How to Identify the Best Financing for Your Startup
For years, launching a startup meant a lot of things, not the least the undisputed fact that entrepreneurs were entering the world of venture capital (VC). VC financing has long been touted as the primary — if not only — route to company growth, with few other options on the table.
But, especially in the early stages of a startup, this path isn’t the only option nor is it the best one.
This one-option-only landscape also isn’t conducive for large portions of the founder population that have limited access to VC funding. Women founders received just over 2 percent of the venture capital allocations in the United States for the past several years (and that went down in the last half of 2020). Latinx and Black women have it far worse, receiving 0.32 percent and 0.0006 percent of VC funding, respectively. And founders from lower socioeconomic backgrounds often don’t have access to a network to fuel the Friends and Family round that often leads to larger VC dollars.
Luckily, there are many other financing opportunities to consider in the early stages of your company.
Crowdfunding and equity crowdfunding are on the rise, allowing folks with a large network to collect smaller dollar amounts in high volume while demonstrating product demand. Existing and new debt-based vehicles are rethinking risk assessment, opening the door to many profitable business owners to access debt and credit. For companies with a healthy sales track record, invoice factoring is a good option to resource individual purchase orders.
One of the biggest first steps a founder can take is to educate themselves on these and other forms of financing options. With an understanding of the broader marketplace of capital, you’re better equipped to identify which is right for your business in both the short and long term and come up with a plan of attack.
How to Start
Before starting this process, entrepreneurs should make sure they’ve developed a six- to 12-month outlook from a projection standpoint and know what they have and need in terms of capital (this is something founders should be doing regardless).
From there, the following questions can be used to get closer to a financing match.
What Are the Growth Opportunities?
Is your company growth potential 25 times or closer to three to five times growth? This could mean the difference between targeting angel investors versus venture capital, as many angel investors are looking for lower return rates. There are also schools of companies that have never taken on dilutive financing and have made tens, sometimes hundreds, of millions of dollars in revenue.
Is the growth opportunity quick or will it take longer? Some investors want or need quicker returns. Likewise, some debt-based financing options may not be conducive to longer-term revenue growth.
Ask yourself how your company grows and use that timeline to inform what type of capital injection can facilitate growth.
How Big Is the Market (or the Market You Want)?
In the VC world, a number used often (and, for some firms, this is one of the biggest investment influencers) is total addressable market, or TAM. Many investment teams want to see this in the billions.
But what if your product has a large regional or local potential but perhaps a lower national or global one?
More importantly, what if you only want to focus on a smaller number of users? For instance, only 5,000 users. Perhaps there’s a quality versus quantity argument to serve. If those 5,000 users are each paying a yearly membership fee of $6,000, that’s $30 million in yearly revenue — entirely satisfying to many founders and funded very differently than if it were a 1,000,000-user target.
A founder with a lower-growth company that generates millions of dollars who’s able to take home all the profits or has a “small” exit is definitely still winning.
How and When Does Your Revenue Come In?
Do you have recurring revenue or do you have to repeatedly sell contracts? Predictable recurring revenue is smiled at in the venture capital space, while large contracts on a less-regular schedule can be attractive while obtaining a bank loan.
Is your revenue seasonal? Revenue-based financing, when a loan payback period is based on revenues coming in, could be a great option if so. This allows founders to breathe during the off-season and catch back up when revenues come back into play.
What are some of the triggers your company has that bring in money? Is it a freemium-to-paid model? Is it business-to-business (B2B) where you’ve got a lengthy sales process? What areas of your company do you need to resource to get to those sales? (A sales team? A digital marketing budget?)
How Much Money Do You Need?
This is an interesting question, and I generally see founders fall on both sides of the line: either thinking they need too much or too little.
When a founder overestimates the amount of financing they need, they risk everything from giving up too much equity to not being able to fulfill a loan.
But there’s also a risk in underestimating, which is something I’ve noticed more frequently in early stage deals recently, whether based on ownership or being frugal. In this instance, entrepreneurs risk having to seek out additional financing (of any form) earlier than they anticipated.
The answer to this question also allows founders to be strategic about putting together a 12- to 24-month financing plan that involves multiple types of capital. For example, using non-dilutive financing to seed six months of revenue growth, followed by a venture round at a higher valuation.
How Much of Your Company Do You Want to Give Up?
This seems like an obvious question but it’s important to think about at the early stages of your company. Once you start down the road of equity-based investing, you’re going to give away more of your company, potentially over the course of multiple rounds.
By taking a nuanced look at the ownership stake you have and want to have, developing a sense of both the gains and sacrifices that come from adding equity holders and going through dilution, you can flush out resource options that best support you as a founder in that journey.
Giving up ownership in your company is not a bad thing — it can often lead to quicker and larger returns — but being clear on that process from the beginning will help you avoid unintended and disadvantageous situations of ownership.
Do You Have a Product That People Could Evangelize Around?
Having access to a large community of potential customers or funders could play a big part in your financing decision. Crowdfunding or equity crowdfunding require much smaller check sizes than, for instance, angel investing or venture capital, and can be highly advantageous for people with a large personal or community network available, as well as those who don’t have access to a high-net-worth individual (HNWI).
If you’re a startup founder, you know the toils of capitalizing company growth and identifying the right type of financing has become more important in the startup journey.
Luckily, there’s a wide world of business financing out there that founders have at their fingertips. Being strategic about what type of capital you take can not only lower the risk of stalling growth or giving up ownership but also offers huge upsides for long-term success.