Starting up a venture is, perhaps, what makes an entrepreneurial heart pump. And raising adequate startup funds to launch and run the business is probably the most important challenge in getting those ideas off the floor. Knowing the various types of startup funding gives one a lot of help in keeping afloat through the complex world of business financing. So, read this guide wherein we dive into different types of startup funding that can help founders make informed decisions, and get the necessary fuel they need to find the right direction to steer the organization forward.
1. Bootstrapping To Fund Your Startup
Bootstrapped startups are the ones that have no external support. There are two ways to get funds if you bootstrap. One, generate funds for your startup business ideas using your personal savings. Two, channel all the profits generated by the business back into building the same. And that’s the key thing in bootstrapped business. You are financing it yourself, and so, you cannot afford to burn money. The business must have to be profitable within the available runway. Or your startup may crash running out of financial fuel.
Pros
- Founders have full control over the business decisions.
- You own the equity. You doon’t have to dilute your ownership since external investors are not involved.
- You will have to lean upon pure business fundamentals and build a robust business from day one. In fact, constrained resources can motivate you to be more creative and resourceful.
Cons
- You have fewer resources at your disposal, thus, tight capital may result in slow growth.
- High personal financial risk in case savings get consumed, and if by then you have not built a sustainable and profitable business.
- Bootstrapping isn’t a viable option for setting up startups that need upfront investment. Especially, original equipment manufacturing (OEM) startups, or investment-intensive hardware startups. For such startups, while you can use personal savings to make a PoC, you need to try other sources of startup capital for commercial scale.
2. Raise Funds From Friends and Family
Amazon, Alibaba, and many other startups went this way in the early days. This is a form of startup funding that involves raising capital from close friends and family. This is the next frontier for you to raise funds when you don’t have much in personal savings. This should be preferred when you are sure that your idea will work. As in the early days, it will save you from diluting the majority stake in your startup to venture capital who at times can behave as greedy vultures. So, safeguarding your equity for better valuation days makes sense. Your friends and family circle may not demand equity, however, you still need to return their money or allocate them equity worth higher than the money they invested or with certain perks. Basically, you need to reward them for trusting in you.
Pros
- It is relatively more accessible than the other formal sources of funds.
- Terms of engagement are more tolerant and flexible as you are raising closely knit circle, who might not have intentions of earning multi-fold returns.
- The investors would trust in your words as they know you personally, and thus will be more forgiving and patient.
Cons
- There will be a possibility of straining personal relationships. It’s because your family and friends, most probably, would fund you from personal savings. And they might get into a situation where they would need immediate funds. In such a scenario, they would ask to pull out their money, which can create trouble for you. But that’s the nature of informal funding. Also, your business and financial failures can stretch the time for returning the money, and it can strain personal relationships.
- Lack of a formal agreement hence miscommunication and misunderstanding.
- This source or method to raise startup capital is often not sufficient. Most of the time, it can help you raise only limited money.
3. Angel Investment Funds
Angel investors are wealthy investors who put capital into startups in return for equity or convertible debt. These investors are serious with the money they put into your startups. The amount they invest is comparatively much higher than what you can invest using personal savings or what you may raise from family and friends circle. Typically, the amount raised from Angel investors ranges between USD 100,000 to multi-million dollars…mostly, in 6,7 figures. The angel investors put money in startups at an early stage and thus take a fair amount of equity in lieu of the funds provided.
Pros
- Angel investors double down as your mentor because they have put money into your business. Many times, they offer substantial industrial experience and network.
- Everything is documented when there is an angel investment coming your way. However, the intervention into your business and the compliance & paperwork needs are not as complex as institutional investors. You get more flexibility for risks and to experiment with ideas.
- The investment process is comparatively faster compared to venture capitalists.
Cons
- Founders need to dilute some percentage of ownership. Typically, it is between 1% to 10%.
- Angel investors, to an extent, may want some degree of control or influence on business decisions.
- High expectations of significant returns on investment. Most angel investments fail. So, the expectation usually is north of 10x returns. And that creates growth pressure on founders.
4. Venture Capital Funds
A venture capital fund is usually a limited partnership firm, wherein you have investors (limited partners) and management (general partners). The job of limited partners (LP) is to only give funds. They don’t have any involvement in how the fund is managed. And their risk is capped at the amount of money they invest. It’s the General partners (GP) who decide where the investments and follow-up investments will be made. General partners too can invest money, depending on the clauses in the management rules. However, the returns that general partners (GP) make are comparatively lesser than LPs because most of the funds are from LPs. LPs can be large funds or accredited high-net-worth individuals. Venture capital investment firms are used to invest in high-potential startups with proven traction in exchange for equity. Usually, the investment duration is approximately a decade long, which can involve multiple rounds of funding. And the returns could be multi-fold. VCs differ from angel investors in terms of the involvement they have in the startup. Whilst angel investors put in their money and do not interfere much in the day-to-day operations, VCs demand a fair share of operational control on the operations.
