Wondering how to finance your startup? You can buy books on that topic, take courses, and hire consultants. It’s complex and it changes fast for different times, places, and financing options. But for people just looking at this question for the first time, here 10 general rules and guidelines.
Warning: There are exceptions in every case. This is business. There are always exceptions. Also: I’m not an attorney and not a commercial lender. There is no legal advice here. I’m just trying to summarize what I’ve seen. And this is about the U.S. market only. Some of it might apply to other markets, but if you’re not in the U.S., please double-check before assuming it does.
1. Start with a number
You have to start with knowing how much you need. It’s not a random number, and it’s not how much you like. You look for the startup sweet spot, as set by the business plan.
2. The main sources of funding aren’t what you think
The main sources funding new businesses are personal savings, personal debt, commercial debt, friends and family investment, and outside investment. Debt means you pay it back or lose your collateral, and investment means you don’t pay it back but investors own a share of your business. This doesn’t include alternative ways to get startup financing.
3. Using savings and personal debt is very common
Personal savings and personal debt are by far the most common sources of startup funding. Most startups take a few thousand dollars. The advantages of this include not having to ask anybody else and being able to start quickly. The disadvantage is that this money is at risk. If the business fails, savings are lost. And personal debt must be repaid or you lose credit rating and sometimes the house or the car or whatever.
4. Bank loans require collateral
Commercial lending requires collateral, like business receivables, inventory, or personal assets like your house. Banks aren’t allowed to lend money to startups without assets to pledge.
5. SBA loans relieve some of that risk
In some cases an SBA-guaranteed loan can lower the personal risk. You get these loans through commercial banks. The SBA (Small Business Administration) requires business plans and additional criteria depending on which of the various programs you use. The executive summary is that with most SBA loans you put up 30 percent of the startup cost, and get the rest from the loan.
6. Investment comes from many places
Investment divides roughly into friends and family, angel investment, and venture capital. Crowd funding may be available in the near future. And be aware of good reasons not to seek outside investors.
7. Crowd funding isn’t here yet
So-called crowd funding—finding large numbers of investors for small amounts each—is likely to open up soon but hasn’t yet. The current flock of crowd funding sites are really doing advanced sales or donations; it’s still not legal to sell investment through crowd funding. Last year’s JOBS Act opened up the possibility, but regulations to make it happen are still pending.
8. Friends and family are common (but dangerous) investors
Friends and family investment is the most common type. Do this carefully, and with good legal help, because it’s a mine field. It can work for a few thousand dollars up to a few hundred thousand, depending on your personal resources. It can also go dreadfully sour if not done right. Do your homework well on this option. Start with this article on friends and family financing.
9. Angel investment is rare
Angel investment is for a select few businesses that offer a reasonable chance of future returns on a few hundred thousand dollars. Occasionally that dips down into the tens of thousands. Real investors usually want scalable, defensible, high-growth businesses that can be sold in 3-5 years, with experienced management teams. The background includes three essential truths on getting investment and here’s what investors want.
10. Venture capital is even rarer
Venture capital is like angel investment but with professional managers of other people’s money. It’s harder to get and rarer. It takes strong management teams with good track records, very high growth potential, defensible, scalable businesses.
And that’s my best effort at a quick summary of the A-Z of financing that startup. I hope it’s helpful.