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Posted by on Nov 10, 2012 in Business Plan, Featured, Food For Thought | 0 comments

Funding Your Startup: 10 Options with Pros and Cons

Funding Your Startup: 10 Options with Pros and Cons

You might call it money, cash, dinero, masari, grimata, para, soldi, argent, dinheiro, moola, or something else. Whatever you call it, you need it to start and run your business. Many entrepreneurs don’t know where to go, are overwhelmed with the choices, or are unaware of some of the options for financing their businesses. Here I will list and expand on the funding options for your startup.

To better understand the different sources of financing, lets first break them down by type and by stage they fit in. Then we will put them all together to make sense of it all:

Financing Your Startup

Type of Financing:

Generally, financing comes in the form of Debt or Equity.

  • Debt means you borrow the money from someone and agree to pay it back at a certain date, or schedule, along with interest. The lenders make their profit from the interest. The riskier your business is (i.e. chance of you not paying back the loan), the higher the interest rate they will charge you. This is why lenders check your risk level by looking at your track record, assets you can pledge, and potentially someone to vouch for you and pay them back in case you don’t.
  • Equity investments is when someone gives you money in exchange for ownership in your business. The more developed your business is, the more they have to pay you for that ownership.

There are other types of financing that are a hybrid of equity and debt financing such are convertible debt where the investor lends you money that can be converted to equity later on. For the sake of this article, we will stick to basics.

Funding Stage:

Businesses go through different stages from startup to maturity. The stage your business is in will determine the type of funding you will be looking for. You have four main stages of funding:

i- Idea: At this stage, you have an idea for a product/service. The main priority is to validate that there is demand for it. Some people do that by getting pre-orders, expression of interest, research that supports the need for it, survey results, online registrations on a pre-launch page, etc. Most would-be entrepreneurs don’t move past this stage.

ii- Start-up: At this stage, you barely have any customers or revenues. You are setting up shop and your main focus is on building a product to satisfy the market demand. Your main focus is to build something people want (i.e. your product matches the verified demand).

iii- Early Stage: At this stage, you have an initial product and initial customers bringing in some revenues. The main focus is on growing the business to become profitable and self-sufficient. You will be aiming to grow your customer base, revenues, profitability, and your team to handle the work.

iv- Expansion: This is the stage where your company has an established product, a sizable customer base, growing revenues, some profits, and an established team. The main focus at this stage is usually to expand the business to breakthrough from being an SME (small & medium-sized enterprise) into being a large, mature business. This is done by expanding the product line, moving into new markets, and/or taking market share from existing players.

v- Maturity: At this stage, the business is a well established entity with a proven business model, a crowd of loyal customers, and profits. The sales growth rate slows down as a percentage of larger revenues.

 With that being said, here is a list of sources you can tap into to fund your business:

Funding Sources:

1- Founders’ Savings (Equity or Debt):

Quick description: the founder(s) reach into their savings, bootstrap (work with little/no pay, build the product themselves instead of hiring) to finance the company.

Pros:

  • You keep control of your business
  • Keeps you tied to the business. Something investors want
  • Might be only sources needed since startup costs are decreasing
  • Some founders lend the money to the startup to return when has enough revenues

Cons:

  • Founder(s) might not have enough through the first few phases (valley of death)

Summary: Typically used in the early stages of a business. You can get started quickly because it’s the founder’s money, but might not be enough to tie the business through the first few stages of its life. See related article on how to save-up for your start-up.

2- Family and friends (Equity or Debt):

Quick description: Get family members and friends to lend you money or invest in your business

Pros:

  • They know you, trust you, and want to help you succeed more than strangers
  • There are creative ways to tap into this source of funding. Some decide to have a spouse/founder work at a job with stable income while the other starts up the business. A good example is that of Hotmail founders Sabeer Bhatia and Jack Smith. Before receiving any funding, Sabeer continued working at his job and gave half of his salary to Jack who left his job to develop the product full-time.

