Entrepreneurs have quite a few options available when raising capital that generally fall into three categories – Bootstrapping, Debt and Equity.
Investors want to find the right fit. They want the right Location, Market Size, and Traction among other things.
Funding your business isn’t as easy as saying “I want to speak to investors who will give me a big check for my great idea!”
Even the best ideas often require a long period of proving themselves before any investor is willing to support them with a check. Along the way, there are several forms of capital that entrepreneurs use to address their needs.
How Most Businesses Get Funded
The most common way companies get funded starts with their own capital, which is known as Bootstrapping. They use credit cards, personal savings, and trading some stock in exchange for people’s time.
Most businesses do not start out with a lump of freshly invested capital from an Investor or Lender. That would be nice; it’s just not how it works.
The less you’ve done to move the business forward, the less likely you are to find outside capital.
You can expect to have to invest some of your own time and capital into the business before someone else will start putting outside capital into your company. If you don’t have a lot of cash to put into the business, you’d be expected to at least invest a lot of time doing market research, talking to potential customers, and putting your plans in place to make the business successful. Simply having a business idea certainly isn’t enough.
Once the business has been established, even if that’s as simple as incorporating and putting together the business plan, the search for capital may begin. However, the less you’ve done to move the business forward, the less likely you are to find outside capital.
Our experience in working with hundreds of thousands of businesses has suggested that you want to push the business as far as you possibly can without capital before you seriously begin looking for capital partners.
Debt versus Equity
There are two main sources of capital – Debt and Equity. Debt is capital you have to pay back, and Equity is capital you receive in exchange for stock in your company.
Debt tends to be more accessible than Equity since there are far more lenders in the world than Equity Investors and they tend to finance more types of businesses.
Equity is attractive because it isn’t based on your personal credit or collateral and does not have to be immediately paid back in the form of installment payments. It’s a lot harder to come by though.
Bigger Checks = Less Probability
Debt is capital you have to pay back, and Equity is capital you receive in exchange for stock in your company.
If you look at all of your capital options, the larger checks that come from Venture Capital Firms and Private Equity firms become far harder to find than the Bootstrap capital options you will start with.
That’s why most entrepreneurs tend to focus on sources of capital that are more probable and accessible first; so that they can build the traction they need in order to become attractive to equity investors later on.
The goal isn’t to prove that no one else will ever compete with you. It’s to prove that when they do, they will lose to you hands down.
Even Debt options in the form of SBA Loans and Lines of Credit tend to be easier to obtain due to the fact that there are more checks to be written and the process is more linear.
Despite all of these facts, many entrepreneurs will want to move straight to equity investors like Angel Investors and Venture Capital Firms. There are certainly instances where these groups will fund a company in its infancy but that tends to be the exception, not the norm.
If you’re optimizing for the likelihood you will find capital, our recommendation is always to start with Bootstrap capital and then move on to Debt and Equity options as you’ve built some traction in the business. Short of that, your risk of not finding an investor is going to be pretty high.
Evaluate All Forms of Capital
A good Funding Plan considers all forms of capital available for each stage of the business. As your company evolves, different forms of capital and investment types will make more sense for that stage of the business.
As your business evolves, you will migrate from simple forms of capital like credit cards and personal savings, to more complicated sources, like Angel Investors and Commercial Loans.
You can find yourself wasting a lot of time trying to leverage the wrong type of investment at the wrong stage of your business. If you’re at the Idea Stage where you’re still figuring out what your business might be, it probably doesn’t make sense to be pitching Private Equity firms who only fund companies with significant revenue.
As your business evolves, you will migrate from simple forms of capital like credit cards and personal savings, to more complicated sources, like Angel Investors and Commercial Loans.
When to Bootstrap
Most businesses start out by bootstrapping which includes using the founder’s personal credit and money from friends and family to cover startup essentials like incorporating, basic office supplies or maybe a domain name for their website.
Sweat equity contributions from the founder, team members, or service providers can also help move a startup along while limiting the capital spent to essentials.
Bootstrapping is a given for 99% of all small businesses nowadays. You should expect to utilize those personal credit cards, ask your friends and family for cash, and try to convince others to work for stock in exchange for a piece of your future success.
When to Use Debt
Debt options like business loans, larger lines of credit, factoring and other forms of financing are useful when there is a well-identified means to service the debt in place.
For example, if you were opening a restaurant and you knew that the loan would go directly toward building out your operation to begin serving customers and generating revenue, a debt product makes sense.
Where debt doesn’t make sense is when you are financing non-recoverable expenses, like salaries or rent. Every business has these costs, but without a very specific plan for turning those expenses into revenue, that can repay that expense, you may face serious problems.
There are a handful of debt options available to entrepreneurs very early in the company’s formation, such as the U.S. Government-backed SBA loan program. While these are government-supported, they still may require the entrepreneur to provide substantial planning and resources to support the loan.
Entrepreneurs often avoid looking into debt because it feels scary and complicated. The idea of creating a mountain of liabilities that are tied to you personally and having to go through a complex process to get there doesn’t sound very appealing.
Debt, however, is one of the most frequently used forms of capital used to launch businesses. Most other types of capital, like Angel Investors and Venture Capital, are most likely to be invested in just a handful of specific industries like technology and healthcare. For everyone else, a traditional loan is typically the most viable path to funding.
When to Use Equity
Equity is one of the most sought after forms of capital for entrepreneurs, although certainly the least available. There are many reasons, among them the fact that entrepreneurs do not have to tie their personal credit to the financing needs of the business.
Equity is valuable when the business requires an investment that will involve a high degree of risk without an immediate payback or return of capital. That’s why certain companies that require a long runway before they will start generating cash flow look to equity capital. They cannot be stuck making monthly debt payments when they don’t yet have income!
There are two disadvantages to using equity capital – it’s very hard to get and you will have to give up a percentage of your company to get it.
The reason the probability of getting an equity investment is low is simply because there are far more people looking for equity capital than there are those who write checks. Consider that over 6 million new businesses are incorporated in the U.S. each year yet venture capitalists alone only fund around 3,000 companies annually. That means the competition for these dollars is fierce.
The other concern for entrepreneurs involves giving up a percentage of their company. Once you sell a stake in your company, you’re not likely to get it back. That means you’re now married to an investor for the life of the company, and that can bring its own challenges.
Despite the challenges, many entrepreneurs are aggressively pursuing equity investors for their startups. Many cite the benefit of having other partners in their deal to help them grow the business and provide more connections, while others frankly point out that it’s the only viable way to fund the business.
When equity is available, most entrepreneurs jump on it. That said, most entrepreneurs are not given this option, and therefore must pursue other options like credit and debt to bring their companies to market.
Summary
What you’ve seen here is just a primer to the types of capital available. As you continue reading this section you can start to dig deeper into how each form of capital works and what’s right for you.
As you’re getting your head around the entire funding landscape, be patient. It’s a big issue to tackle and even experienced entrepreneurs haven’t dealt with all types of capital in their careers. All you need to know for now is how to understand which types of capital are available to you, and where to begin preparing your business for fundraising.