Any discussion on early venture funding should begin with what is needed based on the stage of the development. Most founders start the funding discussion with questions like, how can I meet venture capitalists to fund my new enterprise? The more savvy founder may ask the question: when is the appropriate time to start thinking about venture capital? Typically, this is the more astute question and reflects the basic fact that most founders will never be ready for venture capital or other equity-based funds. Look to any founder over the past decade, and venture capital is a minor contributor to total capital provided to new enterprises. In 2018, the Pepperdine Private Capital Markets Project demonstrated that venture capital was a minor contributor to total sources of capital, coming in at 1%. The more prominent contributing sources of capital came from bank loans and business & personal credit cards. Approximately half of all new startups get initial funding from credit cards. As you will see, bank loans are more challenging for small businesses unless they secure the loans with home or other significant assets. Most significantly, 35% of small enterprises had no financing.
There are several sources of funding available for new ventures. Below find the most common sources. Remember that for early-stage startups, self-funding, friends and family, crowdfunding, and loans are usually the most feasible options. I think it is worth taking these early funding stage methods seriously. As you will see, there are several advantages and little downsides. Along the way, you will learn how to focus, create a disciplined approach to your venture development, and possibly find ways to build your business without ever requiring outside funds.
This form of financing is usually available to highly motivated entrepreneurs committed to using personal resources to launch a venture. Most new businesses generally start with funds from personal savings or various forms of personal equity of the founder(s). This form of capital reflects the business founder’s degree of motivation, commitment, and belief. Personal investment can also include sweat equity, where owners donate their time or provide it below market value to help the business get established. Sometimes it is possible to pay the first hires with some ownership in the company rather than with a salary. However, the aspirations of these new hires must be in line with those of the founder(s); otherwise, a conflict may arise later, similar to when investors seek an exit. Also, in some cases, entrepreneurs use profits from previous endeavors to invest in their new enterprises.
When considering self‐funding, carefully decide how much financial risk you are willing to take. This decision is very personal and should involve other family members. Some entrepreneurs will stretch themselves to the limit and use every cent they have, including pledging all of their assets—their house—to the bank. Others are much more cautious. However, investors and lenders expect entrepreneurs to put some of their assets at risk, so entrepreneurs must learn to be comfortable with this scenario.
One self-funding strategy that works for many founders is to work on launching their ventures while maintaining full or part-time employment. Many businesses begin while the founder is still working a full-time job. The job’s income helps support the owner during negative or low cash flow and provides working capital to augment the business’s cash flow. Usually, when the company begins paying as well or better than the regular job, entrepreneurs can leave the job and devote all their time to building a new business.
Similarly, most people have skills that are valuable to established companies part-time, perhaps as an advisory experts. Skills can include deep technical knowledge, design skills, the ability to write computer code, or the like, which are currently in demand on a part-time basis. Perhaps the existing employer is willing to have the work performed for six months or so in a part-time capacity, continuing the current position while they recruit a replacement. This approach may be a better solution for both parties than just leaving the company. Having a source of “survival” income while the company is getting started removes a lot of stress and improves the chance of success. If a technical consulting assignment is available, the entrepreneur must make it clear who owns the result of the work—usually the client. Therefore, it is vital to document what areas are the entrepreneur’s property so that future opportunities are not hampered due to questionable intellectual property ownership.
While some experts lump bootstrapping as a sub-category of self-funding, it is different. In self-funding strategies, you use your money and resources to fund your business’s development and early stages. In bootstrapping, you effectively leverage both internal and external assets in the service of your venture. Subtle, perhaps, but still a different approach. The fact is that people that are good at bootstrapping can create space to develop their business model strategy and begin developing early versions of their product. The more time you spend engaging early customers with product iterations, the closer you get to validate your capacity to solve customers’ problems and meet their needs. The stronger the customer engagement with your product, the stronger your case becomes for future external fundraising. Bootstrapping is an integral part of your toolkit at this early stage of development.
One way to look at bootstrapping phase is to dedicate your time to pre-selling. Before you build any product, see if anyone will buy your product or service before it is ready. This approach works well with a service-driven business. If you can make it happen in an acceptable timeframe, you will have a sale without spending any development money. The critical point is that this only works if you can produce the product or offer the service within a reasonable period. And you need to manage your customer expectations about timing. You will find that early customers are often flexible about timing, but you need to communicate the product status transparently. Of course, this is not scalable, but that is not the goal. Instead, you validate the customer’s willingness to pay for your service. Either way, you are already engaging potential customers and learning more about their needs.
Family and Friends
Friends and family members are a prevalent source of startup capital because they are not as worried about quick profits as are professional investors. However, there are problems associated with this method. Usually, friends and family do not investigate the business very well and are not familiar with the company’s risks. In many cases, friends and family accept the word of the entrepreneur without any analysis or detailed review of the business venture. To guard against the risks of failure and to avoid being blamed for not disclosing all the essential information about the proposed venture, the best method is to provide the same disclosure to a friend or relative as to the most sophisticated investors. Entrepreneurs should always resist the temptation to keep the venture on an informal basis and not document the details of the company’s risks and financial requirements.