Cons:

  • Will strain relationships if things don’t go well
  • Family and friends might feel they can interfere with the business they don’t understand

Summary: It is also a popular source or financing at the early stages of a business since family and friends already know you and want to help you succeed. Mixing money and family/friend can be tricky, so make sure you treat it as a business transaction and manage expectations up front. Manage expectations up front. For example, clarify if it is a loan or an investment, how the money will be paid back and at what interest rate (if a loan) or what percentage of the company they will get (if investment), and what role (if any) they will have in the company.

3- Special Program Grants (Gifts):

Quick description: Government programs that give grants for specific profile entrepreneurs and companies. Government programs that guarantee loans for businesses. Government or private competitions that grant money to the “best” business ideas and plans.

Pros:

  • There are some government programs or business plan competitions that set out to help budding entrepreneurs
  • Many of the programs will give grants, favorable loans, or loan guarantees (i.e. they guarantee loan repayment to the bank in case you can’t, which gets you the loan and at a lower interest rate)
  • Gives entrepreneur and startup exposure, which might attract other investors, lenders, and/or customers

Cons:

  • Each program has their own agenda and requirements so you need to make sure you fit their criteria. Government programs are usually aiming to stimulate their economy and will thus be looking for a specific type of entrepreneurs or businesses (e.g. women entrepreneurs, specific industry startups, etc)
  • You will have to spend a lot of time and effort to meet their requirements. This is time away from building your business

Summary: This is a great way to get a boost in cash, marketing, and morale. Just make sure you manage your time well so you don’t end up spending it jumping through hoops for the programs at the expense of building your product.

4- Loan / Line of Credit (Debt):

Quick description: A loan provides cash and expects repayment over a specific schedule (X amount per month) of the principle (amount you borrow) plus interest percentage. A line of credit is a more flexible loan where the entrepreneurs borrows cash for as long as s/he needs and only pays interest on the period the money was borrowed.

Pros:

  • You keep ownership in the company
  • A line of credit limits interest payment commitments since you pay interest only for time the money is borrowed (e.g. take out money for a week and only pay the interest for that week vs. a fixed loan that charges locks you in for a pre-set period of interest payment or early payment fees)

Cons:

  • Banks are very conservative lenders and will require assets to guarantee the loan, which entrepreneurs might not have
  • Too much debt can debilitate your company. A rule of thumb is to keep your debt/equity ratio below 2 (i.e. don’t borrow more than $2 for each $1 of equity)

Summary: Getting a line of credit will serve as a good buffer for times when you will have unexpected shortage of cash. Make sure you can pay back a loan or credit line; the bank will not give you the loan if can’t. That being said, banks are conservative because they are technically lending you other people’s money. Some entrepreneurs choose to mortgage their homes to secure the loans.

5- Credit Card (Debt):

Quick description: Make purchases using your credit card and pay back with interest. Some credit cards provide a grace period where they don’t charge interest if the amount is paid back within that period.

Pros:

  • Easy to use and widely accepted as a form of payment
  • Provides a track record of all purchases vs. cash that will depend on your memory or record keeping discipline
  • You can use it as an interest-free loan if you pay back the money within the grace period
  • Can get discount, preferential treatment and rates with some suppliers if you pay by credit card

Cons:

  • Very high interest rates on most credit cards
  • There is a lot of fine print so make sure you check the details before using it (is there a grace period, what the length, etc)
  • Be careful not to mix personal and business spending on your credit cards

Summary: This is and expensive source of debt with the high interest rates. Use it wisely if you must and make sure you know the terms well before using it.

6- Supplier Credit (Debt):

Quick description: You buy from your suppliers today and pay them back later on (e.g. in 14 days)

Pros:

  • A great way to get short-term financing by getting suppliers to collect payment from you after a period of time from selling you their product/service (e.g. 30 days).

Cons:

  • Not all suppliers give credit
  • Suppliers might charge you more if you take the product with delayed payment (or give you a discount to pay immediately).

Summary: This is quick way to get short-term credit for your operations. Use it when you can, but make sure the credit is worth more to you than the discount of paying immediately. Treat the immediate payment discount like the interest rate you would pay a bank and make sure it’s a fair amount.

7- Incubators/Accelerators (Equity +):

Quick description: An entity run by experienced entrepreneurs that invests in your idea, gives you space to work along with infrastructure, provides guidance to help you succeed, and introduces you to potential investors.

