90-Second Lesson: How to Raise Money for Your Start-Up

The Big Picture: Three Basic Ways to Fund a Start-up

Here’s the big picture: there are three basics ways to raise money for your start-up: (1) use your own savings and any revenue your start-up may produce (the fancy term of art for this is “bootstrapping”); (2) you can borrow the money; and/or (3) you can sell part of your business to investors. These are not mutually exclusive options; many companies raise money using as many as all three of these options.

Bootstrapping

Bootstrapping is great because your company will not have to worry about repaying debt. Major problems with it, though, are: (1) your start-up may need more money than your bootstrapping can provide; and (2) even if you can afford to keep funding for the foreseeable future, all the risk is on you. This is why even serial entrepreneurs who have made fortunes from prior startups typically do not fund a new company they found by themselves.

Borrowing (a/k/a Debt Financing)

The option of borrowing certainly spreads the risk to others. And, if the interest rate at which your start-up can borrow money is low enough and if the other terms to which it must agree to be bound under the loan documents with its lender are reasonable enough, borrowing can be an excellent option. Those are big “ifs,” however.

Equity Financing

Taking on investors (a/k/a partners if a limited partnership, shareholders if a corporation, or members if your start-up is organized as an LLC) avoids the risk of defaulting on a loan and the expense of interest. However, once someone else has an equity stake in your company, they may have a seat at the table with respect to many decisions going forward because such investors will be equity holders of your company.

The Devil’s In the Details

The expression “the devil’s in the details” is appropriate when approaching financing. Three examples:

1. Despite the last paragraph, it is possible to structure the relationship between an equity holder and the company in a way that severely limits that equity holder’s seat at the table.
2. The lines separating these options are porous in that funding (i.e., the money provided by you, a lender, or an equity investor) does not have to be, and commonly is not, “straight” equity or “straight” debt. Rather, hybrid financing is common. A convertible note is a good example of this.
3. Bootstrapping is not really a form of financing in the same sense that borrowing money (i.e., essentially selling debt) or selling equity is. Those two things represent the legal and business relationship between the company and those providing the funding.

So, if you go back and read my first paragraph, you can rightfully point out that it is misleading. Well, guilty as charged but I did that with intention.

My point here is this: if you bootstrap and that bootstrapping involves taking money out of your pocket and putting it into the company’s bank account, you need to figure out what the legal and business relationship between the company and you is with respect to that transaction. In other words, will it be a loan or an equity infusion? The answer will depend on the answer to several questions about your particular situation.

Some Advanced Concepts

Not all Start-ups are Start-ups

If you are starting a business that you intend to own and operate, that business can be called a start-up in the sense that you are starting it up. You might start a repair business, a restaurant, a newsstand, or any one of an almost unlimited number of businesses and you could call each a start-up.  That is not the way the term is generally used, however.

The term start-up is really reserved for a newly forming, or recently formed company that has the potential to scale to a very large business that can make its founders, early employees, and early investors very wealthy. At least that is the way Financial Poise uses the term.

But we can get even more precise: if you are experienced in this area, you may want to fault me for using the term start-up to include companies that are both in the very, very early stages and those that are in merely the early stages.

In other words, this was another intentional oversimplification. But I think you can handle the truth now: the term start-up is, depending on how precise you want to be, narrower. The following chart shows you what I mean:

Who Might Invest?

Early investors in start-ups are commonly broken into the following categories:

• Friends & family — Most entrepreneurs fund the very earliest stage of a company’s development with their own funds as well as investments from friends or family members who personally invest in a company. Using the terminology in the chart above, these investors invest primarily in seed-stage companies.
• Angel investors — An angel investor is an individual who provides capital from his or her own funds to a private business owned and operated by someone who is neither a friend nor a family member. Angels invest predominantly in start-ups in among the earliest stages of development (using the terminology in the chart above, these investors invest primarily in the start-up stage and early-stage companies. Read David M. Freedman’s What is an Angel Investor and What Motivates Angels to Invest? for more.
• Venture Capital — VC firms attract funds from individual and institutional investors, all of whom are accredited investors. The fund manager uses those pooled funds to invest in portfolio companies, usually later in the life of a start-up as compared to angel investors, but sometimes dipping into the earlier stage as well. Using the terminology in the chart above, these investors invest primarily in early and expansion-stage companies. Read Alternative Assets and the “Average” Accredited Investor Installment #4 for more.
• Start-up Accelerators — A start-up accelerator is one way for entrepreneurs to obtain both financing and help in the form of other things, such as access to experts who can help with the business, important contacts, and physical working space. Read Brian Dixon’s How Start-up Accelerators Work to Grow Early-Stage Businesses for more.

©All Rights Reserved. December, 2020. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM