May 22 | By team Unifinn
How to fund your startup? What are the sources for startup funding?
Fundraising is one of the key functions, rather a very important milestone for a start-up to succeed in its mission. The right type of capital at the right time is inevitable for start-ups to sustain and grow consistently. “Fundraising is an extreme sport!”- Marc A. Pitman. Your ideas are meaningless without a masterful execution for which fundraising becomes critical. We all have ideas, but translating those ideas into something tangible -a product or a service- is what separates doers from thinkers. Facebook was not the first social network, the iPhone was not the first smartphone, Google was not the first search engine and Stripe was not the first payments processor in the world.
What differentiates these companies from others is their level of execution, how they took existing products, improved them, raised the right form of capital at the perfect time and successfully built enterprises around them. A process that has been highlighted by many entrepreneurs in the history of technology.
“Start-up Financing is not just about raising funds, it is a holistic process that involves proper business planning with thoughtful growth targets, deciding business valuation as per the current market standards, planning potential exit options for investors,” – Nucleus Partners.
Necessity of fundraising
Just like any other business, start-ups also need funding to expand their business, product/ service enhancements, spend on technology, marketing, hiring, infrastructure, meeting operating expenses, working capital, capital expenditure etc. When a business first starts, profits are always low so different funding rounds are essential to allow for the cash flow to meet expenses until profits pick up. When a business outgrows its current location, or there is a demand for new goods or services, expansion becomes an option.
Types of Start-up Capital
Start-ups obtain capital in a number of ways. The funding you hear about most in the news involves raising money through outside investment, known as funding rounds. In those cases, investors exchange capital for equity — or partial ownership — of the company. High-potential start-ups attract the most investors, but the capital comes with a caveat — investors often get partial ownership and take an active role in the company’s decision-making process.
Here’s an overview of seven typical sources of financing for start-ups:
Founders that don’t seek start-up funding from external sources usually choose to bootstrap, or self-fund, their businesses. Entrepreneurs who bootstrap their companies start with very little money and no outside investments to build their business. They use personal savings or money from family and friends to get their companies up and running. For most start-ups, bootstrapping is an essential first stage because it: Demonstrates the entrepreneur’s commitment and determination. Keeps the company focused. Allows the business concept to mature more into a product or service.
Some of the bootstrapping methods are:
- Financing from own personal savings
- Personal debts such as credit card debts, personal mortgage loans, unsecured personal loans, private loans, borrowings from friends and relatives, gold loans, loans against securities etc.
- Issuing Sweat Equity in return for the contributions
The advantages of bootstrapping include the use of low-cost finance, little or no dilution in equity capital/ common stocks, increased concentration on building the business and no dilution in management controls by the sponsors. Building the financial foundations of a business on your own is a huge attraction to future investors. Investors are much more confident funding businesses that are already backed and show promise and commitment by their owners. Business glitches can be rectified with growth, which means that perfection at the launch of the business is not a necessity.
The main disadvantage of bootstrapping is that because of the lack of capital and cash flow, may create cash flow issues. Equity issues can become a problem when there’s more than one founder. Bootstrapping involves much more risk where losses and failures may be experienced. Also, you may find your stress levels shooting up when you face any cash crunches.
2. Raising from Friends and Relatives (Love Money)
Borrowing capital from family members, friends are relatives usually happens with many start-ups. In essence, friends and family investors are a form of crowdfunding. You might take small amounts of money from several family members or close friends, to raise a more significant overall sum.
The factors that need to be considered before accepting money from your friends and family are:
- State whether the funding is a Gift, Equity, Loan or a Convertible Debt.
- There must be a contract similar to one with an angel investor
- Maximum avoid accepting money as debt funding as nothing ever goes according to your plan.
- Have a professional third party advisor for the transaction as they can protect the relationship by acting as the bad guy when necessary
- Communicate the risk honestly while you present the start-up idea to your friend and family
- Expect the worst situation before making the decision to accept money from your friend and family
- Accept the money only after ensuring that they can afford to lose the same and communicate the same in advance.
