Startup Financing: 5 Key Funding Options For Your Company
By Richard D. Harroch and Mike Sullivan
No matter how great your business idea is, one essential element of startup success is your ability to obtain sufficient funding to start and grow the business. While many people finance their new companies with their own capital or by borrowing money from family or friends, there are other options available. But startup founders must understand that raising startup funding is never easy, and usually takes longer than anticipated.
In this article, we review five key options to obtain startup funding for your company.
No matter how great your new business idea is, without proper financing, you won’t be able to start … [+] it.
© Sergey Nivens- Adobe Stock
1. Angel Financing
Angel investors are typically individuals who invest in startup or early-stage companies in exchange for an equity ownership interest. Angel investing in startups has been accelerating, and high-profile success stories like Uber, WhatsApp, and Facebook have spurred angel investors to make multiple bets with the hopes of getting outsized returns.
The typical angel investment is $25,000 to $100,000 per company, but can go higher.
Here is what angels particularly care about:
- The quality, passion, commitment, and integrity of the founders
- The market opportunity being addressed and the potential for the company to become very big
- A clearly thought out business plan, and any early evidence of obtaining traction toward the plan
- Interesting technology or intellectual property
- An appropriate valuation with reasonable terms (angel investors are investing at an early stage when risk is highest, so they typically require lower valuations to compensate)
- The viability of raising additional rounds of startup funding if progress is made
There are a variety of ways to find angel investors, including through:
- Other entrepreneurs
- Lawyers and accountants
- Angel investor networks
- Venture capitalists and investment bankers
- Crowdfunding sites like Kickstarter and Indiegogo
The best way to find an angel investor is a solid introduction from a colleague or friend of an angel. Use LinkedIn to determine what connections you may already have. Angel investors are much more likely to invest if they know your sector well, so it often helps to start with your connections in that sector.
Serial entrepreneurs with successful past liquidity events are often some of the best angel investors—they have the cash to invest, but in addition to cash they also often bring other important benefits to a startup relationship, such as:
- Contacts to venture capitalists
- Contacts to strategic partners
- Advice and counsel
- Credibility by being associated with the investor
- Contacts to potential customers
- Contacts to potential employees
- Contacts with lawyers, banks, accountants, and investment bankers
- Knowledge of the marketplace and strategies of similar companies
For a comprehensive discussion of angel investing, see Angel Investing: 20 Things Entrepreneurs Should Know and 15 Expert Tips for Startups Seeking Angel or Seed Financing.
“Crowdfunding” is the practice of raising funding through multiple funders, often via popular crowdfunding websites.
Crowdfunding gives startup entrepreneurs the opportunity to raise startup funding for their business, and can help a company promote its products or services. Setting up a crowdfunding campaign is not very difficult. You set up a profile on a crowdfunding site, describing your company and its business, and the amount of money you are trying to raise. People who are interested in what you are trying to do can donate to your campaign, typically in exchange for some kind of reward for their donation (one of your products or services, a discount based on how much donated, or some other perk), or for some form of equity or profit share in your business.
The key to successful crowdfunding campaigns is to have a compelling story about your product, service, or company, and to offer a meaningful reward for donations. Some startups have been able to raise thousands to even millions of dollars via crowdfunding campaigns.
Rewards-based crowdfunding is a particularly attractive option for startups, as you are not giving away equity or part ownership in your company—you are just offering some of your products or services, or a discount on those products or services. And rewards-based campaigns are not burdened with interest or principal repayments the way small business loans are.
A crowdfunding campaign can also work to build a community of people interested in your company or products, and provides a sense of engagement for the donor.
Equity crowdfunding, a scenario in which you are selling stock or some other interest in your company in exchange for cash, requires strict compliance with federal and state securities laws, and you should not attempt to do this without help from a lawyer with relevant experience.
Each crowdfunding site charges some kind of fee to list your campaign, either a processing fee or a percentage of the funds raised. Some of the most popular sites include:
See Is Your Startup Ready for Equity Crowdfunding? 7 Questions to Ask
3. Small Business Credit Cards
A number of credit card issuers specifically cater to the small business market, and many come with special benefits: cash back rewards, airline mileage points, and other perks.
Some issuers require that the card be tied to the owner’s personal credit score and credit history and a guarantee from the owner. This would mean, of course, that any defaults or late payments on the business credit card would affect your personal credit rating.
Interest on unpaid balances on the credit card can be quite high, ranging from 5% to 19.9%. Some issuers offer a low or no interest introductory charge for a few months.
Applying for a small business credit card can be made through your bank or online. The main traditional small business lenders include Capital One, Wells Fargo, Chase, Bank of America, and American Express.
