Learn how to attract capital for your startup and learn about the different funding options for small businesses.
Once you have decided to start a small business, your first few questions might relate to how you will fund your new company. Unless you already have a few million dollars lying around, you will most likely need help from outside sources. This article will aim to answer a few questions startup owners often have about types of funding, and how to receive them.
🔬Read: Funding Options for Biotech Startups to learn more about different sources of capital.
The first questions you might ask yourself should be:
Let’s start with the first, and more simple question...
The answer to the first question can depend on the type of service you offer, and what types of funding are available to your line of service.
The first strategy is to take as much money as you can, when you can. For example, if you are looking for $500,000 to fund your business, and an investor offers you $1 million, do you take it? According to this school of thought, the answer is yes! The reasoning for this is that more money is almost always better, especially when unforeseen circumstances pop up (like COVID).
The second strategy is to only take as much money as you need in order to get your startup off the ground. The reasoning for this strategy is that you won't want to give up partial ownership, stock options, or other control early on in your business. If you don’t need the extra money, you might not want to take it because the tradeoffs are not worth it.
Both are viable strategies, but only taking as much money as you absolutely need from outside investors will allow you to dilute your company less, and therefore take greater ownership of your company in the long run.
Now that you know how much money you want to ask for from investors, you will want to know where that money can come from. Here are a few funding sources commonly utilized by small businesses:
When you first start out your company, you are often bootstrapped for funds. Founders and initial employees exchange their time and energy for shares of common stock, to be paid back later. Until you get an outside source of investment or start generating capital, you are stuck.
Friends and family are most often the first point of contact for new startup owners to ask for capital. There is an issue with this that many small business owners might not know; according to US law, you should only be receiving money from accredited investors. In order for an investor to be accredited, he/she must meet certain criteria. For example, he/she must have a net worth of at least $1 million (not including their primary residence) or an annual income of $200,000 or above.
You can also raise money from a non-accredited investor, by making them a sophisticated investor. In order to make a non-accredited investor a sophisticated investor, you need to give them various pieces of information on what their investment entails and the risk they could be taking on. Before attempting to make a close friend or family member a sophisticated investor, be sure to consult with a lawyer in order to follow the proper rules and regulations.
Traditional angels are individuals that have a high net worth and have experience investing in early stage companies. Most angel investors will invest in amounts from around $50,000 to $1 million. Typically, these angels will also be accredited investors, so you don’t have to worry about that (like you might with friends and family).
Angel investors can also come in groups, for example: the Tech Coast Angels, Sand Hill Angels, Golden Seeds, and many more. These angel groups are syndicates of some of the most active angel investors in a particular area. They aim to centralize pitching, due diligence, and the overall investment process. These groups can make the investment process smoother for both the angel investor and the small business. There are also individuals known as “super-angels”. These individuals will invest large sums of money in your company as an individual; they are also called “micro-venture capitalists”.
The question of which investment type is best for you will depend on your company’s needs and goals. Meeting with different types of investors to see what projects they are interested in will help you with deciding which investor type is right for you.
Incubators and accelerators typically make a one-time investment of around $15,000 to $150,000 toward each company in their program. Usually you need to apply to the program by sending in your executive summary and meeting with the management of the program. Incubators can also take a percentage of the ownership in your firm if that is written in the contract.
Applying to an incubator/accelerator is a great way to get your company’s foot in the door; they can provide guidance through advisors, strategists, VC groups, and other helpful contacts.
Other times, the incubators will not give you direct investment, but rather provide free lab space or discounts to certain business services (like Amazon Web Services, RackSpace, PayPal, etc). Incubators can also be funded by Venture Capital firms or super-angels. Their main goal is to help your company grow, whether through direct investment, network connections, free services, or some other ‘perk’.
Venture capital investors are generally long-term investors that take an active role in the early-stage companies they invest in. They do not expect immediate returns on their investment. Rather, they expect to see their money grow over time with the aid of their resources and expertise.
One important thing to note: VC firms are typically structured as limited partnerships, so they will often ask you to convert your company to a C-Corporation if you have not already. This is mainly for tax purposes, but it is something to keep in mind if your company is looking for VC funding.
VCs are often looking for specific types of companies. This can be separated based on the industry, the stage of the company, or another categorization.
🔬 Read about: The Ins and Outs of Venture Capital Funding
VCs often fall into 2 camps when choosing their investments. They can either bet on the horse, or bet on the jockey. Betting on the horse means that they are investing in the company because they like the technology or product. Betting on the jockey refers to supporting the executive team, and relying on their expertise to carry the technology.
VCs aim to grow with you, so they will most likely want to continue investing in your company for many rounds of funding. They also will look for managerial rights in your company in order to solidify their share or leadership.
A statistic to keep in mind is that VCs receive an average of 200 executive summaries per month, with only around 5% being invited to meet with the partners. 2% of the 200 companies will make it to the due diligence phase, and only 1% will be offered a term sheet. These numbers aren’t meant to be depressing, but you should keep them in mind when targeting VCs and other investors.
🔬 Read: Top 7 Venture Capital Firms
Many large companies have separate investment departments specifically for strategic investments. These departments aim to invest in companies that offer a strategic gain for the parent company. These large companies invest in early stage technologies to see if it can be used later on in their own products. In addition, these types of investments can lead to an acquisition down the line.
Commercial bank loans are often personally guaranteed and hard to get for new businesses. Nonetheless, they can be a great short term option for working capital. These loans typically are for equipment financing, A/R financing, etc. Small Business Administration (SBA) loans are also available, but they may require a personal guarantee.
Government grants are a great option for small businesses looking to receive non-dilutive funding. Some examples of well-funded government grants are the Small Business Innovative Research (SBIR) and Small Business Technology Transfer (STTR) grant programs.
🔬Learn more: What are SBIR/STTR Grants?
Securing funding for your startup is not an easy task. It requires patience and motivation, but there are significant resources in the US and around the world to help get startups on their feet. Understanding the different types of investors, like Angels or VCs is crucial to understanding what type would be best for your company. You also need to understand what type of investments are best for you, whether it be debt or equity, or a combination of both. As with most things regarding significant business changes, talk with a lawyer or consultant to ensure that you are being treated fairly.
Q: Are there any online platforms for emerging growth companies where they can attract Angel Investors?
A: There is a consensus from the federal securities law standpoint that companies should not use general solicitations to raise capital. However, there has been a recent development, in Regulation D of the Federal Securities Laws, that allows some types of general solicitations. Before posting anything online be sure to talk to a securities lawyer to ensure that you are not breaking any laws.
Q: When is the best time to engage with a lawyer while attempting to raise capital for a startup?
A: The sooner you have a lawyer involved, the better you will be. But cost is a large consideration when getting a lawyer. Luckily, there are many resources available to startups that can provide free consulting or legal advice. A great place to start is your local SBDC branch! You can also look at your local law offices and see if they host free office hours or other similar services for the community.
Bardia has significant experience representing companies and financial firms in a broad range of general corporate governance and transactional matters, including venture capital financings, mergers and acquisitions, debt offerings, spin-offs/divestitures, joint ventures, IPOs, follow-on offerings, and tender offers. He is a trusted advisor, often serving as the go-to outside counsel or lead counsel to his clients.
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