3. Small Business Loans
Plenty of options exists for financing your start-up through loans. For example, the U.S. Small Business Administration offers programs, such as the SBA microloan, to provide companies with up to $50,000 of working capital. The money can be used to build, repair, enhance, or re-open a business.
In India, there are several start-up business loans offered by the Government of India such as loans by the National Bank for Agriculture and Rural Development (NABARD), Pradhan Mantri Mudra Yojana, Credit Guarantee Scheme, Stand Up India Scheme, Coir Udyami Yojana, Market Development Assistance, Bank Credit Facilitation, Sustainable Finance Scheme, Udyogini etc.
If you have a strong credit score and personal finances, you can also take out a personal business loan. This type of loan may have a lower interest rate and a quicker approval time — but make sure your lender doesn’t have restrictions about taking out a loan for business funding.
Another option is a microloan, which is great for founders who may not qualify for standard business loans. This type of capital can help a founder build their credit score so they can access more funding in the future.
4. Bank Loans/ NBFC funding/ Other Private Credit funding
Bank loans are the most commonly used source of funding for small and medium-sized businesses. Consider the fact that all banks offer different advantages, whether it’s personalized service or customized repayment. It’s a good idea to shop around and find the bank that meets your specific needs. There are non-banking financial companies, private debt funds, business development companies, digital lending platforms, investment banks etc provide start-up funding in the form of debt capital.
Crowdfunding is an easy way to raise a substantial amount of money for your startup through small contributions from a large number of people over the Internet. Using the power of the Internet to reach out to future investors to put your start-up on a growth trajectory in terms of capital and support. While it’s free to set up a campaign on most crowdfunding websites, campaign creators are charged two different fees if they receive funds: the platform fee and the payment processing fee. The platform fee is charged when the campaign creator collects their money and is a percentage of the total funds raised.
The main advantage of crowdfunding is that it can be a fast way to raise finance with no upfront fees. Pitching a project or business through the online platform can be a valuable form of marketing and result in media attention. By sharing your idea, you can often get feedback and expert guidance on how to improve it. However, it will not necessarily be an easier process to go through compared to the more traditional ways of raising finance – not all projects that apply to crowdfunding platforms get onto them.
Some of the leading Crowdfunding platforms for start-ups include:
6. Venture Capital (Equity)
Venture capital (VC) is a form of private equity and a type of financing that investors provide to start-up companies and small businesses that are believed to have long-term growth potential. Venture capital generally comes from well-off investors, investment banks, and any other financial institutions. Venture Capital Fund is made up of investments from wealthy individuals or companies (called Limited Partners) who give their money to a VC firm (called the General Partner) to manage their investment portfolios for them and to invest in high-risk start-ups in exchange for equity. Every VC investor has its own criteria for investing in start-ups.
There are 3 main types of VC funding that are early-stage financing, expansion financing, and acquisition/buyout financing. Under certain circumstances, VC firms reduce the risk of investments by co-investing with other VC firms. Usually, there will be the main investor called the ‘lead investor’ and other investors will be called ‘followers’.
There are five typical stages of any venture capital financing:
- The seed stage
- Start-up Stage
- Start-up stage
- Early-stage (also called first stage or second stage capital)
- Expansion stage (also called second stage or third stage capital)
- Bridge stage (also called mezzanine or pre-IPO stage)
Venture capitalists generally take an equity position in the company to help it carry out a promising but higher risk project. Such equity investments can be in the form of direct equity, convertible to equity or a preferred equity model.
Read more about our VC funding advisory services.
7. Venture Debt
Venture debt or venture lending is a type of debt financing provided to venture-backed companies by specialized banks or non-bank lenders to fund working capital or capital expenses, such as purchasing equipment. This type of debt financing is typically used as a complementary method to equity venture financing.
Venture debt can be a viable alternative to equity venture financing. Similar to other methods of debt financing, a primary benefit is preventing the further dilution of the equity stake of a company’s existing investors, including its employees.
8. Angel Investing
An angel investor (also known as a private investor, seed investor or angel funder) is a high-net-worth individual who provides financial backing for small start-ups or entrepreneurs, typically in exchange for ownership equity in the company. Angel investors usually give support to start-ups at the initial moments and when most investors are not prepared to back them.
