How you will finance your company is an important decision. Financing will impact how you operate and how you make decisions. For example, a company financed by the founder's personal savings will operate differently than a company that has received funding from venture capital investors.
While the former may need to earn revenue in the first few months of operations in order to survive, the latter might have the flexibility to focus on building a product for several months before needing to make a single sale.
Going after the wrong type of funding can lead to undesired consequences like a shift of control or conflict between you and your financiers/partners.
How Does Financing Work?
Financing comes in many different flavors. Ultimately, it answers the question: who will provide capital to fund start-up costs for a business? When we talk about capital here, it means initial money invested into the business. There are other details involved like will there be an exchange for ownership in the company or will the money need to be paid back?
You should be aware that the individuals holding ownership positions may impact the decision-making and day-to-day operations of your company. There is not an optimal number of investors for a company either, but, the greater number of people involved in the decision-making of the company, the greater the distribution of control among more than one person.
Now that we have discussed how taking on investors and seeking investor funding can affect your company, let’s discuss the types of financing that may be available to your company.
1. Personal Financing
Personal financing, sometimes referred to as “bootstrapping”, is when you use your own funds (from savings or wages), to finance the startup of your business. If you're bootstrapping your business, you need to understand how long your funds will last.
If you’re going into business with a partner or a group of people, everyone involved may invest their own personal savings to finance the business. If that is how your company decides to finance its startup and operations, one other thing to consider like how much capital will each person contribute.
If founders contribute unequal capital amounts to the business, the amount of influence over the company direction and decisions may not be equal o, which means, some founders may have more control than others due to the discrepancy in equity ownership.
Pros + Cons to Personal Financing
The upside to personally financing your business is that you (and/or partners) maintain control of your company.
The biggest downside is you’ll be limited to how much savings you have. So if you're starting a business that requires a large chunk of start-up capital, then the cost may beyond reach for a single individual. Once your runway runs out, your business will need to start earning revenue (preferably at break-even or a profit) to stay in business.
Who Should Personally Finance?
Anyone looking to maintain control of their business and slowly grow it. If you're not looking to build a business to sell for a profit, personally financing might be right for you.
2. Debt Financing
Debt financing is getting a loan through financial institutions like banks for a pile of money that you'll use to start your business.
The bank will look carefully at your company’s financials (cash flow, collateral and the liquidity of your assets) to determine if they'll loan you the money. If you're just starting out and you don't have any financial history for the bank to see, it might be hard for you to get a loan.
If you're a brand new business, you may need to apply for a bank loan with a written business plan that includes financial projections. Establishing a relationship with your banker prior to your loan request will increase your odds of getting a loan.
Pros + Cons to Debt Financing
This type of financing will allow the founders to maintain control of the company.
The biggest drawback is having to pay back interest and having to pay back the loan every month in the form of a monthly payment. The cost of borrowing money is the loan's interest rate. This monthly payment will increase the amount of money the business needs to spend each month in order to operate.
Who Should Use Debt Financing?
Anyone who can't personally finance their business but wants to maintain control of their business and slowly grow it. If you're not looking to build a business to sell for a profit, debt financing might be right for you. You must be ready to operate so you can make your loan repayments.
3. Equity Financing
Equity financing is wildly popular, especially in the tech startup space. There are various types of equity financing available. The types range from the informal family investors to sophisticated, professional investors. Let’s take a look at the various types of equity financing.
Friends and Family
Friends and family who are investing early on are often investing in you and your idea. They are usually the first investors you'll have and it typically comes in small amounts without a lot of hassle or legal expense. Typically, the family and friends financing is $50,000 or less.
Pros to Friends and Family Financing
Financing through friends and family is usually a quick process compared to the formalities involved with borrowing money from a bank or raising money through more sophisticated investors. Depending on your agreement, the funding may also have few string attached and little contractual obligations.
Cons to Friends and Family Financing
Investment from family and friends tends to be limited to a one-time source of capital. Like personal financing, once the funds run out, your business needs to be earning money to keep it's doors open.
You should also consider that borrowing money from friends and family may have a psychic or emotional price if you lose their money when they are expecting it to be returned. Proceed with caution and weigh whether or not it's truly worth it.
Who Should Use Family and Friend Financing?
Anyone who can't personally finance or get a loan for their business. If you do want to sell your business or grow it into a very large company, you can start with family and friends financing.
An angel investor is an affluent individual who invests capital into a business, usually in exchange for some type of ownership (equity) in the company. Their goal is to sell their ownership for a return on their initial investment.
They usually invest after friends and family have invested and before venture capitalists (VC) invest. Sometimes Angel Investors will invest as a group. Sometimes an angel investors will hold a Board member position. Typically, angel investor financings ranges anywhere from $25,000 to $1 million.
Pros + Cons to Angel Investor Financing
Angel Investors can provide value beyond just the capital they invest. They can be a source for guidance, consulting, and networking opportunities.
Angel investors can be difficult to find and if you are working with a large group, you may have to manage different interests within the group.
Who Should Use Angel Investor Financing?
Anyone who wants to grow and scale their business. You have to be willing to give up some ownership and understand Angel investors will want to sell their ownership eventually.
VC investors are professional investors. They often invest a lot of money, require a large piece of equity and want huge returns. They're like angel investors on steroids. Since VC's are swinging for the fences, they're looking for returns of at least 10-20 times the initial investment. Here's some quick and dirty math: a $2 million investment would require a $20 to $40 million return.
Pros + Cons to VC Financing
The pro and the con are different sides of the same coin. Your idea gets funded - in a major way. You have the capital you need to build your idea. But you lose control of your company and are beholden to your investors.
Weston Bergman, the lead investor in BetaBlox, an equity-based business incubator for startup entrepreneurs compares "receiving a large amount of VC funding to having a rocket strapped to your back – either you’ll make it to the moon or you’ll blow up trying."
Who Should Use VC Financing?
Those who want to grow a business and sell it for a profit or a payout should seek VC funding. You should be comfortable with giving away ownership and answering to investors.
Choose the Proper Financing
The right financing option is unique to your business, your goals and your vision for the company. Some financing options will be too complicated or too risky. Some might come with giving up control in ways you're not ready to. And some may not be available to your company. Be thorough in continuing your research and constructing the right ask: the right amount from the right source at the right time.