by David Ehrenberg
I am always meeting young entrepreneurs who are in need of capital to support the early costs associated with starting a business. With so many funding options out there, raising funds can be a confusing, and somewhat overwhelming exercise. Further complicating the issue, the type of funding you pursue will depend on the particular needs of your company, your company stage, and the specific milestones you hope to achieve.
That said, knowing the most common funding options gives you the foundation you need to develop your customized fundraising strategy. So here is a quick(ish) overview of the most common funding types for early-stage startups:
Okay, I realize this isn’t actually “fundraising,” but sometimes the best funding option is not to seek funding at all, and instead cut corners wherever you can and working on building your company from your personal savings. Besides saving you money, bootstrapping also helps you to focus on execution and building traction without outside interference. It’s also a means for avoiding dilution and yielding larger profit margins.
2. EQUITY FUNDING
Equity funding is an umbrella term that refers to any means of financing your company in which you receive money in exchange for issuing shares of your stock. There are multiple methods for raising equity capital but, depending on how you raise this money, you could be giving up anywhere from 1-100 percent of your business. Equity rounds include:
Seed financing, as the name implies, is the relatively small amount of money a business needs early on to get started. Usually businesses seeking a seed round are still in the concept stage and need just a small capital infusion to cover expenses until they can start earning revenue. Seed money can also be a helpful tool for attracting future money from bigger investors. Because seed capital is smaller and more of a high-risk investment, it generally will come from friends and family or smaller angel investors.
While borrowing from family and friends can be appealing since it’s less formal than borrowing from a professional investor, it also holds personal as well as professional risks. If you are going to go this route, make sure you formalize the process and are a transparent as possible about the risks of investment.
It can be easier to raise seed rounds from a smaller angel investor, as opposed to going for the brass ring of VC investment. With an angel investor, you will usually pay less of a premium in the amount of the stock or percentage of your company you give up because angel investors have other means of making money. They may not be looking for as specific a level of return as venture capitalists might be.
There are downsides to working with angel investors. Often you will need to find multiple investors to give you the kind of capital you need (as opposed to working with just one VC). This can lead to “herding cat syndrome,” wherein you find yourself facing the challenge of managing multiple people and relationships. But for seed money, your angel investors are still generally going to be a good first bet.
Series A refers to the first round of stock offered to investors during early-stage rounds. Typical Series A rounds fall in the range of $2-5M, offer options for 20-40 percent of the company, and are intended to support a company through the early stages of building a business — from product development to hiring to marketing. Because the Series A round is for more significant cash, investors are usually professional angel investors or boutique VC firms who specialize in this first round of financing.
Series B refers to second-stage financing. Series B usually happens after the company has already achieved certain business milestones and thus proven its potential viability as a company. This series is also sometimes called a venture round since it is at this point that venture capitalists usually get involved. Venture capitalists don’t just offer a greater capital investment for a given round; there’s also a greater possibility for going back to this same well for future rounds. Also, experienced VCs can offer the kind of networking opportunities and mentorship that unconnected smaller angel investors may not.
As companies grow, they might continue to seek additional funds to meet future milestones. Each successive venture round follows alphabetically down the line (e.g. C, D, E…). VCs and private equity investors support these financing rounds as well as future funding rounds that more established companies may have to look forward to such as bridge financing, expansion capital, late-stage capital, and leveraged buyout.
3. DEBT FUNDING
Debt funding is also a viable funding option. With debt funding, you borrow cash that you will have to pay back, regardless of whether or not your company is making a profit. While you may choose to incur debt (i.e. borrow cash) from friends and family, there are other kinds of debt funding you could also pursue. The most common are:
In some ways, this kind of debt feels a lot like equity – at least in the short term. The difference comes in the long term: at some point, you will have to repay this debt, regardless of company performance. For term loans, typically repayment terms are multi-year (three years being the most common). Non-formula lines of credit usually have a shorter term of just one year.
AR line (accounts receivable-based credit lines).
If your company has accounts receivable (in other words, you are already generating revenue), this can be a great funding option. It’s cheaper and less risky than other forms of venture debt. There are many lenders who are willing to finance accounts receivable. If you are experiencing a working capital gap between the time it takes to collect and make payments, you can leverage your billed accounts receivable at a significantly discounted rate. In other words, you’re essentially taking out a loan on payments yet to be paid. Most of what we see with our clients in terms of debt funding is venture debt and/or AR lines.
This is essentially a loan that is collateralized by equipment. If you need a significant amount of capital equipment, you can finance these purchases. This kind of loan doesn’t always require the equipment you are purchasing to be specifically tied to the funding you receive. Sometimes you can even use this loan to fund growth in other areas. This kind of debt is pretty hard to get, so we don’t see it too often. But it’s worth seeking out if you have equipment needs.
These are bank loans guaranteed by the Small Business Administration (SBA), usually with a lower interest rate than that of loans not guaranteed by the SBA. This guarantee doesn’t mean that you are off the hook if your business fails. In that case, you still need to pay back the loan. The main advantage to this type of loan is access: with the backing of the SBA, you might be approved for loans that you wouldn’t have received otherwise. Though none of our clients have received SBA loans, it’s still worth looking into if you’re a new startup in need of funds.
Now that you have a basic understanding of the most common funding types, you’re ready to take your company to the next level. First outline exactly what that “next level” looks like – specifically, what milestones do you hope to achieve? Then use these milestones to create financial projections that you can use to calculate how much funding you will need and what funding type is the best bet for your company.
David Ehrenberg is the founder and CEO of Early Growth Financial Services, a financial services firm providing a complete suite of financial services to companies at every stage of the development process. He’s a financial expert and startup mentor, whose passion is helping businesses focus on what they do best. Follow David @EarlyGrowthFS.