, actually, quite intuitive. Turning to your relatives and friends is the easiest way to get cash for your business.
Statistics confirm it: more than ¾ of startups rely on their founders' savings, and over 30% - on their family and friends' money2. So what options for self-financing are there?
Bootstrapping and family & friends
The most common type of startup financing is self-financing or bootstrapping (according to the Harvard Business Review, it is the primary funding source for about 80% of startups). Bootstrap means using your savings to finance the business operations, and there's no external input (e.g., venture capital).
Bootstrapping includes the money that belongs to you, but you can also borrow money from your family and friends or ask them for a donation. Borrowing money from online lenders, getting a personal credit card or a personal loan - all funding resources that are personal (not business) count for bootstrapping.
This solution gives you complete control over all decisions because you don't share ownership with other investors. On the other hand, it may be risky to depend only on your savings, and you might slow down your business's growth.
Having said that, bootstrapping can meet with success. GitHub, GoPro, and eBay are just a few examples.
Another way to fund your idea early in stages is by participating in startup contests. This form of small business financing implies that you take part in a contest and, if you win, get a cash prize or some other kind of support. Such competitions are usually organized by various organizations (state-run or privately owned) to support entrepreneurs.
Many of them take the form of pitch competitions where founders present their startup concepts to potential investors, and the more convincing they are, the more chances to win they have.
Most of the time, monetary prizes in contests range from a few thousand to even hundreds of thousand dollars. They sure are what most business owners strive for, but we shouldn't forget other benefits such competitions give.
Even if you don't win any funds, don't waste your chance to network and get most of the mentors' knowledge.
Come to mention it, there is an initiative called Global Startup Awards. It's the largest independent startup competition present in over 124 countries. Although winning their awards doesn't come with any particular funds, it gives you somewhat of promotion and recognition, which may result in finding a sponsor.
Grant is a sum of money a government or other organization gives for a specific purpose. To be more precise, there are three types of grants: government grants, private foundations grants, and business foundations grants (the last ones often take the form of contests).
The best thing about grants is they are non-refundable. It means you don't have to pay back the money you received, there's no interest, and, since grants aren't investment capital, the issuers won't own the assets of your startup.
Moreover, winning a grant makes you more reliable in the eyes of your future investors and clients. They wouldn't give you the money if your idea weren't worthy of notice, right?
Grants are a dream come true for small business owners, but it's no easy money.
Government grants, for example, are challenging to apply for. You will most likely need to provide a great deal of paperwork (detailed project descriptions, financing plans), follow the requirements, and meet the deadlines. The issuer will also want you to show how you've implemented the grant money.
Gerri Detweiler, credit & finance expert, explains three significant mistakes business owners make when applying for small business grants3.
- You are being too specific. When searching for a grant, check out all the opportunities there are.
- You lack patience. Receiving a grant takes time (the federal grants application period often takes 3 to 6 months). So if you need money ASAP, look for other small business financing options.
- You think a grant is a one-time thing. Grants open and close regularly, so you want to look for them regularly.
Small businesses are the backbone of the economy, and they need access to capital to grow and create jobs. According to the latest data from the Federal Reserve4, the average small business loan amount is $663,00. However, this number varies depending on which type of lender you go through. Small business loans can range from $13,000 to $1.2 million, while alternative lender small business loans range from $5,000 to $200,000.
A term loan is a type of loan borrowed from an online lender, a traditional bank, or a credit union that is repaid over a set period. Short-term loans range from 3 to 18 months, whereas long-term business loans may be extended for up to 10 years5. While some term loans are designed for specific uses—like financing equipment or inventory—term loans traditionally can be used to fund most large business-related purchases.
One of the benefits of a term loan is that it can provide businesses with the liquidity they need to grow. In addition, term loans typically have lower interest rates than credit cards and other forms of financing. It makes them an attractive option for businesses that must finance large purchases.
There are a few things to remember when applying for a term loan. One is that you need to have a good credit score to qualify. Additionally, you will need to provide evidence of your business's financial health and stability. This can include your company's financial statements, credit history, and projections for future growth.
If your startup's based in the US, you should consider applying for an SBA loan.
The Small Business Administration (SBA) offers a variety of loan products to help small business owners secure the capital they need to start or grow their businesses. One such product is the SBA loan, guaranteed by the Small Business Administration and offered through traditional and some untraditional lenders. SBA loans range $50,000 to $5,000,000. Terms also cover a broad range, typically from 10 to 25 years (from 7 years if you need working capital, 10 for equipment purchases, to 25 when buying real estate)6.
