To be able to take off, every startup requires funding. In this article, we’ll try to answer the question “What is startup capital?” and explain how to attract it.
Startup funding for different stages
The type of capital a startup needs might vary depending on which stage this business is currently at.
- Seed capital — funds for the initial research and planning.
- Working capital, or startup capital — money used to pay for supplies, rent, equipment, payroll, utilities, taxes, insurance, etc. during the first year of operations.
- Expansion capital, or mezzanine capital — funds for scaling and improvement.
- Bridge capital — money to close the gap between current and next level of startup financing.
As the name of our article suggests, we’ll be talking about the startup capital.
Two types of capital for your startup
When launching a business, you can rely on two types of capital: debt and equity. Debt means that you borrow funds from people or organizations and pay this money back later. By doing so, you’ll retain full control over your business. Equity suggests that you don’t need to pay anything back; instead, you give a part of your company in exchange for money.
To determine which type of capital for startup suits you best, answer the following questions.
- Will anyone be eager to lend money to you?
- How much funds can you borrow from various sources?
- How hard will it be for you to pay back the debt?
- What will you lose if your startup fails to take off? Will you be ready to put up with such losses?
- Will your small business idea seem appealing to investors?
- Are you ready to let others control a part of your company?
- How comfortable would you be with letting investors know confidential information about your business?
- Will you be able to provide the investors with all the information they might require?
- How easy will it be for you to share your profits with third parties?
If you need a lot of money, it would be wiser to look for investors. They can give you more funds than you could borrow.
When calculating the minimum required sum, you should not only determine how much funds you need for a launch but also factor in contingent losses. You might need to hire more staff members, or increase the production volumes, or pay higher taxes because of a new law. Lack of financing is one of the top six reasons why new businesses fail.
How to make the most of various types of capital?
Now, we’ll talk about the following types of capital:
- personal savings
- FFF round
- business loans
- investors’ funds.
77% of small business owners rely on their personal savings in the initial stages of their companies’ development. This type of funding is perfect for startups that don’t need to hire staff members, rent actual office spaces, or manufacture physical products. Such companies spend most of their funds on marketing. If your startup belongs to this category, you can try to
- take money from your savings account,
- get a mortgage or home equity loan,
- ask for a personal loan,
- use pre-approved credit cards offered by various banks.
When asking for a personal loan, you might need to tell the bank how you’re planning to use these funds. If you need a larger loan in the future, the bank will be more eager to provide it after you prove that you have invested your own funds in your business.
Simple businesses, especially those from the service industry, can resort to bootstrapping. You get your startup going with the minimum investment from your own pocket. You make a profit on sales and use this income to grow your business. This approach is great for companies that don’t need staff members until they begin to scale.
Dot-coms can serve as an example of an industry where bootstrapping doesn’t work. Such startups need a lot of money for hiring and outsourcing professionals, advertising, and adjusting to the Internet environment that evolves at a very high speed. To take off, dot-coms require $50–100 million. Advertising consumes up to 50% of that amount.
FFF stands for “Friends, Family, and Fools.” These are people who would be the first to invest in your product. When asking for financial support from your dearest and nearest, you should treat them as professional investors.
- Pitch your business project to them.
- Inform them about the risks they might need to take.
- Compose a written agreement to specify the conditions of the loan.
- Be ready to answer questions.
Unlike banks or venture capitalists, your friends and family members will stay in close touch with you. They might ask you about your business’ development every few days. Some entrepreneurs perceive it as a considerable psychological pressure.
Before applying for a loan, you should ask yourself:
- Which assets can you use as collateral?
- When will you be able to pay the money back?
- How exactly are you planning to use the borrowed funds?
Banks are not too enthusiastic about financing startups that have not shown considerable results yet. Nevertheless, you can benefit from asset-backed borrowing. You’ll need to offer your house or car as collateral. The bank might not be sold on the potential success of your business, but it wants to be sure you can pay back the debt.
To increase your chances to succeed when asking for a loan, follow these easy tips.
- Call the branch of your bank by phone to make an appointment in advance.
- Stick to a formal dress code, try to talk and behave professionally.
- Bring a detailed business plan and all financial documents with you.
- Tell the truth without exaggerating your startup’s potential.
Be ready to answer the questions about your business and your financial status. But don’t try to sell your business idea to the bank since it’s irrelevant to them.
To boost your odds of getting a loan, you can ask a friend or relative to cosign the credit line. This person doesn’t need to invest money in your startup, all they need is a good credit record. You can pay them a fee for this service.
Venture capitalists and angel investors
You can think of this way of raising funds if your startup
- belongs to the high-tech industry or is extremely innovative,
- can grow very quickly,
- needs a lot of money.
An angel investor is a wealthy person who acts independently, without representing the interests of a fund. They tend to invest less than $100,000 and prefer to fund companies within their own geographical region. Instead of controlling your business, they will support you with knowledge and expertise. Your communication with them will be less formal than with a VC fund.
Venture capitalists can support any business if it seems promising to them. Usually, they would open a fund from where they will draw money for investments. The cash pool will be replenished by pension funds, companies, and wealthy individuals who’re interested in investing.