There has also been a new wave of credit card issuers that focus on the small business market and do not require personal guarantees, which means use of the card will not impact your personal credit score. One example is Brex, which offers a small business card for early-stage technology companies with professional funding. The credit limits of these types of cards can be substantially higher than traditional credit cards, and they often provide valuable rewards.
4. Venture Capital
Startups seeking financing often turn to venture capital (VC) firms. These firms can provide capital; strategic assistance; introductions to potential customers, partners, and employees; and much more.
Venture capital financings are not easy to obtain. Venture capitalists typically want to invest in startups that are pursuing big opportunities with high growth potential, and that have already shown some traction; for example, they have a working product prototype, early customer adoption, etc.
It is important to know that venture capitalists typically focus their investment efforts using one or more of the following criteria:
- Specific industry sectors (software, digital media, semiconductor, mobile, SaaS, biotech, mobile devices, consumer, etc.)
- Stage of company (early-stage seed or Series A rounds, or later stage rounds with companies that have achieved meaningful revenues and traction)
- Geography (e.g., San Francisco/Silicon Valley, New York, etc.)
Before approaching a venture capitalist, try to learn whether his or her focus aligns with your company and its stage of development.
The second key point to understand is that VCs get inundated with investment opportunities, many through unsolicited emails. Almost all of those unsolicited emails are ignored. The best way to get the attention of a VC is to have a warm introduction through one of their trusted colleagues, or another professional acquaintance of the VC, such as a lawyer or fellow entrepreneur.
A startup must have a good “elevator pitch” and a strong investor pitch deck to attract the interest of a VC. For more detailed advice on this (as well as a sample pitch deck), see How to Create a Great Investor Pitch Deck for Startups Seeking Financing.
Startups should also understand that the venture process can be very time consuming—just getting a meeting with a principal of a VC firm can take weeks; followed up with more meetings and conversations; followed by a presentation to all of the partners of the venture capital fund; followed by the issuance and negotiation of a term sheet, with continued due diligence; and finally the drafting and negotiation by lawyers on both sides of numerous legal documents to evidence the investment.
The key terms negotiated in a venture financing deal include:
- Valuation of the company
- Amount of the investment
- Form of the investment (typically through convertible preferred stock)
- Liquidation preference of the equity investment (the right to be paid back first on sale of the business or its liquidation)
- Board of Directors composition and any Board observer rights
- Approval or “veto” rights of the investors, covering items such as future equity financings, sale of the company, or changes to charter documents
- Rights to participate in future financings (“preemptive rights”)
- Rights to receive periodic financial reports and other information
- Vesting requirements for any founder stock
- Anti-dilution protection, protecting the investment from dilution if future rounds of financing occur at a reduced valuation (there are different types of formulas for this)
- Redemption rights (if any)
- Rights of first refusal or co-sale/tag-along rights on sales of any founder shares
- Drag-along rights (giving the company the right to force all shareholders to vote for a sale of the company if the sale has been approved by a specified percentage of shareholders)
- Registration rights (giving the investor the right to require the company to register their shares with the SEC in a public offering)
For a comprehensive discussion of venture capital financings, see A Guide to Venture Capital Financings for Startups.
5. Small Business Loans
Small business loans are available from a large number of traditional and alternative lenders. These types of loans can help your business grow, fund new research and development, help you expand into new territories, enhance sales and marketing efforts, allow you to hire new people, and much more.
There are multiple types of small business loans available, and options vary depending on your business needs, the length of the loan, and the specific terms of the loan:
- Small business line of credit. Under a small business line of credit, your business can access funds from the lender as needed. There will be a cap on the amount of funds accessible (e.g., $100,000) but a line of credit is useful for managing a company’s cash flow and unexpected expenses. There will typically be a fee for setting up the line of credit, but you don’t get charged interest until you actually draw down the funds. Interest is typically paid monthly and the principal drawn down on the line is often amortized over years. However, most lines of credit require annual renewal, which may require an additional fee. If the line is not renewed, you will be required to pay it in full at that time.
- Accounts receivable financing. An accounts receivable line of credit is a credit facility secured by the company’s accounts receivable (AR). The AR line allows you to get cash immediately depending on the level of your accounts receivable, and the interest rate is variable. The AR line is paid down as the accounts receivable are paid by your customers.
- Working capital loans. A working capital loan is a debt borrowing vehicle used by the company to finance its daily operations. Companies use such loans to manage fluctuations in revenues and expenses due to seasonality or other circumstances in their business. Some working capital loans are unsecured, but companies that have little or no credit history will typically have to pledge collateral for the loan or provide a personal guarantee. Working capital loans tend to be short-term loans of 30 days to 1 year. Such loans typically vary from $5,000 to $100,000 for small businesses.