Angel investors prefer to get involved in the early stage of a company, at the “seed” or “angel” funding phase. That could mean the angel invests when the company exists only as an idea, or it could come when a business is already up and running. However, angel investors also invest at the advanced stages like the late seed, pre-series A, Series A etc.
Sometimes angel investors arrive on the scene after the initial round of funding, which normally comes from the founders themselves, friends and family of the founders or from bank financing. Typically, initial business funding isn’t substantial—it’s common for founders to roll out their product or service with $10,000 or so in initial funding.
9. Business Incubator or Accelerator
Incubators and accelerators are programs for startup companies that provide capital, mentorship, and networking. There’s a slight difference between the two, which you need to know if you’re considering this type of startup funding.
Incubators focus on early-phase start-ups that are in the product-development phase and do not have a developed business model. Accelerators focus on speeding up the growth of existing companies that already have a minimum viable product (MVP) in the hands of early adopters with an established product-market fit.
Commonly, incubators will invite future businesses and other fledgling companies to share their premises, as well as their administrative, logistical and technical resources. They help nurture a start-up by developing its strong idea into a viable product and are commonly referred to as a school for start-ups. Incubators typically work on a fee basis as opposed to taking an equity stake in the start-up. The services of incubators include office space, entity formation, administrative support, marketing support, capital raising and many more.
10. Revenue Based Financing
The revenue-based financing allows a start-up to get its future revenues upfront so that it can be easily deployed for inventory, advertising and marketing spending. The payment part is flexible, amounting to a pre-decided percentage of the revenue a company generates month after month.
11. Government Grants and Subsidies
Government agencies provide financing such as grants and subsidies that may be available to your business. In most countries, government agencies provide financial and non-financial assistance to start-ups to grow the start-up ecosystem in the country. Getting grants can be tough. There may be strong competition and the criteria for awards are often stringent.
Generally, most grants require you to match the funds you are being given and this amount varies greatly, depending on the granter. Grants are mission-driven, so your business goals or values have to align with the organization’s in order to apply for and be awarded the capital.
12. Family Offices
Family offices have emerged as a sound and strategic investment choice for startups worldwide. Many family offices now started investing directly in startups. Family offices are more patient than angel investors and give startups more time, money, and resources to grow their businesses. But the trick is to approach the right family office.
The top 10 family investment offices with the most VC deals are:
- Omidyar Network
- Kapor Capital
- Webb Investment Network
- Hunt Holdings
- Winklevoss Capital
- Bezos Expeditions
- Iconiq Capital
- The R-Group, LLC
- Smedvig Capital
13. Corporate Venture Capital (CVC)
Corporate venture capital is the investment of corporate funds directly in external startup companies. Corporate VC capitalists take the risk of investing in startup companies, with the hope that they will earn significant returns when the companies become a success. – is the practice of directly investing corporate funds into external startup companies.
They do so through joint venture agreements and the acquisition of equity stakes. The investing company may also provide the startup with management and marketing expertise, strategic direction, and/or a line of credit. CVC was started due to the vast emergence of startup companies in the technology field. The main goal of CVC is to gain a competitive advantage and/or access to new, innovative companies that may become potential competitors in the future.
The success of every startup largely depends on the availability of the right form of capital and raising the same at the critical time when needed. The right mix of capital is also very important. Many startups fail mainly due to the lack of adequate liquidity to meet their operating costs, especially at the early stages when the revenue is not enough to meet their payments.
The above discussed are the options largely used by VCs across the world. You need to choose the right form of capital to take your startup moving forward.
About the author
Dileep K Nair
Mr Dileep is currently the managing partner of Unifinn Capital Global and an advisor to the investment banking and corporate finance world. He is a mentor, entrepreneur and business advisor with overall 19 years experience, 12 plus years of banking and finance experience and 7 plus years experience in investment banking and corporate finance, with relevant experience in handling private equity transactions, private debt, venture capital, angel investing, M&A, other growth capital transactions and real estate financing transactions.