Guide to business funding for startups and early-stage investing
Innovation and creativity are core qualities of American culture, making entrepreneurship a key driver of job creation and economic growth. Yet, for most startup founders, the number one challenge in keeping their business afloat isn’t a lack of ideas or grit but inadequate funding. Indeed, research shows that 90 percent of startups fail.
This handy guide highlights various financing options for startup and small business owners. And for investors looking to support these companies, we’ll highlight how you can get involved.
Startup financing statistics
- The United States is the leading country with the most startups, according to StartupRanking, a company that tracks startups and companies around the world.
- 77% of startup founders rely on personal savings to fund their business venture, according to a 2018 survey from Lendio, a financial services company.
- Nearly 80% of small businesses employ only the founder.
- More than 69% of entrepreneurs start their businesses at home.
- Immigrant entrepreneurs start 25% of all new businesses in the U.S., according to a study from the National Bureau of Economic Research.
- Only 1% of venture-funded startup founders are Black.
How to get funding for a business
Although each entrepreneur has a unique story and mission, all small business owners have access to multiple options for funding their company. Ultimately, the best choice depends on the specifics of your business, including its stage of development, the industry you operate in, and the amount of funding you need.
Before you approach a potential investor, though, there are a few actions you can take to increase your odds of success:
- Develop a business plan: A comprehensive business plan is essential for securing financing from investors or lenders. Your plan should outline your business concept, target market, competitive analysis, financial projections, and marketing strategy.
- Build your credit history: A solid personal credit score can increase your chances of being approved for a loan or line of credit. Make sure to pay bills on time and reduce debt.
- Gather financial documents: Lenders will want to see financial documents, such as tax returns, bank statements, and proof of income, to assess your ability to repay a loan.
- Identify your financing needs: Determine how much capital you need to start your business and how you plan to use it. This information will help you decide what financing is best for your business.
- Network with other entrepreneurs: Attend industry events, join business organizations, and reach out to your network to learn from their business experiences. In short, don’t discount the power of collaboration and mentorship.
Types of startup financing available
Getting funding for a new business can be difficult. Typically, there are two main options:
- Equity financing involves offering shares of the business in exchange for money. Through this approach, an investor becomes a partial owner of your company, sharing its profits or losses and possibly even participating in business decisions.
- Debt financing involves loans given to small business owners in exchange for interest payments over a predetermined period. By agreeing to pay back the total balance plus interest, entrepreneurs maintain full ownership of the business.
While each deal is unique and may include a combination of equity and debt, these principles are the foundation of most transactions. And like any other investment, each option carries pros and cons.
With equity financing, for example, entrepreneurs gain access to capital and other resources like business strategy and advice. However, in exchange for these benefits, entrepreneurs often give up decision-making authority, which can be problematic when disagreements over critical business decisions arise.
On the other hand, with debt financing, entrepreneurs pitch their business ideas to potential investors, like banks or credit lenders, while keeping complete control of their company. Nonetheless, the fees and expenses you pay for those services can be high.
While deciding which financing option is most suitable for your business, there are other factors to consider.
For example, depending on the corporate structure of your company, entrepreneurs must also account for state laws that govern who gets paid first if their business fails. As a result, it’s essential to consult with a financial advisor, accountant or lawyer to determine the best funding option for your business.
Here are the most common alternatives to fund your startup:
Crowdfunding
Crowdfunding involves raising small amounts of money from many people through online platforms. This method can be an excellent choice for entrepreneurs with a compelling story or product. In exchange for their money, supporters often receive early-release products and other perks.
Beyond raising money, crowdfunding platforms allow business owners to market their products and services to their target audiences. Crowdfunding is also an efficient way to receive feedback about your products, engage with future customers and gather valuable insights before officially launching your business.
When a crowdfunding campaign is successful, entrepreneurs can do subsequent rounds of funding and even use that information as leverage to seek additional capital from other investors. Because of regulations, however, note that there are limits on how much money small businesses can receive from retail investors.
Friends and family
Another common practice to fund a startup or small business is seeking investments from close personal connections, such as friends, family members or even acquaintances. This type of financing is often easier to secure than traditional methods, and the terms and conditions may be more flexible.