Typically, the fund would raise a fixed sum of money. It will distribute its pool among several startups. Most funds specialize in a certain type of business, selecting particular industries or stages of development. Such an approach enables investors to minimize their risks and analyze the chances of success more thoroughly. However, some funds can be ready to invest in a startup regardless of its features. But be careful, it still doesn’t make sense to apply to a VC fund that has never supported startups with the same characteristics as yours.
When a VC fund supports a business, within the time frame of 3–7 years, it expects the startup to be acquired by a larger company and go public/start selling shares on a stock exchange. In either case, the VC fund will be able to get back the cash it invested in the startup. Nevertheless, very few startups manage to go public. In 2019, VCs funded over 10,000 promising businesses in the US, yet only 82 venture-backed IPOs took place that year.
By going public, the company earns millions of dollars. If only one startup among those supported by the fund achieves this goal, the profit that the fund gets should compensate for the losses of investing in all the other companies. This approach can be characterized as “playing the law of averages”. The fund will distribute the profit among its investors based on the percentage each of them originally contributed.
How does the process of attracting venture capital look from a business owner’s viewpoint?
This is how you attract venture capital as an entrepreneur.
- You launch a business and realize that it needs funds to grow.
- You compile a business plan where you explain the results your company can reach within a certain time frame, adding how much money it can bring to investors.
- You find contacts of venture capitalists and pitch your business to those who might be interested in supporting your company.
- If a venture capitalist approves of your plan, they give you money during the seed round of investment.
- Over time, you’ll receive other rounds of investment (3 rounds on average).
- Finally, your business goes public or gets acquired by a larger company.
In exchange for financial support, you’ll need to give the venture capitalist a share of your company. The VC might require a seat on the board of directors. Alternatively, they might allow the company to only spend a limited sum of money per month, with extra expenses upon approval. The VC might also want to control the processes of hiring new specialists, asking for loans, and so on.
Entrepreneurs with little experience might think that attracting venture capital might impose too many restrictions on them. In fact, they will get much more than just money in return. The VC can help you get access to useful contacts from the industry. Plus, it can share valuable expertise.
How much equity should startups give to VCs in exchange for financial support?
Typically, startups and venture capitalists rely on this formula:
- Both parties agree on how much the startup is worth. It’s called the pre-money valuation.
- After the VC provides financial support to the business, the price of the latter grows. It’s called post-money valuation.
- The equity that the startup founder gives to the VC equals the percentage increase in the value of the company.
Normally, the VC gets control over 10–50% of the business. The shares of other investors will be diluted. The more rounds of funding take place, the smaller the shares of the initial shareholders.
How to sell your business idea to venture capitalists?
To attract the attention of venture capitalists and angel investors, you should build a strong network of professional contacts. In this case, your ability to find the contacts of an investor eager to support you is more important than your skills or background. VCs review thousands of business plans each year but support only a handful of them. You should do your best to impress your potential investor and convince them your business genuinely stands out from the rest!
Rule number one: VCs support only those startups whose management teams have relevant expertise. They will be unlikely to support you if you have distributed all the shares among your friends and relatives.
Rule number two: present your idea in the language that VCs speak. If you’re a geek, translate your speech into casual words. If you and your team members use slang, discard it in your presentation. Provide your potential investor with the answers to the following questions:
- What are the characteristics of your target audience?
- How much does it cost to produce your product?
- What’s the price of your product?
- How many units are you planning to sell in the first year?
- When will your business begin to generate profit?
- What are your long-term growth plans?
- What is your exit strategy?
- How much money do you need and how will you spend it?
Prepare your presentation in two versions: an elevator pitch (1–2 minutes long) and a full pitch (up to 20 minutes). It would be wise to create the pitch deck in PowerPoint and print it out. If an emergency takes place (such as an electricity outage), you’ll be able to hand out the papers.
Overall, you can’t be guessing or showing off when talking about your startup’s capital. Your presentation should only contain facts and figures. Instead of praising your business, let the VC get to know its essence. Think of which questions the investor might ask you and try to prepare the answers in advance.
How to find capital-providing startup financing?
The VC that funds your business should have enough expertise in your industry. Otherwise, they won’t be able to share their knowledge and network with you. Once you’ve detected a potential investor that suits you, try to collect exhaustive information about them.
Find the list of companies that this VC has supported in the past and reach out to ask the following questions:
- Were these businesses happy with their relationships with the investor?
- Did they get what they wanted?
- Was the VC too controlling?
- How eager is the VC to share knowledge and contacts?
- Would they recommend other companies to work with this VC?
The VCs themselves might help you get in touch with the startups that they supported. Besides, it’s important to have a good rapport with the investor and make sure that your tempers don’t clash.
Hopefully, now you understand the specifics of raising startup capital better. You can rely on your personal savings, borrow money from your friends and relatives, get a business loan, or attract venture capitalists. Before asking for money, prepare a detailed business plan. When choosing an investor, make sure they have expertise in your industry and can establish a beneficial and healthy relationship with you.