By Working Woman
So you have decided to be an entrepreneur and start your own startup. To make this a reality you are going to need money. So how do you go about financing your startup?
The most common ways of financing are seed capital, angels, and crowdfunding. Feeling lost in translation? Not to worry, we are here to give you an overview of your funding options and the things that you have to consider while you go about making your choice.
In the business world, financing options are divided into 2 main categories: equity and debt. Let’s see what each is:
|What is it||Directly invested into company and investors receive shares||Mainly: Bank loans|
|Investor’s involvement||Investors obtain some control over the company||External parties|
|Risk involved||Risk involved for the investor||Lower risks for the debt investors since they rank senior to equity|
The problem however is that these two options are actually not always possible for startup entrepreneurs. And if you are not one with money saved up, the chances are that you are not going to be able to secure a bank loan. And that is because as Schiwienbacher and Larralde, 2010 indicate, as a startup entrepreneur you don’t have either a stable cash flow to qualify for equity nor the necessary collateral to secure a bank loan (debt). By now you are probably thinking “What was I ever thinking, starting a startup?” Before, you put all your entrepreneurial dreams to rest, know that although there are financial hiccups involved, there are solutions and that is what we are here to do. So let’s proceed with the available options:
You might actually be in a position to fund your own venture, in which case, great for you. We would only advise you to consider getting involvement from investors anyway and here’s why: whether you are the sole founder or not, at this point your goal should be to make money out of your business. Merely focusing on keeping your stock isn’t guaranteed to do that and as Jayawarna, Woodhams and Jones (2012), state, it is also a risk to personal finances and ties (if you borrow from friends and family). Plus in order for your business to grow, self-funding will not be enough and opportunities might be lost.
- Seed Capital
Seed capital is initial capital, to help you cover your first expenses while you are developing a prototype, hence the term seed. At this point, your investors are likely to be individuals who are rich or specific funds that are referred to as “angels” and their version of a “business” plan they’ll need from you is a description of what you plan and how you plan to do it along with your curriculum vitae. Note at this point that in order for angels to invest, you need to have a company set up. Angels, apart from being rich individuals are also people who look into investing into something sound and worthwhile. What will it take them to invest? Well, apart from the what and the how, if they find your plan sound and plausible, they will require stock in exchange for their money’s worth. As David Ehrenberg in his article, argues, because angels have other means of making money, they will usually require less of your stock or percentage of your company.
- Venture capital firms
As seed capital is the initial money to help you get started in your business, as you grow, you are very likely to need additional funding and that funding, may be provided by venture capital firms. As the amount required is greater, it is expected that the demands of the investors will be greater leading to a higher level of control or decision making influence over the company (by bringing in their CEO of their choice for example). Issues to consider at this point are that although venture capital firms have the necessary capital to invest, they might lack in actual expertise (especially if your startup is technology-related) which can backfire if they need to be involved in strategic decision-making. On the other hand, like in any exchange you still have negotiation power, given there is not only 1 venture capital firm out there. Try to get the best deal possible, meaning getting funding, with least release of control. You also need to be careful of the information you’ll disclose as these are people who might one day or already be investing in your competition. In this case it is wise to secure your ideas, through intellectual property rights, prior reaching out to potential VCs (Schwienbacher and Larralde, 2010).
Crowdfunding allows you to fund your startup by drawing relatively small contributions from large crowds. Crowdfunding draws characteristics from the concept of crowdsourcing, whereby many people, especially from online communities, come together to provide ideas, services, tasks, things, which traditionally would be provided by employees or suppliers. In the case of crowdfunding, the contribution is solely capital-related and as Mollick (2014) indicates, more and more entrepreneurs use it as seed capital.
So, that’s great, right? Well, yes, but even in this case there are certain things that you need to be made aware of prior to deciding whether crowdfunding is the way to go. On the plus side, unlike angels and venture capital, decision-making stays with you. It is likely easier to obtain since there is a plethora of startup entrepreneurs in comparison to the number of venture capital firms and what’s more it gives you the chance to test your product’s or idea’s marketability. This rests on the concept of the wisdom of the crowd, whereby if a large number of individuals believe in the idea to fund it, then it is likelier to succeed.
Be aware though, that it is a challenge to manage the administrative and accounting task of recording and rewarding all those people, not to mention that you need to consider the tasks involved once those investors become shareholders and you need to calculate the share of profits each one is entitled to. Another concern is safeguarding your idea from being stolen. Last but not least, you have to be careful in choosing a trustworthy platform.
There are ways however, to work around those issues. Social networks can help with the trustworthiness issue. When friends and families recommend the business through those networks, others are more likely to contribute. Also, there are ways of securing your information (business plan, shareholder contracts, etc) in websites requiring private logins and signing of non-disclosure agreementw. That allows for major filtering of users and safeguarding that only people serious about investing would participate (Schwienbacher and Larralde, 2010).
So, now you have an idea of the financing options available to you and the pros and cons of each. Depending on your startup needs and preferences, you can proceed to the financing type you consider best for your business. Seed and venture capital are more established options while crowdfunding is a novelty. However, as we live in a network-based economy which is constantly evolving, crowdfunding which is largely rooted in the concept of crowdsourcing and online networks, can prove to be a very valuable tool. There are ways to protect yourself against potential pitfalls, as there are a number of emerging crowdfunding sites to help you overcome them.
Check out Forbes library of the top crowdfunding sites:
Crowdfunding. (n.d.). In Wikipedia. Retrieved April 2, 2016, from https://en.wikipedia.org/wiki/Crowdfunding
Ehrenberg, D. (n.d.). The most common funding types for young startups, explained. Small Business. Retrieved from https://www.aabacosmallbusiness.com/advisor/blogs/young-entrepreneurs/most-common-funding-types-young-startups-explained-180127980.html
Graham, P. (2005). How to start a startup. Retrieved from http://paulgraham.com/start.html
Jayawarna, D., Woodhams, C. & Jones, O. (2012). Gender and alternative start-up business funding. Competition and Change. Vol. 16(4), 303-322 doi: 10.1179/10245294 12Z00000000019
Mollick, E. (2013). The dynamics of crowdfunding: An exploratory study. Journal of Business Venturing 29(2014), 1-16
Schwienbacher, A. & Larralde, B. (2010). Crowdfunding of small entrepreneurial ventures. Handbook of Entrepreneurial Finance, Oxford University Press, (Forthcoming). Retrieved from http://ssrn.com/abstract=1699183
Taylor N. F. (2015, July 29). 14 creative financing methods for startups. Business News Daily. Retrieved from http://www.businessnewsdaily.com/1733-small-business-financing-options-.html
Valanciene, L. & Jegeleviciute, S. (2013). Valuation of crowdfunding: Benefits and drawbacks. Economics and Management. Vol. 18(1), 39-48 doi: 10.5755/j01.em.18.1.3713