Should you pursue external funding opportunities?
Startup funding is usually associated with venture capital and highly valued technology firms. In reality, venture capital funds only a small percentage of companies. Many more companies are funded by personal debt, loans, and investments from friends and family. Deciding how to fund a business can be challenging, in part because of the variety of funding structures available. Each type of funding has its own risks and rewards for the business and its founders. This article will describe the most common types of external funding. It will also explain which business models are most suitable for external funding, and the reasons why one might seek — or avoid — external funding. Finally, we’ll talk about some of the questions entrepreneurs should ask themselves before accepting an offer of funding.
Types of Startup Funding
Startup funding can be divided into four broad categories. The first, and most common, is personal savings and debt. The second category is business debt from loans and lines of credit. The third is funding from friends, family, and business acquaintances. And the fourth type of funding is from angel investors and venture capitalists.
Personal Savings and Debt
Majority of the entrepreneurs start with personal savings to fund their businesses. These savings may come in the form of cash, investments, or retirement savings. From the entrepreneur’s perspective, using personal savings means avoiding the interest rates associated with loans.
However, few entrepreneurs are able to fund a business entirely from personal savings. Personal credit cards and bank loans are another source of funding. The downside of using personal credit cards and bank loans is that the business owner is personally liable for repayment if the business fails.
Business Loan
About 40 percent of the capital in new businesses is debt in the form of loans or lines of credit. Business loans are offered for a specific amount of capital at a specified interest rate with specified repayment terms. Typically business loans are made for startup costs, as opposed to lines of credit for ongoing operating expenses are also common. Small banks that specialize in evaluating soft information, such as business plans and market research, dominate this field. The entrepreneur’s personal property is not used as collateral, so business debt provides more protection to the entrepreneur in the case of bankruptcy.
However, this may not be the case in developing countries with poor credit infrastructure. In such cases, even the business debt may have to be backed by a personal guarantee from the entrepreneur.
Family and Friends
New businesses often receive funding from the founder’s friends and family. This funding can be structured as a loan, where the person offering the loan is paid back with interest unless the business fails and is forced to declare bankruptcy.
The funding can also be structured as an investment, where the funder gets a percentage of the upside of the business if it succeeds. Typically, family and friends do not require any control over business decisions when they provide external funding.
Angel Investors
Angel investors are wealthy individuals who provide funding for a very early-stage company in exchange for a stake in its ownership. They usually invest small amounts. Along with the funding, they may offer mentoring and guidance to new entrepreneurs, or they may demand some control over business decisions.
Historically, angel investors have financed less than three percent of all new companies, and seven percent of the fastest growing companies. However, angel investing has grown exponentially in 2014-15. The successful IPOs of tech firms has created a crop of millionaires who have turned into aggressive angel investors. For some, angel investing has become a social status and these investors often participate in funding rounds with no lead investor and little due diligence – the so-called “party rounds“. Such rounds can result in a startups with a large number of angels since each investor contributes a small sum.
If each angel expects to “mentor” the founder, you can have a kitchen with too many cooks in it. Just the communication overhead of providing a polite ear to their advice (often conflicting or trivial) can drain your time. Therefore, if you are considering angel investors, you should avoid having more than a handful of them.
Venture Capitalists
Less than 1 percent of all new startups are backed by venture capital funds. Many individuals invest in these funds, which then invest these funds in a variety of companies in exchange for equity. New Enterprise Associates, Khosla Ventures and Sequoia Capital are three examples of Venture Capital funds that invest heavily in Asia.
Like angel investors, venture capital funds may offer mentoring and guidance and will demand certain control over the business.
External Funding Considerations
External funding in our context means when you are getting funded by angel investors and venture funds. It essentially refers to the sale of a partial ownership interest to raise funds for your startup business purposes.
Do You Need External Funding?
Many startups do not need external funding. To a large degree, the decision to look for external funding depends on the type of business you are starting.
External funding is most often used by high growth startups, businesses that will scale rapidly or that need to acquire equipment, personnel, intellectual property or other assets quickly. High growth startups, which have an innovative business model and/or large potential customer base, use this funding to establish themselves before competitors enter the market.
Lifestyle businesses and traditional small businesses rarely fit this profile. These businesses grow slowly and are not designed to scale. The main purpose of the business is to support the entrepreneur and his or her family. Most purchases are made from the business’ savings. If the entrepreneur carries debt, it is usually in the form of a small business loan, line of credit or mortgage.
Before searching out and taking external funding, it’s important that you understand the consequences of it. Below are some key points that you should consider.
Dilution of Equity
One of the biggest consequences of external funding is the dilution of the owner’s equity. Understanding how equity works is particularly important for entrepreneurs who intend to support themselves with the company.
When a business receives external funding, the owner exchanges equity in the company for capital to run the company. Every time you get funding, you give up a piece of your company. The more funding you get, the more company you give up. That ‘piece of company’ is ‘equity.’ Everyone you give it to becomes a co-owner of your company.
