Every start-up funding strategy has its advantages and disadvantages. But how do you know which way to raise funds for your company?
Your decision depends on the amount you need, how much control you’re ready to give up and how big your start-up is.
We're here to help you make an informed decision. In this article, we explore the pros and cons of six popular methods of start-up funding.
Friends and family are usually a start-up's first exposure to funding. When needed, they provide the initial boost to start a business. The founders later 'graduate' to more formal funding methods as the business matures.
However, the importance of friends and family as a type of start-up funding shouldn’t be underestimated. Start-ups receive more than 60 billion USD a year from friends and family, more than angel investors and venture capitalists (VC) combined.
Your friends and family are more willing to invest in your company without looking at business results, legal compliance and other things formal investors look into.
They're also much easier to find than other methods where you need to apply, pitch and follow a legal process.
Speed is critical when building a start-up, especially in the initial stages. So using friends and family is a great way to cover early start-up expenses.
If your business fails and you can't return your investor's money, your relationships will be at risk. Moreover, investments gone wrong can lead to legal accusations of breach of contract or other financial disputes.
Most friends and family aren't as well-connected as angel investors or venture capitalists. This can hinder your access to much-needed professional expertise and investor networks to grow your start-up.
Friends and family may ask you for constant updates on your progress. They may expect to make business decisions now that they have a financial stake in your company, which can complicate your decision-making process.
TIP: Consider putting repayment terms and drafting a formal contract for any investment with a friend or family. Define in writing how much they can expect to be involved in the business.
A proper arrangement becomes a safety net to avoid any significant issues, and a guide about the steps to follow should anything go wrong. Clear communication is crucial here to navigate a potentially tricky situation.
Avoid assuming you can be casual and personal with these types of investments.
You already know them, but it's essential to treat this as a business relationship. Draft a solid business plan that explains how you're going to make your new company profitable. It should include your target milestones, financial information and business metrics.
Angel investors are affluent individuals who fund early-stage start-ups with their own money for partial ownership. Angel investors are different from venture capitalists who pool money from investors and combine the money in a managed investment fund.
Angel investors are usually business executives, other entrepreneurs or professional investors who make a living from investing. They invest relatively smaller amounts (USD25,000 to USD100,000).
Unlike loans, you don't need to pay back the original investment amount as the angel investor receives equity in exchange. Having an angel investor can help free up your time and give you peace of mind to focus on establishing your business.
Angel investors are usually veteran entrepreneurs. They have business expertise, industry knowledge and professional networks to support you.
Angel investors become your business partner and want to see your start-up succeed. They can connect you with potential future investors, business development opportunities or other forms of expertise.
Finding a credible angel investor can set your business up for success early and improve your survival chances.
An angel investor operates independently and focuses on early-stage start-ups. Because angel investors own their money, the due diligence process is usually faster and less complicated than with VCs.
On average, start-up founders exchange 20% of their start-up’s equity for investment capital. Bringing an angel investor onboard also means they become your business partner. They will be invested in your business decisions and can influence your direction.
Angel investors expect a significant return (sometimes even up to ten times their original investment over a five-year horizon). This creates pressure on you and your team to deliver results.
Start-up incubators invest small amounts at early stages. They support you as a company, and not as individuals like angel investors. Incubators are usually part of a broader, more structured programme.
These are fantastic for first-time founders. You learn from a structured programme and more experienced entrepreneurs who can connect you to investors for future fundraising efforts.
Start-up incubators come with nearly everything an early start-up needs. Incubators offer a company workspace, mentorship and funding support. Moreover, they grant access to professional services like lawyers and accountants, helping you save costs on overheads and operations.
Start-up incubators invest as a company. They're more likely to offer reasonable investment terms to start-ups.
Start-up incubator programmes are structured. They require you to submit a detailed business plan, disclosing all business activities.
Attending start-up incubators is like enrolling in a university degree. There's a fixed time commitment of up to two years, training and workshops to follow, and people to report to.
All this is fantastic if you thrive on a structured approach and need time to learn the ropes, but more experienced founders may want to give this a pass.
Approaching a venture capitalist or investor fund is similar to approaching angel investors. If accepted, the VC puts aside a sum of money and invests it in your start-up in exchange for partial ownership of your company.