Pros:

  • Accelerators have popped up not too long ago and have caused a major storm in the startup world. Pioneered by Paul Graham’s Y-Combinator, accelerators provide initial financing to entrepreneurs (e.g. $20k), give office space and infrastructure, provide guidance by people who have succeeded before, and make connections with investors. Some do that in a specific time-frame (e.g. 3 months) to get the “if you fail, do it cheap and fast”
  • Working with the right accelerator gives a lot of credibility to the entrepreneurs as the big brother figure

Cons:

  • Not all accelerators/incubators are created equally. It’s easy for anyone to set up an accelerator, but not many can add value to entrepreneurs
  • Some take too much equity from entrepreneurs

Summary: This is a great source of funding and guidance (worth more than the funding) for entrepreneurs, especially first-time founders. Make sure you check the background of the people at the accelerator and the success stories of companies that went through them. The good ones will have a nice track record of successful companies graduating from them.

8- Crowdfunding (Equity, Debt, or Gifts):

Quick description:  Take a loan, investment, pre-order, or contribution from multiple people at the same time rather than large lenders/investors. This is also referred to as peer-to-peer model. So for example, you can borrow $50,000 from a number of people, rather than a bank, using a crowdfunding platform

Pros:

  • They come in different forms, so you can take a loan, sell equity, or pre-sell your product to the crowd (peer-to-peer) depending on your needs
  • Can generate more money than you expected. There are examples of companies generating over millions when their goal was $100k
  • Can generate significant interest in your product, which gives you a double whammy of funding and marketing
  • A good way to test and validate demand for your product with pre-orders before starting

Cons:

  • Not suitable for everyone. Some products/services are better suited for crowdfunding than others

Summary: This is a great way to tap into a larger pool of individuals interested in financing your company. The crowdfunding sites can be for either investments, lending, donations, pre-order type of contributions. Go for it if your product fits.

9- Angel Investors (Equity):

Quick description: Wealthy individuals who are usually prior entrepreneurs or successful executives that are willing to invest in early stage growing companies with potential for major growth.

Pros:

  • They will invest much needed cash in the early stages of the startup
  • Can open doors by introducing the entrepreneur to customers and other investors
  • Will act as an ambassador for the company and might even get some sales
  • Can share experience and give a reality check to the entrepreneurs by highlighting missing elements for the business to grow (e.g. missing business acumen for technical founders, etc)
  • Might become executives in the company based on their experience (e.g. Peter Thiel invested in Max Levchin’s idea and later hopped on board to become CEO)

Cons:

  • Might have a different view of what your company should do that clashes with the entrepreneurs
  • The money they will give you is not a gift, they are expecting handsome returns for their investment. They will aggressively press you if you are not delivering as expected to protect their money
  • Some investors will take advantage of entrepreneurs with no funding experience. Do your homework on how the funding process goes and find an impartial and experienced adviser during the process.

Summary: A good Angel investor is worth his/her weight in gold because s/he can provide money, connections, guidance, and support that can help entrepreneurs break past some of their limitations. Not all are created equally, so read up on the funding process, check the investor’s experience and reputation, and make sure you are comfortable with him/her before going ahead.

10- Venture Capital (Equity):

Quick description: an investment firm that invests large amounts (millions of $) and expect it to expand and sell through an IPO or to a larger player in the industry.

Pros:

  • They inject cash that can unleash the company’s ability grow at a much faster pace
  • A reputable VC investor gives the company credibility and opens doors to some large customers and other investors

Cons:

  • They generally don’t look at start-ups and early stage
  • They can be ruthless. They are in it for the money, not for you.
  • If the believe the founders no longer are the right people to run the company, they will force them to hire someone with that profile (e.g. Google forced to hire Eric Schmidt as “adult supervision“)

Summary: Venture capital firms are the entry into the big leagues, but they come with their own baggage. They will force changes to the way the company is run to become a large entity. From this stage on, the company will not have the startup feel anymore. Your next step is usually an IPO or being acquired by a big player.

Are you ready to fund and start your business? Are there other options you are considering?

 

Here’s an Infographic that ties it all up together and shows the relationship between the financing options, company growth stages, and type of financing. 

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