Consider the best case and worst case scenarios before offering equity. In the best case scenario, the entrepreneur will own a small piece of a large and successful company. However, in the worst case, it is possible to start a company and yet walk away with nothing. Protective provisions regarding selling or dissolving the company often require that investors get paid first. If the value of a business declines after an investment is made in it, a majority of the sale price may be used to pay back investors — and the owner could be left with nothing.
Loss of Control
Business owners have less control over the course of the company as their equity is diluted and more directors are being added to the board.
Many business decisions require a majority vote from the board of directors or from shareholders. This requirement can influence the direction of the company and hamper the business owner’s strategy. Examples of decisions that require votes include: making strategic decisions about the company direction, raising additional capital; selling the company; changing board members.
Conflicting Goals
Because external funders now have a voice in business decisions, conflicting goals among shareholders can lead to poor business decisions. Many investors buy in to multiple businesses, and may not have a deep knowledge of the business landscape affecting a single business. This tendency may contribute to the low success rates of VC funded startups. Overall, only one in ten companies funded by venture capital succeeds.
Many new entrepreneurs regard venture capital or angel investors as a sign of a successful business model. It is important to note that the ability to obtain venture capital or angel investors is neither a measurement nor predictor of a business’ success. On the contrary, obtaining this funding too early can cause the company to disperse its efforts among many products. Without focused development and problem solving, the business fails to develop any standout products and does not connect with customers.
Protective Provisions
Protective provisions are a standard part of most venture capital deals. These protective provisions give the venture capital fund, which holds a minority position, the right to block certain business actions. Accordingly, even if the Board of Directors authorizes a particular action, the consent of a certain percentage of the preferred stockholders would be required prior to the company taking such action.
Each subsequent round of funding usually carries its own protective provisions. Protective provisions can prevent the business owner from taking certain courses of action and contribute to a loss of control over business decisions.
Ask Yourself
Entrepreneurs who choose to pursue external funding should ask themselves the following questions before agreeing to external funding.
How much funding does the business need?
Understand your funding requirements by calculating your runway needs for the next 12-18 months. Can you meet these needs through existing sources?
Is the business marketable enough to receive competitive funding offers?
Many outside investors are likely to demand a higher stake and less agreeable terms when your product/service is in the early stages of inception and its prospects are ambiguous. In such case, it will be a better idea for you to fine-tune your product/service and business model in a stealth mode first and seek funding only when you can present a high degree of certainty about its prospects.
Do the funder’s goals align with your own?
Venture capital firms typically have very different risk and reward cycles than entrepreneurs do. A typical venture capital firm will invest in multiple startups. VC funding is often designed as a 10 year investment instrument, so few investors expect to see returns in the near future. Does the funder expect feasible returns in a reasonable amount of time? If the funder will be offering advice and guidance, what experience do they have in your market?
Lean Startup
A way to avoid or delay the need for external funding
The lean startup is a philosophy that focuses on developing a minimum viable product and using business resources effectively. Lean startups are able to fund growth via sales to customers, thereby avoiding external funding. Lean startup processes include building a product quickly, measuring customer response, and using these findings to improve the product quickly. The business establishes a customer base early, and is able to use sales to fund growth.
Avoiding or delaying external funding via the lean startup or bootstrapping philosophies offers many benefits. Entrepreneurs have more freedom in the their business decisions and don’t need to court investors. Because their ownership stake isn’t diluted in early funding rounds, they’re able to maintain a larger percentage of ownership in their own company.
Entrepreneurs concerned about these issues often choose to bootstrap their companies. These bootstrapped companies, also known as lean startups, avoid external funding until the business has a successful product. Lean development focuses on a three-step process:
Customer discovery/Ideation
Customer validation
Customer creation
During the first and second steps, a lean startup focuses on conserving capital and maximizing profits. During the third phase, some lean startups look for external funding. These lean startups, particularly if they produce physical products, are excellent candidates for crowdsourced funding.
In this business model, the first step is a business idea or customer solution. The idea is prototyped, offered for sale, and refined. The company is funded by sales from customers, which are re-invested to grow the company and improve the product. Venture capital or angel investors are only sought to finance expansion once the company has a successful product.
By contrast, a more traditional startup model begins with a business plan. The entrepreneur then seeks funding. Product development rarely begins until the company is funded. Profits from sales to customers are divided among a variety of investors rather than re-invested into the company.
Conclusion
Traditional small businesses and lifestyle businesses, which grow slowly and are designed to support the entrepreneur, are better suited to bootstrapping. However, businesses with a novel business model and a large potential target market are good prospects for venture capital funding. Seeking external funding for these businesses carries certain risks: the owner’s equity is diluted and the owner loses certain control over the direction of the company. These risks can be mitigated by getting a better deal through increased transparency or reducing the amount of funding you need through lean start up methods.
