There’s No Such Thing as Free Lunch: How to Choose the Best Fundraising Option for Your New Business
One in four U.S. businesses are not able to obtain the funding they want, according to a survey by the National Small Business Association. Funding can be a maze for even the most experienced of entrepreneurs, who need to choose from multiple paths—each with its own risks. Ideally, you'll seek the solution that's best tailored to your business needs but also to your personal financial status.
Every source of funding comes with its own specific costs. There’s cheap money, and then there's expensive money. Each option takes a different amount of time, requires giving away a different amount of equity, and has a varying level of risk involved. Be sure to do your research, assess your runway and money management skills honestly, and look at your competitors for a general sense of how to successfully raise funds in your industry.
Here are the most common funding routes for startups, plus tips and insights from seasoned investors:
Revenue from customer sales
The least expensive form of funding is customer sales. It’s a form of revenue that you don't have to give back to anyone, and you don't lose a portion of control over your business in the process. Naturally, the hard part is generating sufficient revenue from sales on a regular enough basis to keep your operations ticking over. Still, it's a popular choice for many founders who see early positive traction and have sound financial projections. You could even opt to sell your product or service before it's officially launched in order to cover any expenses you incur in the construction phase.
Pros: Don't have to pay money back or give up equity
Cons: Difficult to generate enough money to sustain operations
Difficulty: Medium – leveraged through early profit
Business type: Subscription-based companies, pre-sale models
Business loans, credit cards, and lines of credit account for roughly three-quarters of financing for new businesses. In fact, it's unusual to meet an entrepreneur who hasn't gone into debt starting their company. Most investors want to see that you have skin in the game, meaning that you've personally contributed to your own business – whether that's opening a new credit card, borrowing against your retirement savings or against your home.
Personal debt is high risk, high reward. The advantages are that you don't have to give up equity and you have total control of the funding as the money you borrow is attached to you personally. That is also the downside. If your business doesn't perform as you expect, you are the person who loses out. Compared to other funding options, where everyone loses out in a poor performance scenario, personal debt is a heavier burden to carry. You also won't be paid back for your personal investment as you can't raise money to cover that debt.
Ramin Behzadi, general partner at 7 Gate Ventures, notes that personal debt is typically used to maintain the status quo in a company and not for immediate short or mid-term growth—that comes from equity rounds.
If personal debt is the right funding path for you, check in advance that your credit score makes you eligible for the amounts you'll be requesting, and speak with a financial advisor before committing to new lines of credit.
Pros: Don't give up equity and it shows investors you have skin in the game
Cons: Debt is tied to you personally and you can't raise money to cover the debt
Difficulty: Medium- leveraged through financial institutions but dependent on personal credit history
Business type: Various
Government and bank loans
Getting a government-backed loan is a good funding route but be aware that you'll have to jump through some hoops. These types of loans aren't particularly common and typically only apply to founders who have lots of assets or income. They also vary in amount and conditions, so you have to find information from your local economic agency to suss out if it's right for your startup. The U.S. Small Business Administration is useful for local-level government funding, as is the State and Territory Business Resource.
Gabe Zichermann, chief executive of Failosophy, suggests that if you want to secure funding via a bank loan, identify the bank that you have the closest relationship with and ideally where you have all your accounts, so that they can see your financial position. As well as offering a standard business loan, bank credit processors can also provide financing where you borrow money against your projected revenue streams. This option is preferable for startups that have recurring revenue but can't raise capital, for example, restaurants, retail stores, and wholesalers.
“Bank loans have the same benefits as personal debt in terms of keeping equity and control, but they often aren't viewed favorably by venture capitalists," Zichermann adds. If you have debt on your company books when approaching investors, they'll know that they aren't your primary payback group and may think that the money they give you would only be used to repay the bank.
To listen in to Gabe Zichermann and Ramin Behzadi discuss different options to find funding for your business sign up for a risk-free trial of the Start Your Own Business course and check out our live webinar on 10/07 at 3 pm ET.
Remember, any loan you receive will have interest rates, so you'll eventually pay back more than you took out. If you can't afford the extra amount, consider looking to friends and family for investment.