One downside to Small Business Administration loans is they're famous for being slow and paperwork-intensive. You will be obliged to deliver a bunch of documents, e.g., your startup business plan, personal credit score, or tax returns. No wonder the bureaucratic process usually takes up to 2-3 months.
Business Credit Card
A business credit card is a great way to build your company's credit history. A revolving line of credit gives you access to funds you can use for various purposes, such as buying inventory or paying suppliers. There are both secured and unsecured business credit cards. Borrowers whose credit scores aren't very high will need to provide collateral. If you prove to the lender that you're trustworthy (e.g., by keeping your payments on time), you might get an unsecured credit card.
Limits? In 2020, the average amount for small business credit cards was $56,1007.
Line of Credit
A line of credit is a business loan that gives business owners a revolving credit limit they can access through a checking account. Check out this option if you're unsure of the amount of money you'll need since you are charged only on the amount you withdraw. Many business lines of credit are unsecured, so you don't require collateral. However, with secured lines of credit, you can get more money. For example, RBC Royal Bank provides unsecured lines of credit where limits are available from $5,000. In the case of secured lines of credit, limits are available from $5,000 to as much as 65% of the value of your home8.
An equipment loan may be the best option for financing expensive machinery, vehicles or equipment, computers, or furniture. In most cases, the equipment you purchase will be used as collateral if you can't repay the loan.
Each lender will have different terms, but in general, with a loan, you can finance around 80% of the total purchase price of the item. You own the thing from day one when choosing to buy your equipment and finance through a loan. A down payment of around 20% is generally required for most small business equipment loans9.
Merchant Cash Advance
A merchant cash advance can be a valuable tool for a business owner that needs quick access to capital. These advances use credit card sales as collateral, making them relatively easy to obtain. However, the high-interest rates make this type of loan an enormous risk.
With merchant cash advances, you receive a lump sum of cash that you have to repay with a percentage of your future credit card sales or through weekly transfers from your bank account.
The loan amounts available through merchant cash advances range from $2,500 to $500,000, and the interest rates can be as high as 350% APR. The repayment terms typically last 3-36 months10.
Seed-funding: angel investors, incubators & accelerators, crowdfunding
In the seed-funding stage, an idea transforms into something tangible, such as market research and product development. Financing options most associated with this stage are business angels, incubators, accelerators, and crowdfunding.
Business angels account for 29% of startup financing options, which makes them the 3rd most popular source of financing11. Who are they?
The term angel investor refers to wealthy individuals who invest private funds in startups or small businesses, usually in exchange for ownership equity. An angel investor is often somebody who knows the founder personally and believes in the business concept and the team behind it. They fill in the gap when an owner's savings has run out, but venture capitalists have not yet shown interest in funding a startup.
How much funding can you expect? The average angel's investment ranges from $50,000 to $1 million per company12.
Business angels are often business professionals themselves (entrepreneurs, small business owners). Because of this, they may bring to the table not only money but also their own experience and knowledge.
Ideally, since they invest in startups in very early stages, when chances of achieving success are still on the line, they should have more motivation to take an active role in managing the startup.
Unfortunately, there's no such thing as a free lunch.
As I mentioned, they fund your business but want a percentage of ownership in return. The numbers vary from 10 to 50%, leaning more towards the 10-25% span according to some sources13 or 20-40% according to others14. This may lead to a loss of control over your startup.
Let's assume you've decided to seek out an angel investor's help. Where can you find one? Many professional online platforms connect investors and startup founders worldwide, such as Angel Capital Association, AngelList Venture, and Angel Investment Network. Despite the many international websites and forums, looking for an angel nearby is a good idea, as most of them invest close to home (75-85% within 50 miles of home), according to A Profile of Angel Investor by Stephen G. Morrissette.
If you can't find an angel in your area or if you don't feel comfortable with the idea of giving up partial ownership of your company, there are other options for seed-stage funding, such as crowdfunding.
Crowdfunding means raising money (usually relatively small amounts) from many people (individuals and organizations) to fund a project. Most crowdfunding campaigns are launched online and have set time frames. The startup financing method that most of us probably associate best with Kickstarter is, however, much more complex.
Once a startupper has launched a financing campaign to help bring their creative project to life, donators may pledge to pay a set amount of money with a reward and then receive the product they helped to fund. This scenario is one of four crowdfunding types: reward crowdfunding. If you donate cash but expect nothing in return, it's donation crowdfunding. With debt crowdfunding, sums paid by backers are, in fact, loans that must be repaid with interest before the deadline is over. The last type of donation, equity crowdfunding, refers to a situation when you give sponsors shares in your business in exchange for funding it.