Pros
- It is suited for those kinds of startups that need large amounts of capital to grab market share.
- It offers access to a large network of contacts, such as customers, partners, and other investors.
- VCs quite frequently provide strategic guidance and support.
Cons
- High expectations and the pressure for high returns can be crushing.
- You have to hand over substantial influence over business decisions to owners to board seats and voting shares.
- High competition and diligent due diligence processes could be taxing (tiring) for entrepreneurs.
5. Crowdfunding
Crowdfunding is a way to raise small amounts of money from many people, typically online. It’s like raising from investors & individuals who you don’t know. These investments are reward-driven. An incentive, mostly a product or service is returned to the backers for their investment.
Sometimes, investors are offered shares in the company against their investment. It could direct ownership, or through the crowdfunding investment platform. The 3rd type of startup crowdfunding is debt-based. A pool of people contributes funds to the borrowing entity with an agreement to return principal and interest on it.
Pros
- It’s a good way to get market validation. You can gauze the buzz and generic people’s trust in your product. Market demand for your products or services can be checked through this.
- This can help you win champions who would make early customer engagement easier for you. A community is built comprising early adopters and loyal customers.
- It gives you the ability to raise money without giving up a lot of equity or control.
Cons
- Running a successful crowdfunding campaign requires an immense amount of work.
- No assurance the funding goal will be met.
- Ideas and plans are made public, and thus, can be risky if not well protected.
6. Grants and Competitions
Grants are money provided by government agencies, foundations, or corporations that do not have to be repaid. Contests award prizes, typically in the form of money, for winning business plans or pitches. Techstars is a known name for startups looking for this type of funding. In the early days, Oyo Rooms got funding through this channel.
Pros
- No equity is given up, thus preserving ownership.
- Winning grants or contests can lend credibility and validation.
- Unlike loans, grants do not need to be repaid.
Cons
- Grants and contests are fiercely competitive.
- Most grants have narrow eligibility criteria and cumbersome reporting.
- The application process is rather lengthy.
7. Bank Loans
The most common form of a bank loan is a lump sum provided by a financial institution, which is repaid with interest during a fixed period.
Pros
- Founders get to retain their ownership fully.
- Each repayment amount is fixed and at fixed intervals thus making it easier to plan finances.
- It is a clearly understood and open process.
Cons
- Banks mostly conduct their transactions based on collateral which can be risky.
- Uncertain eligibility criteria can make everything difficult for early-stage startups.
- Sometimes expensive, due to interest and fees. So, if the market goes unfavourable, your problems will pile up exponentially.
8. Convertible Notes
Seed investors use convertible notes for funding a startup. It is an example of short-term debt that startups borrow with a promise to convert into equity at a later stage normally in the instance of a future investment round. This type of financing is carried out when valuation of a startup is tough to calculate in the early stages.
Pros
- Less complex and faster to negotiate as compared to order financing.
- Valuation is deferred to the next funding round, which benefits early-stage startups.
- Can be done with a range of terms that best accommodate both investors and founders.
Cons
- The terms of conversion can be complex and may imply further dilution in the future.
- The startup carries debt on its balance sheet until it is converted.
- It may require interest payments until conversion.
9. Private Equity Funds
Private equity funds are like VC firms, however, they differ because private equity funds don’t invest in startups. They invest mostly in large companies, which they can overtake for restructuring or reselling. If your startup has sailed through all the series rounds of capital raising and then goes awry right before the IPO, as in the case of WeWork, your only escape could be a private equity firm. Basically, it invests in growth companies that have expanded beyond the startup phase.
Pros
- They give a new life to your distressed startup.
- They are sector specialists with a niche focus on specific industries.
- Shoulders the responsibility of mergers and acquisitions post-revival.
Cons
- If a startup gets in need of private equity funds, most probably it will need to devalue itself a lot.
- It’s the end of your journey at your startup because you will no longer have any control over it.
Conclusion
Depending on the stage of your startup, do proper research and assess how much investment you would need, how you will utilize it, how you will handle things if anything goes wrong, how would you manage the growth, and plan for further funding rounds if they will be needed. In short, be very diligent with raising capital, and very responsible with utilizing capital. Many founders don’t have a formal accountancy or finance background and may struggle to navigate tough financial situations. Educate yourself as much as possible about startup finance. For more startup insights, follow GrowthRomeo on LinkedIn. If you need content marketing services for your SaaS startups, contact us.
