Financing your startup.
I’m always amazed when new entrepreneurs tell me that their biggest hurdle is finding financing for their startup. In my own startup career, raising money has been the relatively easy part; the hard part is actually building a successful business.
Silicon Valley mythology has created a notion that it’s all about the venture capital. Go big, or go home. Every wannabe entrepreneur sits around fantasizing about the day they meet a venture capitalist who bestows upon them a wheelbarrow full of cash. And then life will be great.
Meanwhile, others just go out and build great businesses. In fact, 99% of the successful businesses in the world have never raised a single penny of venture capital.
There are many ways to finance a startup — and today there are more sources and structures for financing than ever before. It’s a great time to be an entrepreneur — if you let go of the misguided notion that you can’t do anything until you find some yummy venture capital. In this post I’ll review some of the many financing options for startups today.
See my companion post with a glossary of terms for startup financing.
Bootstrap it, baby.
The absolute best way to finance a startup, of course, is to simply grow it out of profits. This is the way most businesses have been built. Want a Silicon Valley example? Farmgirl Flowers was created entirely from the founder’s own savings account, she’s grown it strictly organically (pun intended) and she now has a company doing more than $50 million a year. And she still owns 100% of the company. This remains the best way for any entrepreneur to build a company.
Rich Uncle Bob
Many entrepreneurs have gotten their venture off the ground with friends and family money. Borrowing from relatives has its pros and cons, of course (if you lose your mother-in-law’s money she’ll never let you forget it), but if there is someone in your family who has the capacity to help, and believes in you, this is a very common way to raise initial funding for your startup.
Structure: Can be anything you agree upon. A convertible note (which converts at the holder’s option) can be a family-friendly structure.
Walk down to your friendly bank and ask the manager for a loan to get your startup off the ground. You’ll get a reasonable interest rate, and you won’t give away any equity in your startup! The downside is that you will almost certainly need to personally guarantee the loan (eg: pledging your house) which can be a difficult conversation with your spouse. The amount you can borrow may be limited by your credit and personal assets (see my post on debt vs equity) Structure: Typically either fixed-term or revolving debt.
Take a stroll down Sand Hill Road, hoping to show someone your pretty pitch deck! The purpose of venture capital is to allow companies to grow at an unnatural velocity, in return for a large chunk of equity. Outcomes with a venture-financed business tend to be binary — home run or a strike out (eg, IPO or bankruptcy). It’s like airplane travel — you either arrive safely or you die (except the odds with airplane travel are much better). This model is a great fit for some high-growth startups (Google, Uber) but less good for ordinary businesses. The other key thing to know about traditional venture capital is that the partners aren’t investing their own money — they are investing the money of the Limited Partners who put money into the fund (typically large institutional investors). This fiduciary relationship often limits their flexibility in investment decisions. Structure: Preferred equity.
While VC investors are investing from funds of other people’s money, Angel Investors are individuals investing their own money. This gives them the ability to make “gut level” investment decisions (which early-stage investing usually is), and more flexibility. Structure: Typically either Convertible Notes or SAFE’s (both of which end up eventually as preferred equity).
Sites such as Kickstarter and Indiegogo primarily focus on creative projects (music, film, technology, art, design, etc) not startup businesses, per se, because selling debt or equity gets into highly-regulated territory. But pre-sales of products on these platforms can be a great way to launch a startup. Many entrepreneurs have built a prototype of a product and then launched a Kickstarter campaign seeking pre-purchasers of the product. If you get 10,000 people to each pledge to pre-purchase your product for $100 — boom! - you’ve raised a million dollars and also proven market demand for your product! Meanwhile, sites such as AngelList can connect you with angel investors, and sites such as NextSeed provide platforms for entrepreneur fundraising. Structure: Wide range. Through NextSeed, for example, you can raise funding structured as Term Notes, Revenue Sharing Notes, or Preferred Equity.
The most famous startup accelerator is Y-Combinator, which offers $150,000 in cash plus other benefits in return for 7% equity in your startup. There are many of these startup accelerators now, including several that are sector-specific. Alchemist is exclusively for enterprise-focused startups, and Miller Center is exclusively for social entrepreneurs. Not all come with cash funding, but all promise to accelerate your startup progress and introduce you to investors. A good list of accelerators can be found on AngelList. Structure: A very wide range, including SAFE, an investment structure which was developed by Y-Combinator.
