Sources of Capital For Startups
An entrepreneur without funding is a musician without an instrument.
Think of a startup in terms of this equation; I call it the entrepreneurship equation: vision + technical capacity + capital = startup.
In other words, a startup is born when a person (entrepreneur) gets an idea for a business, he either has the skill or finds a team to build the business, and he finds the financial resources to fund the operations for the project. These three pieces together lead to the startup.
While we have covered what makes a good entrepreneur and what to look for in a team in other articles, this article is going to focus on where (or from whom) to get the third piece: capital.
There are four main people you will talk to for startup funding: family members, bankers, angel investors, and venture capitalists.
Before jumping in, note that the founder of any idea should be expected to put skin in the game. It shows all of the below parties that you are serious. How can you expect someone else to put money down for something into which you have not put some of your own cash?
If you are the person who has a family member (grandson, nephew, cousin, etc.) asking for investment, remember what David Bahnson, VC and fund manager at Morgan Stanley, said, “Never invest more than 10% of your net worth into high risk ventures.” Chances are, your family member has not launched a startup before and therefore is considered a high risk venture.
The point: the first and foremost source of capital should be your own pocket.
The Family Member
Interestingly enough, it is more common for Americans to give money to friends before family to fund a business venture. In 2010, 5% of U.S. adults polled said they had provided funding to someone starting a business in the past three years, according to a survey by the Global Entrepreneurship Monitor, a research consortium which includes Babson College. Of those respondents, 32% said the funding went to a friend or neighbor, 26% to a close family member, 11% to some other relative and 8% to a work colleague.
This may not come as a surprise because putting money in between a family relationship will strain the relationship even if it goes well. As one who has received an investment sum from a family member to launch a startup, I recommend the following tips:
- Treat the transaction as you would with a stranger or banker. Have paperwork, clear expectations, and success/failure outcomes mapped out before taking/giving any money.
- Treat the family member as an adviser. Submit reports on a consistent basis of where the startup is at and how progress is going.
- To relieve strain and reduce risk, treat it as a loan instead of an investment. This is a guarantee to the giving party that they will get their money back with interest, whereas an investment can be lost if the business goes under.
If the amount of money goes beyond what family members can provide, the next place to check is the bank. Bankers want to give out money, it is their job. But they want to give it out responsibly and securely. It’s your job to convince them that you are a responsible and secure opportunity. To do this they look at your credit history, your net worth, income, and the business idea itself. To decrease exposure to themselves, bankers will often require collateral. In other words, if you are wanting a $100,000 loan, the bank may want your real estate — your home — to serve as collateral. Collateral is something pledged as security for repayment of a loan, to be forfeited in the event of a default.
In terms of financing your startup, a loan is a great way to access capital that is locked in at a set interest rate for an established term, and retain full control of your company.
But be warned. Investors hate debt!
The Angel Investor
At the same crossroads where family funding will not be enough, an entrepreneur can turn to an angel investor instead of a bank. This is where the important question of debt vs. equity financing come into play. Debt financing is simply getting a loan from a bank or lending institution. Equity financing is giving up ownership of your company in return for capital. The benefit here is the cost of the capital is monetarily free in the moment. But the disadvantage is down the road when your company exits (gets bought or goes public) you do not receive the full value of your company.
An angel investor typically invests $10,000 to $100,000 in early stage startups, and with a group of angels together, $1 million is not a long shot for a syndicated deal. Angels tend to be formerly (or currently) successful entrepreneurs so, depending on their time, expect an angel to lend their experience and potentially be “hands on.”
The Venture Capitalist
Moving up the scale, venture capital is equity financing (similar to angel investing) but is rarely invested in early stage startups. Rather, a venture capitalist will look for a stabilized venture already making sales. Venture capital is the large capital injection to take a proven concept and scale it to national volumes.
Another significant difference between an angel and a venture capitalist is that venture capitalists tend to be a company or a business rather than an individual. As a more sizable entity, a venture capital fund can dole out larger investments in sums of $1 million and more. Venture capital firms will often ask for a greater stake in the company, including a seat on the board, because they are investing a larger sum.