This startup funding model lets you test your business idea in real life.
But what happens if you cannot gather the set amount of money you need to start? Does it mean your startup idea makes no sense?
No. It simply shows you didn't manage to interest people with it.
And here, we move on to the disadvantages of online crowdfunding campaigns.
To succeed, you need marketing skills. It's not easy to have your project noticed and your idea funded. You've got to build a community around it.
Then, the lack of success in a crowdfunding campaign is not necessarily a sign of a poor business idea. It might be you just didn't know how to promote it.
Moreover, crowdfunding may turn out to be very time-consuming. You must create a video, write texts, come up with rewards, post updates, answer questions, and promote your campaign on social media. Doing it all by yourself will take a lot of time and effort, which you could spend on developing your product.
Advice: Include crowdfunding marketing strategies in your business plan to ensure your crowdfunding campaign doesn't fail.
Incubators & Accelerators
In 2018, every fifth startup business turned to accelerators or incubators for help.
I&A are a great option if you're looking for complex support services for your small businesses (getting funds, workspace, mentorship, training, business support, networking), but they're not the same.
Differences between these two could make for another article, so I'll give you a brief description below so that you can grasp how they work.
Let's review the chief characteristics of incubators and accelerators.
As the names suggest, incubators are the best option if your small business is just starting, and maybe all you have is just an idea for a business. Then, if ideas and startups were eggs, incubators would be hens. Accelerators, on the other hand, help accelerate a startup's development. This means that if you want to work with accelerators, you usually must already have an MVP.
Even if not open-ended, cooperation with incubators would be counted in years. Accelerator programs have fixed timeframes and take up to 6 months.
Incubators, being non-profit organizations financed by universities, governments, or private corporations, are, most of the time, free.
Accelerators want an equity stake in your startup for their services, but you can count on more considerable funding for your startup. For example, Y Combinator, probably the most recognizable accelerator program (Airbnb or Reddit in its portfolio), has been investing around $120,000, and from January 2022, even $500,000 in each startup they work with16.
While incubators work with a more significant amount of small businesses, accelerators focus on fewer businesses at the same time. Because of this, it's much easier to cooperate with incubators. Accelerators focus on rapid growth, so if your startup isn't showing any signs of it, it'll be harder to engage them.
Series A Funding: Venture Capital
Once we've finally got through the planting stages (which wasn't that obvious as about 60% of companies fail to make it to Series A we can start the alphabet. Series A in the startup funding system concentrates on developing a business model and generating revenue growth. This is when venture capital financing often comes into play.
What is venture capital (VC)?
Venture capital is a type of private equity financing provided to high-growth startups that need funds to scale.
It's a type of private equity funding provided by firms or funds to small early-stage startup companies with high-growth potential. Venture capital is not a loan.
Venture funds are probably the most common financing option for startups, as founders seek their help in most funding stages. Additionally, over half of US startups expect venture money to be their next source of money17. Thus, the VC landscape is quite diverse: privately held VC-backed companies may consist of two founders and an idea or have a $10 billion+ valuation and thousands of employees (and everything in between)18.
Still, finding a venture capitalist can be somewhat of a challenge—statistically, VCs fund less than 5 companies out of each 1,000 proposals they receive.
How does venture capital funding work?
- First, there's the introduction. A startup owner needs to draw the VCs attention, presumably by making a pitch and providing the investor with a business plan.
- If the VCs show interest, they perform due diligence. In this investigatory process, they assess the project's viability, establish its commercial potential, and evaluate the accuracy of information provided by the company (business plan) to mitigate risk. The entire process can take several months. The bureaucracy, seemingly redundant, is, in fact, compulsory. VCs raise pools from limited partners (and from them, they create the so-called venture capital fund), so they have to report their actions.
- When the results of the due diligence sound promising, the collaboration starts. VCs secure the capital, management, and advice.
- As 5-10 years pass and a high-growth company is established, VCs exit their stake (for example, by acquisition or IPO).
- VC is a funding option for small businesses that can't access stock markets or don't qualify for bank loans (unlike banks, venture capitalists don't demand assets or collateral from small business owners).
- The investors secure not only necessary funding for your startup but also mentoring and networking.
- Some of them have a lot of experience and can teach you how to run a business. Also, they know other people who might be interested in your product or service. VCs improve the startup's image as their reputation is at stake. If a venture capitalist invests in your company, they believe in its success. Consequently, it's easier to attract more investors.