However, there are potential drawbacks. First, personal relationships can become strained if the business does not perform as expected or the entrepreneur cannot repay the investment. Second, friends and family may have different levels of financial expertise than professional investors, which could lead to misunderstandings or disagreements. Despite these challenges, friends and family can be a critical lifeline for a new business – at least in the early stages.
Like any other personal matter, it is crucial to be transparent and honest about the state of your business while setting realistic expectations for repaying the investment. Additionally, it may be beneficial to consult with a lawyer to draft a formal investment agreement that clearly outlines the terms and conditions of the investment.
Small business loan
A small business loan is a type of financing provided to business owners to help them grow, purchase equipment, hire employees, or cover other expenses. Small business loans can come from various sources, including banks, credit unions, online lenders and government-backed loan programs, like the U.S. Small Business Administration.
The terms and conditions of small business loans vary depending on the lender and the specific loan program. Still, they typically require the borrower to provide collateral, such as property or equipment, and to repay the loan with interest over a set period. Consequently, it can be difficult for entrepreneurs to secure startup business loans, especially in the early stages.
Small business loans also have stricter requirements than personal loans, as lenders take additional risk when funding a new venture. According to the most recent data from the Federal Reserve, the average small business loan amount is $663,000.
Grants
Grants are money awards from government agencies, foundations or other organizations to support early-stage startup founders in underserved communities and other visionaries with purpose-driven, innovative products or services.
Unlike other forms of financing, such as loans or investments, grants do not require the recipient to give up ownership or control of the company. Also, entrepreneurs do not need to repay grants. For this reason, securing a grant is time-consuming and very competitive.
Most entrepreneurs and small business owners use grants as supplemental funding after tapping into more traditional sources of financing. Business owners can use grants for research and development, marketing, product development and other business needs.
Here are a few grants to consider:
- For tech programs: Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR)
- For early-stage education startups: 4.0 Essentials Fellowship
- For financial technology (fintech) startups: Visa Everywhere Initiative
- For financing small startup costs: Idea Cafe Small Business Grant Program
- For solo entrepreneurs: National Association for the Self-Employed (NASE) growth grants
- For sustainability initiatives: Patagonia Corporate Grant program
- For small businesses: FedEx Support Small Business Grant Contest
Bootstrapping
Bootstrapping refers to a self-funding approach where entrepreneurs use personal or company resources, such as profits or savings, to finance growth and expansion rather than relying on outside sources of capital, such as loans or investments. This method enables entrepreneurs to maintain control over decision-making and business operations. It also helps business owners minimize the amount of debt and liabilities on the balance sheet.
Bootstrapping can be an effective way to start or grow a business, particularly for entrepreneurs with limited access to capital. However, effective bootstrapping requires careful management of resources and a strong focus on profitability and cash flow.
Examples of bootstrapping involve using money from pre-orders to build a product, pulling back on operations to minimize expenses or reducing inventory.
Angel investors
Angel investors are wealthy individuals who fund startups and entrepreneurs in exchange for equity. Typically, angel investors use personal funds to finance these transactions, taking on higher risk than other types of investors, such as venture capital firms. As a result, they require higher-than-average returns on their investment.
Angel investors are important, especially in the early stages of a startup, because they can assist entrepreneurs in getting their ideas off the ground quickly. In addition, since angel investors are often successful entrepreneurs, they have the expertise and insights to run a business – a key factor in the long-term success of any company. Plus, they can also use their networks and connections to help entrepreneurs find additional sources of financing, customers, or talent.
Because angel investors risk losing their entire investment, partnering with them involves giving up a certain amount of control over business decisions, accepting stricter loan terms, and going through an arduous vetting process.
Venture capital
Venture capital (VC) is a type of private equity financing provided by investment firms or individual investors to startups and early-stage companies with high growth potential. VC firms extend funding in exchange for an equity stake in the company, expecting a high return on investment.
Venture capitalists typically invest in companies with unique products or intellectual property, a differentiated competitive advantage, a growing customer base, and a solid management team. Besides money, venture capitalists also support entrepreneurs with advice and other resources to scale their businesses.
VC firms comprise pools of high net worth individuals, pension funds, and other market participants looking for investments that can be too high risk for most banks and retail investors.
Bottom line
With proper funding and support and no shortage of hard work, startup founders can find the resources they need to build thriving companies. Ultimately, remember that even the most prominent founders today at some point needed someone to believe in their vision.
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