On platforms such as NextSeed you will find financing deals structured such that the startup pays a percentage of revenue to the investor, capped at a certain level. I recently participated in one, as an investor, where I’ll be paid 5% of the revenue of the company until I’ve received 1.5x my investment, and then the agreement terminates. I’ve seen similar deals that are royalty-based — for example the investor gets $1 for every product sold, up to a cap.
There is mythology about entrepreneurs who have launched a business by maxing out their credit cards and then going on to be billionaires. It’s pure mythology. This approach will yield a 99.9% failure rate. Don’t do it.
Find a customer who wants your product so much they’ll help finance your startup! Many software startups have financed themselves by finding a corporate customer to pay for a custom-developed software implementation (which the startup then retains rights to productize and sell to others). In the defense industry, many startups have built an early prototype and then convinced the Department of Defense to provide the funding to develop it further. This will look different for different sectors, of course, but customer financing is a tried-and-true way to launch and grow a startup.
I once started a business which needed some expensive capital equipment in order to get off the ground. I was stuck on how I was going to finance that until I met with the equipment vendors and realized they would finance it for me, in order to get a new customer. It dramatically reduced my startup capital needs.
Almost all venture capital is structured as equity. But there is a category called “venture debt”, offered by certain banks and speciality finance firms. It is typically used alongside a venture capital equity round, with the venture debt component used to purchase capital equipment, for example. Structure: Like a bank loan but with warrants added in to compensate the lender for the higher risk.
Are you starting up a social enterprise that will save the world? Great news — there are funds to pitch for that! Until a few years ago, social enterprises were difficult to finance — they weren’t “non-profit enough” for grant capital from foundations and they were “for-profit enough” for venture capital. But a whole new asset class has appeared, called Impact Capital. This typically comes from impact funds that have been put together partly to have a social impact in a particular sector, and partly to provide an economic return on capital. Examples include New Schools Venture Fund (for startups working in the education sector) and Acumen Fund (focused on global poverty).
The US Small Business Administration can help you finance your business. They don’t make the loans themselves, instead they guarantee loans that you get from a bank. The idea is that banks can make startup loans that are riskier than they would normally issue, and the SBA is helping US businesses to grow, succeed, and create jobs. Use their Lender Match tool to find SBA-approved lenders.
Non-bank Business Lenders
Traditional banks are highly-regulated, so they tend to not have much flexibility in their credit underwriting. Meanwhile, there are some new sources of business loans including Kabbage, which is a non-bank lender that uses a variety of factors (including social media activity) in their credit decisions. Also, sites such as Fundera allow you to fill out one loan application and then they shop the deal around to a variety of business funding sources. Finally, peer-to-peer marketplaces such as LendingClub offer business loans up to $500K from non-bank sources.
Alternative Growth Capital
There is a growing awareness that neither traditional venture capital nor traditional bank lending is well-suited to many online businesses today. A relatively new entrant, ClearBanc, addresses this with revenue-share financing specifically to fund the growth of businesses with a positive CAC (Customer Acquisition Cost) to LTV (Lifetime Value of a customer) ratio. They deploy up to $10 million in capital to a company, in return for a revenue share that is capped at capital infused plus six percent. I think we will see many more of these alternatives to venture capital emerge.
Other alternative structures
There is a great deal of innovation going on today in financing vehicles, especially for social ventures and other startups that don’t fit traditional molds. Miller Center has developed the Variable Payment Obligation (VPO), where the repayment obligation is better-aligned with a startup’s cash curve. There are also structured exit financings, that allow investors to get future liquidity on companies that are unlikely to have a traditional exit (M&A or IPO). The idea behind all of these is to get better alignment of incentives between investors and entrepreneurs across a wider range of venture types.
Obtaining capital is like obtaining anything else for your business — you can buy it, you can rent it, or you can rent-to-own. And you can get it from a bunch of different suppliers. So let go of the thought that the only way to launch your business is to meet a venture capitalist.
Just go build a great business, choosing smart financing at each step. If you do that, the VC’s will be lining up at your door, begging you to take their money.