In entrepreneurship, the old adage “you must spend money to make money” often rings true.
Once you’ve developed an innovative business idea, identified a market need, and created a value proposition, you need to acquire funding to get your company up and running.
There are several sources to consider when looking for start-up financing. But first you need to consider how much money you need and when you will need it.
The financial needs of a business will vary according to the type and size of the business. For example, processing businesses are usually capital intensive, requiring large amounts of capital. Retail businesses usually require less capital.
Debt and equity are the two major sources of financing. Government grants to finance certain aspects of a business may be an option. Also, incentives may be available to locate in certain communities or encourage activities in particular industries.
Before deciding how to finance your business, determine how much money you anticipate needing for startup costs and regular expenses. Whether you run a brick-and-mortar or online business, consider the following when taking stock of expenses:
- Licenses and permits
- Trademarks, copyrights, or patents for your brand and products
- Business insurance
- Legal or accounting assistance
- Rent and utilities (for brick-and-mortar businesses)
- Equipment required for production
- Website platforms
- Marketing materials (both print and digital)
- Shipping supplies
- Subscriptions to content management systems and sales or marketing platforms
- Market research
- Employee salaries
- Rent and utilities for office space
- Travel expenses
- Conferences, conventions, and networking events
Before raising capital, it’s also wise to familiarize yourself with how to read and create a balance sheet, income statement, and statement of cash flows. Financial literacy is a critical skill for entrepreneurs, and being aware of these financial statements will ensure you’re taking the necessary steps to become a responsible business owner.
1. Venture capital
The first thing to keep in mind is that this funding source is not necessarily for all entrepreneurs. Right from the start, you should be aware that venture capitalists are looking for technology-driven businesses and companies with high-growth potential in sectors such as information technology, communications, and biotechnology.
Venture capitalists take an equity position in the company to help it carry out a promising but higher risk project. This involves giving up some ownership or equity in your business to an external party. Venture capitalists also expect a healthy return on their investment, often generated when the business starts selling shares to the public. Be sure to look for investors who bring relevant experience and knowledge to your business.
Venture capital firms are usually focused on creating an investment portfolio of businesses with high-growth potential resulting in high rates of returns. These businesses are often high-risk investments. They may look for annual returns of 25-30% on their overall investment portfolio.
Because these are usually high-risk business investments, they want investments with expected returns of 50% or more. Assuming that some business investments will return 50% or more while others will fail, it is hoped that the overall portfolio will return 25-30%.
More specifically, many venture capitalists subscribe to the 2-6-2 rule of thumb. This means that typically two investments will yield high returns, six will yield moderate returns (or just return their original investment), and two will fail.
2. Government Grants
Federal and state governments often have financial assistance in the form of grants or tax credits for start-up or expanding businesses.
Equity Offerings
In this situation, the business sells stock directly to the public. Depending on the circumstances, equity offerings can raise substantial amounts of funds. The structure of the offering can take many forms and requires careful oversight by the company’s legal representative.
Initial Public Offerings
Initial Public Offerings (IPOs) are used when companies have profitable operations, management stability, and strong demand for their products or services. This generally doesn’t happen until companies have been in business for several years. To get to this point, they usually will raise funds privately one or more times.
Warrants
Warrants are a special type of instrument used for long-term financing. They are useful for start-up companies to encourage investment by minimizing downside risk while providing upside potential. For example, warrants can be issued to management in a start-up company as part of the reimbursement package.
A warrant is a security that grants the owner of the warrant the right to buy stock in the issuing company at a pre-determined (exercise) price at a future date (before a specified expiration date). Its value is the relationship of the market price of the stock to the purchase price (warrant price) of the stock. If the market price of the stock rises above the warrant price, the holder can exercise the warrant. This involves purchasing the stock at the warrant price. So, in this situation, the warrant provides the opportunity to purchase the stock at a price below current market price.
If the current market price of the stock is below the warrant price, the warrant is worthless because exercising the warrant would be the same as buying the stock at a price higher than the current market price. So, the warrant is left to expire. Generally warrants contain a specific date at which they expire if not exercised by that date.
3. Self-Funding/ Personal investment
When borrowing, you invest some of your own money—either in the form of cash or collateral on your assets. This proves to your banker that you have a long-term commitment to your project.