- Small business term loans. Term loans are typically for a set dollar amount (e.g., $250,000) and are used for business operations, capital expenditures, or expansion. Interest is paid monthly and the principal is usually repayable within 6 months to 3 years (which can be amortized over the term of the loan or have a balloon payment at the end). Term loans can be secured or unsecured, and the interest can be variable or fixed. These loans are good for small businesses that need capital for growth or for large, onetime expenditures.
- SBA small business loans. Some banks offer attractive low-interest-rate loans for small businesses, backed and guaranteed by the U.S. Small Business Administration (SBA). Because of the SBA guarantee, the interest rate and repayment terms are more favorable than most loans. Loan amounts range from $30,000 to as high as $5 million. However, the loan process is time consuming with strict requirements for eligible small businesses. Visit the SBA website to see a list of the 100 most active SBA lenders.
- Equipment loans. Small businesses can buy equipment through an equipment loan. This typically requires a down payment of 20% of the purchase price of the equipment, and the loan is secured by the equipment itself. Interest on the loan is typically paid monthly and the principal is usually amortized over a two- to four-year period. In addition to equipment, these loans can also be used to buy things such as vehicles and software. Loan amounts normally range from $5,000 to $500,000, and can accrue interest at either a fixed or variable rate. Equipment loans can also sometimes be structured as equipment leases.
There are more lenders than ever before willing to lend to small businesses, and many of the lenders can be found from a simple online search. Here are the main types of lenders:
- Direct online lenders. There are a number of online lenders that make small business loans through a relatively easy online process. Reputable companies provide very fast small business cash advances, working capital loans, and short-term loans in amounts from $5,000 to $500,000. Sites such as Fundera and LendingTree offer you access to multiple lenders, acting as a lead generation service for lenders.
- Large commercial banks. The traditional lenders to the small business market are banks such as Wells Fargo, JP Morgan, and Citibank. These lenders tend to be slower with more rigorous loan underwriting criteria.
- Local community banks. Many community banks are eager to make small business loans to local businesses.
- Peer-to-peer lending sites. There are a number of sites that act as middlemen between individual and institutional lenders and small borrowers, including Prosper, LendingClub, and Funding Circle. These lenders can make decisions relatively quickly.
- Bank lenders backed by SBA guarantees. A number of bank lenders issue loans backed by the SBA, and, as noted above, this backing allows the lenders to offer more attractive terms.
To make sure the proposed business loan makes sense for your business, you will need to analyze the key terms proposed by a lender and compare them with terms available from alternative lenders. Here are the key terms to review:
- What is the interest rate on the loan and how can it vary over time? Many loans vary over time depending on the prevailing “prime rate” or some other index.
- How often is the interest payable (monthly or quarterly)?
- When is the principal due or how is it amortized over the life of the loan? You need to be comfortable with the combined interest and principal payments from a cash flow perspective.
- What is the loan origination fee?
- What other costs or fees are imposed (such as underwriting fees, administration fees, loan processing fees, etc.)?
- What operating covenants are imposed on your business (such as maximum debt-to-equity ratio or minimum cash amount required to be held by the company)?
- What are the circumstances when the lender can call a default on the loan?
- Is there any security or collateral required?
- What periodic reports or financial statements is the company required to provide to the lender?
- Are there limits on how the loan proceeds can be used?
- Can the loan be prepaid early without a penalty? And if there is a penalty, is the penalty reasonable?
For a comprehensive discussion of small business loans, see 10 Key Steps to Getting a Small Business Loan.
About the Authors
Richard D. Harroch is a Managing Director and Global Head of M&A at VantagePoint Capital Partners, a large venture capital fund in the San Francisco area. His focus is on Internet, digital media, and software companies, and he was the founder of several Internet companies. His articles have appeared online in Forbes, Fortune, MSN, Yahoo, FoxBusiness, and AllBusiness.com. Richard is the author of several books on startups and entrepreneurship as well as the co-author of Poker for Dummies and a Wall Street Journal-bestselling book on small business. He is the co-author of a 1,500-page book by Bloomberg, Mergers and Acquisitions of Privately Held Companies: Analysis, Forms and Agreements. He was also a corporate and M&A partner at the Orrick law firm, with experience in startups, mergers and acquisitions, and venture capital. He has been involved in over 200 M&A transactions and 250 startup financings. He can be reached through LinkedIn.
Mike Sullivan is a partner and head of the Corporate Group in the San Francisco office of Orrick, Herrington & Sutcliffe. He focuses on representing emerging companies, entrepreneurs, and angels/venture capital funds. Mike has led hundreds of financings and M&A transactions for emerging companies in a wide variety of industries, particularly in the software, satellite/space, mobile, digital media, cleantech, and food/wine/spirits sectors. Mike is a contributor to Venture Capital and Public Offering Negotiation (Aspen Law & Business).
Copyright © by Richard D. Harroch. All Rights Reserved.
This article was originally published on AllBusiness. See all articles by Richard Harroch.