- Investors want a say in your startup development strategy. By sharing ownership with them (they usually take between 25-50% equity), you may expose yourself to losing creative control over your startup's future and have disagreements about the company's strategy or other important decisions.
- Stockholders want to sell their equity stakes quickly and gain high investment payoffs. It might lead to the situation when VC pushes the startup founders to have their business listed on the public stock exchange. An exit that happens too quickly may cause the undervaluation of the startup's shares.
Venture Capitalists vs. Angel Funders
To finish this part, let's briefly summarize what we know about business angels and venture capitalists.
Angels usually come first, before VCs, and can give you smaller amounts of financing.
Angels are usually individual capitalists, while the second act in a company with other VCs.
Venture capitalists are full-time professional investors. Business angels treat startup financing more like a hobby or side project and, because of that, are more flexible. However, they may not provide you with the same level of guidance.
Wanna know more about how to raise capital efficiently? Be sure to read our article on what investors look for in startups and what common mistakes you can make when seeking VC funding.
Series B & C: private equity
If you make it to rounds B and C, your startup is about expansion. You still want to cooperate with venture capitalists, but new options, for example, private equity, emerge.
Private equity (PE)
Private equity is a medium- or long-term financing option for private companies (startups) that haven't yet gone public in exchange for an equity stake. Apart from funding, private equity ensures mentoring and management.
Sounds similar, right? We could describe venture capital in the same way. As these two financing models are, to some extent, similar, let's look closer into the differences between them.
How do they operate?
VC is a subset of PE. Both raise funds from limited partners to invest in non-public companies.
Both VC and PE aim to increase the value of the businesses they invest in to sell their equity stakes for later profit.
Who are they interested in?
Venture capital focuses on emerging companies with high-growth potential but riskier (startups). Meanwhile, private equity will concentrate on an existing business that is performing well or, even if stagnant, still shows growth possibilities.
Just as venture capitalists came after business angels, private equity investors come after VCs. The first invest smaller sums, usually between $1 million and $10 million. Private equity investments can reach millions or billions of dollars19.
While VCs usually want 25%-50% equity, an equity investment comes with a higher price. Investors will often take the majority stake.
Going public: IPO & ICO
Once Series C is over, startups may decide to go for the 4th round (Series D) to raise extra funds and increase their value before going public, continue their way down the alphabet to rounds E and further, or become public companies straight after Series C.
You can call your startup a significant success if your startup gets to the IPO. IPO, standing for initial public offering, is the first stock offering by a startup to the public. A company sells its shares to raise additional capital for further growth.
Initial public offerings enable you to access funding from public investors. They come with more significant exposure, making your startup business more reliable and prestigious. At the same time, IPOs are costly because legal, marketing, and accounting expenses increase.
If, in the case of IPO, a company sells shares of stock to the public, an ICO, or initial coin offering, sells units of cryptocurrency. These units are usually called tokens and can be used in a variety of ways. They can represent equity in the startup, act as voting rights, or be used to purchase goods and services from the startup. Startups that issue tokens through an ICO typically do so to bypass the rigorous and expensive process of going public.
IPO, along with ICO (initial coin offerings), venture debts, and others, are the least popular financing sources, accounting for less than 5% of startup funding distribution (as of 2018's statistics).
We've covered the most common funding options available for startups and discussed their relation to financing stages.
Of course, we haven't exhausted the topic (you can also, for example, use your business credit card, connect with the Small Business Development Center in your vicinity, reach out to Small Business Innovation Research or sell a personal asset).
However, now that you have the complete picture in your head, it will be easier to explore the universe of startups, business funding, capital, etc.
I want to highlight that no matter what type of funding you choose, you'll eventually come to the point where the chances of getting the money for your business will be at stake if you don't know how to get your potential investors' interest and attention.
So if you want to start a new business but still need more information about financing options, I do recommend you read our article Tips and tricks on how to fundraise, where you'll find lots of helpful information and steps to follow. And if you already are or soon will be in the early stages of raising capital for your business, check out Early-stage startup fundraising during the 2022 recession with advice on how to survive the tough times ahead.
Okay, now what?
You know how to choose the right type of funding for your business and what are the stages startups go through before they become public companies.
Startups are no child's play, and this is not my opinion. Statistics show that about 90% of startups fail.
We understand that getting funding for your business might be difficult, but we know how to deal with it. Don't let poor cash flow kills your startup business. Contact us, and let's talk about your product and how we could support you in fundraising!
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