Startup Financing Guide For The First Time Entrepreneur
Cash is king. It gives you time. It provides flexibility. When you have enough money to build your business the sky's the limit.
Although every business and founder is different, there are three main ways to fund your business: bootstrapping, equity and debt. The right type of startup financing depends on you and your business.
What do you really want? Do you want a lifestyle business that allows you to build it slowly while you work a full time job and eventually make enough money to live off of? Or do you like the idea of working your butt off for ~7 years at a VC backed startup for the chance of a big payout? WhatsApp was only around for 6 years and got acquired for $19 billion. It is estimated that the co-founders each made over $4 billion. Not too bad.
Are you in the idea stage? Do you have a prototype? Or do you already have paying customers? The stage of your business will also be important in deciding your financing path.
Each type of financing has its advantages and disadvantages. It really comes down to your unique situation and preferences.
1. Bootstrapping: AKA Spending Your Savings
86% of new businesses in the US are funded through personal savings of the founder(s). Even though starting a business with your savings may seem impossible, it can be done.
Since bootstrapped businesses use retained earnings to grow, their businesses typically grow slower than those that have received investment or loans. Founders pay careful attention to how they spend their money. It comes down to prioritizing expenses. For example, should you invest in hiring a salesperson, who can help to increase revenue, or development, which will make the product better and help to increase revenue? It’s a difficult call and only you can decide what will work best for your company.
Bootstrapping is great for businesses that do not require a lot of upfront capital, for example an ecommerce site. Many people are starting ecommerce businesses on the cheap by investing in developing a website and then using dropship to avoid paying for and storing inventory. Although there is a lot more work to creating a successful business than getting a website live, there are many that can be started on a very low budget.
Because of the high initial investment to build the product before making any money, technology companies can be difficult to bootstrap. It is not impossible, however. Freshbooks, a cloud based accounting software company, built a profitable business before taking VC money to compete with VC backed competitors.
One of the main advantages of bootstrapping is the freedom it gives to the founders: there is no board and you can run the business however you want. Additionally, the founders will not need to spend time away from the business talking to potential investors. Also, all of the profits are yours.
One of the main downsides of bootstrapping is that the company will not grow as fast. With less cash in the bank you will need to use retained earnings to fund growth.
But don’t worry if you decide to bootstrap your business in the beginning you can always explore the investor path later.
Check out these companies who bootstrapped their businesses to profitability.
2. Equity: Trading a Piece of Your Pie for Cash, Introductions & Advice
Equity is you selling stock options in your company in exchange for cash. This means that the buyer owns a percentage of your company. Once your company grows to its full potential an exit must occur. The exit will be in the form of an acquisition or IPO. Investors then receive that ownership percentage of the sale. For example, if an investor owns 10% of your company and it sells for $1 million, the investor will get $100 thousand.
Investors come in different forms: angels, incubators and accelerators, and venture capitalists. Investors invest in people.
Angels are individuals who invest their own money. Typically they invest in the first round of financing, when the business is in the idea or early stages. Some angels will want pro rata rights, which means that they can invest in later rounds to maintain the percentage ownership of your company. Angels do not necessarily get a seat on the board.
Angels can be someone who just happens to have some money and wants to make an investment or a professional investor who invests in multiple of companies. Professional angels will typically want to not only invest money in your business but also time and help to advise and guide the founders.
Angel investments can go up to $100 thousand or so and super angels can invest $1 million or more. Angel investment works well for many types of businesses. Since the dynamics really come down to the individuals themselves it is difficult to say there are hard rules.
Professional angels are likely looking for companies who need help getting their business to the stage where it can raise venture capital. Therefore, they are more interested in high growth industries like software and biotech.
Professional angels will be easier to find but are likely hard to get in touch with. The value that they add is that they have seen or even founded businesses and can give advice from their own experience. Here you can read about angel investing from the point of an ex-angel and check out a list of professional angel investors.