Pros: Keep equity and control, and can borrow against projected revenue streams
Cons: Hard to obtain, will be off-putting for venture capitalists
Difficulty: Low -leveraged through formal financial institutions but dependent on location and early traction
Business type: Startups with recurring revenue like restaurants, retail stores, and wholesalers
Friends and family
Raising money from people who know you is a relatively safe choice for founders. Most of the time, friends and family don't have to be sold on your business because they are investing in you, and simply want to help your company grow. They are also less likely to request ownership in your business. However, you may feel a stronger obligation to return their capital because of the relationship you share with them. This option is lower risk than others, but can be higher pressure.
To get started with investment from friends and family, make a list of the people who have money, would be most interested in your idea, and organize a time to pitch them your business.
Pros: People invest in you personally, they don't have to be sold on your business
Cons: Greater obligation to pay people back
Difficulty: High – leveraged through personal network
Business type: Various
For startups, angel investors are often the ideal pathway to funding due to their more "human" touch and hands-off involvement in businesses. Angels tend to work on a case-by-case basis, so they can be more generous with their investments, plus more flexible about returns and equity. The catch is that angel investment is often the result of a serendipitous meeting, meaning it can take anything from days to years to find.
Nonetheless, there are ways you can boost your exposure to angels through networks like AngelList, as well as browse investor groups by location, university, and cultural representation. Zichermann recommends finding angels that have experience in your industry and overlap in your circles of interest. He also notes that if you need to continue developing your business while you search for investors, accelerator programs can expose you to lots of angels. But keep in mind that some programs will ask for equity in exchange, meaning you’ll give up some control for the privilege of being seen.
Pros: More flexible about returns and equity, less risky than business loans
Cons: Hard to find suitable angel investors
Difficulty: Medium – leveraged through personal and professional networks
Business type: Various
One of the newer options for fundraising, crowdfunding is best-suited to companies that have a physical product. Crowdfunding means you don't have to give up equity or accumulate debt, you can earn social proof as you collect investments, and you can build a pool of loyal advocates for your product from the get go.
The downside is that crowdfunding requires a lot of time and effort to launch the campaign itself, and once it’s live, you have to continuously market it. You also have to deal with a number of investors at once, which can be taxing when you're busy running the company. For these reasons, crowdfunding is a longer route to funding and not one that high-growth startups typically use, but it has proven to be very effective for early-stage companies.
Pros: Don't have to give up equity or accumulate debt, earn social proof as you fundraise
Cons: Requires time and effort to launch campaign, have to work with multiple investors
Difficulty: High – leveraged through crowdfunding websites
Business type: Industries with physical products
The last and most expensive fundraising choice is to turn to venture capitalists (VCs). This is far more exclusive than the other options listed, and primarily applies to startups in technology, biotechnology, and clean technology spaces.
For perspective, 1,500 startups get funded by venture capitalists in the U.S. every year, compared to the 50,000 that get funded by angel investors. VCs can offer significant investment amounts and years of expertise—which is what makes them so appealing—but they also expect a lot more control over your business. Some VCs will even appoint their own board of directors within your company.
Similar to angel investors, if you want to move forward with VC funding, you have to target firms that invest in your stage, industry, and ideally, have a shared connection with someone in your current network. Warm introductions are the best stepping stone for VC funding, and pitch competitions are valuable too. Behzadi suggests that a "warm introduction can be initiated from a person within your immediate connections/relationships or it could be cultivated or made with some proper efforts."
Likewise, Kevin Lavelle, senior vice president at Stand Together, says "you should look for a healthy balance of intellectual humility about the challenges of growth consumer investments, and intellectual curiosity about the space."
Keep in mind that obtaining investment from VCs firms takes a long time, normally around one year in total.
Pros: Higher investment amounts, expert knowledge and connections
Cons: Expect greater control in your company, takes a long time to organize
Difficulty: Low – leveraged through events and network but dependent on industry and profit
Business type: Technology, biotechnology, and clean technology spaces
Before charging ahead with fundraising, think carefully about how different pathways can accelerate your company’s vision, and what you might have to sacrifice in the process. Don't feel pressured to accept the first funding offer that comes your way when there could be a smarter route for you. The investment you accept will ultimately be a reflection of what you expect and want for your company.