Understanding Funding: The Wild Ride from Startup to Success
There are many ways to raise money for your business. For many business owners in their 20’s-30’s, traditional methods of raising money are different due to silicon valley-type startups dominating the press. I see startup founders pitching over and over again, almost getting lost in the frenzy of trying to raise funds and losing sight of actually creating a sustainable, profitable business.
If you want to create the next Facebook, you’ll probably need to chase those VCs. But is that the only measure of success? Series A or you’re a failure? I think not. My guess is that wealthy business owners you see driving expensive cars or living in costly houses didn’t get rich via a VC funded business. They built it with more traditional methods.
Here are a few other options to consider for getting your business off the ground.
Bootstrapping isn’t technically “raising money,” but this is the most conservative way of building a business. It is a logical method; make something, sell it for profit and use that profit to pay your team and grow the business. Bootstrapping is typically the slowest method but has the least risk as you would carry little to no debt along the way. You should be able to get by using company credit cards for the early stages of the business.
Short-term loans are quick to get but cost a lot. You don’t need to go through the lengthy process, but you pay for it in higher fees and interest. eCommerce businesses tend to use these to cover inventory float. Sites like Fundbox, Kabbage, Intuit, Amazon are the most common lenders we see in this space. It would be preferable to use a line of credit instead if you can get the bank to provide one. However, this can be challenging for drop shippers as they don’t carry inventory for collateral purposes.
Although super convenient, I would use this type of loan sparingly and not as the core of your operating model.
Line of Credit
A line of credit is the most common type of debt we see. We recommend a line of credit to help cover short-term, timing-based dips in cash. An example would be covering payroll while you wait for a customer’s deposit to hit. Another use would be to fund a salesperson or business development professional. The idea here is using those funds on something that should pay it back in the short-term.
A line of credit will need to be collateralized with something, typically inventory or accounts receivable, so this doesn’t work for all businesses. Software companies have a harder time with this type of debt as there is no tangible asset in the bank’s eyes.
Loans & Convertible Notes
Small Business Administration (SBA) or bank loans are an excellent way to invest in your business. They will require collateral and are typically higher amounts than a line of credit. Loans tend to be paid back over a more extended period, but it’s fixed and have better rates. You may need personally guarantee this type of credit so the risk may go beyond your business assets.
Common reasons to obtain a loan are to buy equipment, a book of business, or build a new product. The idea is to purchase things that should generate a return and eventually cover the debt. Don’t use a loan to cover operating expenses. Those are shortfalls in the operations of the business and are not a wise use of borrowed cash. Bank won’t loan you money to pay for things like that anyway.
You’ll need to be more prepared to obtain a bank loan. Having your financials in order and having a business plan in place will show you are capable of following, and building a relationship with the banker which is essential. Regional banks tend to take in the full picture than the larger national banks where you’re just a number. Depending on the amount, the bank may include debt covenants that need to be met to keep the loan alive, so proper financials are necessary. Debt covenants are financial metrics that you need to achieve.
A good segue from Loans to Investors are convertible notes. These are similar to loans but are not through banks; they are with potential investors. You either pay back the note, just like a loan, or you convert it to equity if you can’t pay it back. The equity component can create some complex accounting requirements, and you should consult with an attorney to review the terms. Don’t just sign it without knowing the consequences.
Friends & Family Investors
Friends and family are a standard way to raise a small amount of capital, generally around $10,000 - $50,000. Friends & family usually won’t require financial documents or business plans but give you the cash based on their trust in you.
In an ideal world, you would only take on investors that are smart-money; those that can help the business beyond a simple cash injection. In the beginning, you may not have a choice. Try not to take on too many investors of this type.
As you grow and consider more savvy investors at higher dollars, they won’t want to see a lot of small, friends and family investors as they may not be willing to take risks needed to grow the business and will get in the way in the savvy investor’s mind.
Angel Investor (Seed Funding)
This type of investor, called Angel Investors, will generally invest around $100,000 to $250,000 based on the ideal or a minimal viable product (MVP). They will be savvier when it comes to investing and will be expecting a 5x-10x return on their money and a significant percent of ownership in the entity. Don’t just follow the Shark Tank model and plan to give up controlling interest. Make sure you consult with an attorney to avoid any stupid mistakes. Try to find angel investors that are more than their money; industry expertise, mentorship, referral contacts are all value-adds that can help you succeed.
This type of investment is high-risk investing as it’s before the product or market fit is finalized. Angel Investors are betting on you more than the product in many cases. You’ll burn this money fast and will now enter the rat race of continually raising funds to continue to scale.
Angel investors are not looking to invest in your lifestyle business. They want something that can scale rapidly giving them that 10x return when an exit occurs.
By this time, your business should be off the ground, and a product or service will generally be in the market. Venture Capitalists (VC’s) kick in from here as you pursue Series A funding and beyond. You’ll now be looking to raise $1M or more to accelerate your growth. Get ready for a wild ride!