Angels can be great for a new business. They provide some capital and can help great businesses get their start. Professional angels can provide advice based on experience as well as introductions to prospective customers and VCs.
Since angel investors are just people, however, not businesses that you can research you may get more than you bargained for. A bad angel investor can range from being an annoyance to bringing down your company.
Always do your due diligence on investors. It will be worth your time.
Incubators and accelerators are business building programs. These programs, which are often vertical specific, invest a small amount of money (<$50 thousand), provide business, tech, advice and other support resources, and make introductions in exchange for a piece of equity (~7% - 15%). Startups are helped to quickly grow their business with the goal of improving their chances of attracting a top VC firm to invest at a later point.
The difference is that accelerators help to build an existing company, while incubators focus on ideas and help the startup to build out the business model and company.
Incubators and accelerator programs are great for new entrepreneurs who think they need help to build or grow their business enough to get VC investment. The biggest brand name programs are known for pushing out great startups and getting more VC attention. If you want to go the VC route and think that one of these programs would help you more than you could do on your own, it might just be for you.
On the other hand, for the amount of cash and resources they provide, incubators and accelerators may just not be worth it. They are heavier on the qualitative resources of building the startup rather than the cold hard cash side. Additionally, startups that come from these programs will likely always carry the program’s name with them.
It really depends on you.
Venture capital firms invest in high growth companies expecting that some will produce very large returns. WhatsApp only had one investor and exited making a 326X return. Those are the types of possible exits VC firms are waiting for when they invest in startups. Aside from being high growth, the market needs to be huge.
It may sound cheesy but VCs invest in people. A startup with a great founding team, traction, growth and a large market will attract VC attention. VCs do not invest in startups in the idea stage.
Venture capital firms typically specialize in verticals and company stages. If you go looking for VC investment make sure that you are approaching VCs that are in your industry and your business is at the right stage. Some believe it is never too early to start talking to VCs so that they can see your progression.
One of the main advantages of getting funded by a VC firm is that it will enable your company to grow quickly. Getting investment from a firm that is well respected will also be good for you. Not only will this validate your business to customer prospects but it will also help you to secure funding in the future. A great VC will not only give you useful advice, they will also introduce you to prospective customers and other VCs.
Although there are many advantages to accepting VC investment it is not for everyone. As a founder you must be prepared to dedicate your life to this business and understand that you will need to move very fast. Once you have accepted investment there is no turning back; you cannot tell your investors that you have decided to run the business as a lifestyle business. They will take their money back.
Also, depending on your company’s situation, you may end up giving up a lot of equity. It may seem like the money is free, but it actually comes attached with an equity price tag. Additionally, since all VCs will take a board seat, you will be giving up some amount of control. At this point you are not the sole owner of the company and will need to take into consideration what the board says.
3. Debt: Taking Out a Business Loan
Small businesses typically go to banks and credit unions to get debt financing. A business loan works like any other loan. You will go through a lengthy application process and need to have some type of collateral, which is often times a home. In the application process you will likely be asked for a business plan as well as details around what you are going to spend the money on. Interest rates and payment terms and duration will vary based on your credit history, your business’ history and current fed interest rates.
Business loans are great for small lifestyle businesses. They work especially well for companies that already have a couple of years in business with positive financials.
Although loans can be helpful, the amounts for a first time start up will be low. Microloans, which are for startups, are typically between $10 thousand and $35 thousand dollars. The other main challenge with a loan is that you are personally on the hook for the cash even if your business does not do well.
It would be difficult to make this financing list exhaustive but there are other ways of financing your company. These include government grants, sweat equity, private equity and institutional investors. If you have an idea and can move it forward yourself, you will have success no matter the financing situation.
In conclusion, the type of financing you choose to fund your business will greatly affect your business and life. Take the time to research and deeply understand the type of financing before you go with it. No matter what: do your due diligence. Research the VC firms, angels, banks, etc. Get to know why you should go with them and talk with other entrepreneurs who have worked with them before.
Life is short. Go for your dreams.