If your projected expenses add up to a manageable amount, you may be able to fund the business yourself. This can involve taking money from your personal savings account, dipping into your retirement funds, using credit cards and paying back the debt, or asking for donations from friends and family.
Self-funding comes with the risk of long-term debt or losing personal savings and, potentially, money from loved ones. However, it’s a financing option that allows you to retain full ownership over your business, which is often seen as a downside of raising venture capital from investors.
4. Crowdfunding
If you believe your business can garner a fan base, crowdfunding could be a good option. Crowdfunding platforms, such as Kickstarter, Indiegogo, and Patreon enable entrepreneurs to pitch their products and request financial backing.
If people are intrigued and support your product, they can donate to your company in exchange for a free item, discount code, or acknowledgment once your business is up and running. For this reason, crowdfunding is typically a good fit for business-to-consumer startup companies with physical products, although there are exceptions. Each platform has its own terms and conditions, which you should read before selecting one.
In return for investing in your business, supporters will receive equity, albeit with less liquidity than what do would get with public stocks. There are also more relaxed rules governing crowdfunding than IPOs.
There are various forms of crowdfunding, including:
Equity crowdfunding, where, in exchange for their money, investors receive shares in a company or the right to a portion of revenues or profits from a specific product.
Debt crowdfunding, where investors lend their money to a company at relatively high interest rates, thus mitigating their overall lending risk by spreading a large amount of money in small increments across a large number of loans.
Donation/rewards-based crowdfunding, where a company sets a fundraising target and asks for donations—in exchange for some kind of token or receipt of the eventual product or service to be developed.
5. Lease
A lease is a method of obtaining the use of assets for the business without using debt or equity financing. It is a legal agreement between two parties that specifies the terms and conditions for the rental use of a tangible resource, such as a building or equipment. Lease payments are often due annually. The agreement is usually between the company and a leasing or financing organization and not directly between the company and the organization providing the assets. When the lease ends, the asset is returned to the owner, the lease is renewed, or the asset is purchased.
A lease may have an advantage because it does not tie up funds from purchasing an asset. It is often compared to purchasing an asset with debt financing where the debt repayment is spread over a period of years. However, lease payments often come at the beginning of the year where debt payments come at the end of the year. So, the business may have more time to generate funds for debt payments, although a down payment is usually required at the beginning of the loan period.
6. Loans
Loans are the most commonly used source of funding for small and medium sized businesses. Consider the fact that all lenders offer different advantages, whether it’s personalized service or customized repayment. It's a good idea to shop around and find the lender that meets your specific needs.
Applying for a small business loan is another way to secure necessary startup funds. Before applying to banks and credit unions, prepare a business plan, value proposition, expense report, and financial projections for the next five years. Most banks or credit unions will ask to see some combination of these documents when considering your application.
Be sure to weigh the pros and cons of every bank loan offer you receive. Which gives you the lowest interest rate? What are the terms and conditions?
7. Business Incubators
Business incubators (or "accelerators") generally focus on the high-tech sector by providing support for new businesses in various stages of development. However, there are also local economic development incubators, which are focused on areas such as job creation, revitalization and hosting and sharing services.
Commonly, incubators will invite future businesses and other fledgling companies to share their premises, as well as their administrative, logistical, and technical resources. For example, an incubator might share the use of its laboratories so that a new business can develop and test its products more cheaply before beginning production.
Generally, the incubation phase can last up to two years. Once the product is ready, the business usually leaves the incubator’s premises to enter its industrial production phase and is on its own.
Businesses that receive this kind of support often operate within state-of-the-art sectors such as biotechnology, information technology, multimedia, or industrial technology. Businesses that were supported by an incubator have a better success rate over five years.
Angel Investors
Angel investors are individuals and businesses that are interested in helping small businesses survive and grow. So their objective may be more than just focusing on economic returns. Although angel investors often have somewhat of a mission focus, they are still interested in profitability and security for their investment. So they may still make many of the same demands as a venture capitalist.
Angel investors may be interested in the economic development of a specific geographic area in which they are located. Angel investors may focus on earlier stage financing and smaller financing amounts than venture capitalists.
Keep in mind that no two businesses are the same—only you know the ins and outs of your company’s needs. By weighing the risks and rewards of each funding option, along with your personal finances, predicted startup costs, and business expenses, you can select the best option for financing your business.