In a venture capital fund, investment money is pooled from private investors to invest in high-growth companies. It does not come from a single individual.
VC funding is more common starting from Series A and above, as it involves millions of dollars in a single round. This isn’t for all entrepreneurs. They favour technology companies in biotech or communications and software with high-growth potential.
With VC funding, you can access more capital than in any other way. The average Series A funding amount is 15.7 million USD as of June 2020.
An endorsement by a top-tier VC firm acts as positive social proof about your company's progress. They also come with their professional networks, business expertise and other funding support that you won't be able to access otherwise.
The entire fundraising process takes months. You need to prepare, pitch and close a deal while running your business. You also need to be prepared for lots of rejection during fundraising.
Introducing a VC into your company requires more formal structures. You'll need to think about structuring a board of directors, board meetings and other organisational structures which take time away from actually running your business.
Bringing a VC onboard means you give up some ownership of your company to the VC. They'll also be involved in your business decision-making, and you'll need to answer to them regularly.
Crowdfunding is raising money through the combined efforts of a large pool of people who contribute various amounts of money. The most popular variant of crowdfunding comes in the form of rewards, where funders receive bonuses, early access and other perks for their financial support.
Crowdfunding campaigns act as viral marketing campaigns, generating a group of engaged customers and word-of-mouth marketing. This can provide an early example of business traction and idea validation. Therefore, it helps generate momentum as you speak to other potential customers or investors.
It’s easier to set up a crowdfunding campaign than to go through the pitching and meeting investors process. Crowdfunding also acts as a strong marketing and press coverage activity.
Putting your business idea out in public exposes you to a strong feedback loop. You may get ideas and questions about your start-up and business model from your backers. Feedback allows you to test and refine your idea, validate the market and engage with potential customers all in one.
Crowdfunders expect regular progress updates on the status of your business, and you need to be able to deliver what you promised if the campaign succeeds.
All the positive word of mouth and marketing you've generated during your campaign can quickly turn against you if you fail to deliver.
Crowdfunding works well if you're looking to start a consumer-facing product like a new tech gadget or designer shoes. It's less likely to favour technology or business-to-business (B2B) start-up companies.
Tip: Mention that you’ve invested your own money in your campaign to help establish trust in your backers.
Bootstrapping is when a start-up founder finances their business with personal funds and avoids external fundraising to build a self-sustaining business. It's a slower, quieter way of developing a business. You focus on making sales and increasing revenue to cover operating costs.
Bringing external investors on board comes with the cost of loss of ownership. Investors may influence your company's direction differently than you're anticipating, or set business targets you disagree with.
Bootstrapping ensures your team receives all your company's profits and you aren't answerable to anyone on your business decisions.
Fundraising in itself is a massive commitment. You need to spend time preparing pitch materials, prospecting investors, meeting them and closing the deal.
Bootstrapping keeps you focused on your business goals and allows you to devote all your attention to growing your revenue.
External investors come with their professional networks and expertise. You also lose out on any credibility that an established investor brings to the table. Because of that, it may take you longer to grow a company without an initial investment.
Bootstrapping means you're entirely reliant on your savings or bank loans to fund your start-up. Growing a company and building a workable product takes time. Be prepared not to be earning much money for a while, which can land you into personal debt, especially if your business doesn’t take off.
Bootstrapping becomes more challenging if you're in a manufacturing, import or high-tech industry as these businesses require a more substantial investment to start.
Tip: Just because you've chosen to bootstrap your start-up doesn't mean you need to bootstrap forever.
One option is to rely on bootstrapping to establish your company and build a product without taking outside investment.
Later, when your company is more mature, look for external funding. This two-step approach may even benefit you as your company becomes a more attractive investment.
Each of these six types of start-up funding has its unique strengths and weaknesses.
To decide which one is best for you, think about your company’s current position and what you’re comfortable with.
Do you thrive in a structured environment and need more support beyond funding? Look at a start-up incubator.
Prefer to do things your way? Think about bootstrapping your start-up.
If you're looking at becoming the next high-growth start-up success story, explore angel investing and venture capital funding to realise your vision.