Crowdfunding is the use of small amounts of funds from a large number of individuals to finance a new business venture. While this approach is constantly evolving, they are several credible platforms, including Kickstarter, Indigogo, and Kiva. There are many benefits to seeking funding through crowdfunding campaigns. First and foremost, crowdsourcing allows the entrepreneur to validate the product-market fit of their offering while lowering the risk of product development. Many campaigns are structured as a pre-sell opportunity, thus allowing the entrepreneur to receive accurate data on how many customers are willing to pay for the product ahead of production. Crowdfunding is a great way to generate pre-sales for a venture with a readily available product. Secondly, crowdfunding campaigns provide opportunities to engage early customers through collaboration and regular conversation. Many campaigns are structured so that they must reach a specific monetary goal, or they cannot enter into full product development. In these cases, customer participation and commentary during the campaign can provide valuable feedback about the product’s value proposition. Finally, crowdfunding increases the capacity and breadth of your market research while reducing cost and time to market.
Entrepreneurs can also utilize various programs to support new and early growth ventures. Local government agencies and universities typically host these programs. There are private entities as well, such as Y-Combinator and TechStars. As the name suggests, the purpose is to provide a supporting infrastructure for new ventures through mentoring, training opportunities, and access to funders. Some incubators are associated with co-working spaces so entrepreneurs can have a place to work along with other founders, creating a robust learning community. Additionally, some accelerator programs offer funding, usually for a small company stake. The funding amount is typically negligible, in the $25-50K range, given for 5-10% equity in the venture.
Government Grants and Loans
There are many opportunities for startups to apply for grants and loans from federal, state, and local government agencies. These grants and loan opportunities vary in both size and purpose. These programs serve a specific purpose or need, so your venture must align with the program’s goals to be eligible. These government programs support early startup activities like product development, testing, and market validation. The funds often come with limited strings attached if you meet eligibility requirements. For example, the funds you receive do not have to be repaid, and the founder retains the intellectual property. On the other hand, loans must be repaid, usually with favorable terms. One thing to remember with all government programs is that the application process can be tedious, and there are always long lead times from initial application to awarding funds.
One of the most common forms of early venture funding is borrowing money from your local bank. The primary advantage of debt financing is that the entrepreneur does not have to give up any part of ownership to receive the funds. However, the loan has to be paid back with interest and may require the entrepreneur to guarantee part or all of the money personally. In addition, many loans have certain conditions (“covenants”) that come with them. Often these conditions are tied to specific milestones or events that the company must make for the loan to remain in place. These covenants are not so different from situations that equity investors might apply. Therefore, they often remove some control of the company from the founders until repayment.
For the formative stages of a company, before any substantial sales, an entrepreneur will generally be required to have some collateral to support a loan. The types of securities used for collateral include endorsers or cosigners, accounts receivables, real estate, stocks and bonds, and personal savings. Even if you are not willing to provide personal guarantees or cannot secure a bank loan at the outset, you should identify a local bank that has supported small companies and begin to develop a relationship with their in-house business banker. These relationships will be invaluable later as your company grows, and you can secure loans based on the company’s performance. In addition, bankers like to get to know you early on, and monitor your track record, before lending.
Understanding Financial Needs
There are several issues to consider as you identify requirements to start and sustain your venture until continually profitable. As a starting point, if your assumptions about revenues are costs are off, then your estimate about how much money you will need to stay in business and grow beyond break-even will also be incorrect. On the other hand, knowing when you can expect to break even and seeing gross profits from sales increase your fixed operating costs, increasing month after month is essential. So starting with reasonable financial projections and monitoring the data is an important first step in understanding your funding requirements.
Beyond the basic financial projections, there are some fundamental funding needs that you should consider to determine the total investment requirements for your venture. First, you should look at all pre-launch needs and costs. Two areas that can be pretty costly are product development and inventory. In the case of product inventory, it is challenging to determine how much early inventory you should have on hand to support sales and find a producer willing to manufacture and package in small quantities. Plan to spend a good deal of time researching and speaking with potential producers. For some industries, they have to build a whole ecosystem of partners willing to support starting inventory and packaging needs. Even if you have a good handle on your cash needs and the timing of required capital investments, there are no guarantees that the funds will be available when needed. There will be limited funding sources for many startups, each with a long line of eager founders requesting funds. You will need to resign because soliciting outside funds is an ongoing task that takes time. Each source will have its process for conducting its analysis and deciding whom to fund and when. While there is no way around this, you will need to be smart about the timing of funding rounds, considering it early in your analysis. In the best of circumstances, you will want enough upfront to provide time to gain traction toward profitability. But there will be plenty of times when this won’t be an option. One of the top reasons for business closings is their running out of cash.
It always makes sense for entrepreneurs who plan on seeking outside investors to delay this event until as late as possible. Investors like to see that entrepreneurs are not dependent on their funding but know how to complement their money with other resources. Every entrepreneur, therefore, needs to learn how to capitalize on early startup financing.
As a startup progresses successfully with its plans before seeking equity-based capital, the higher the company’s value is likely to be and, therefore, the lower the percentage of the company that to raise an equivalent amount of institutional money. Typical milestones that trigger a jump in the company’s value include:
- Developing a working prototype.
- Gaining a few paying customers.
- Having a patent awarded.
- Receiving a government grant.
- Signing up a larger company to test the development results.
- Getting some paying customers.
In upcoming posts, I will dive deeper into two principal funding sources for early-stage ventures, bootstrapping and crowdfunding. Both sources provide ample opportunities for entrepreneurs to test early product iterations with customers and validate that their business models are repeatable and scalable.
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