When you first move into the startup world, there’s this dreamy ideal that everyone’s all about the products and services that will change the world, no matter what it takes. But the reality is a little different. After all, there’s only one thing that really makes the world go round: money. Sure, your business could change the world, but if you don’t have the cash to get there then it’ll never happen. Funding rounds, capital raising, and accelerator programs are the focus 24/7 in startup land — but how do they work? Let’s take a quick look over all the different ways that startups can raise funding.
Equity
Equity funding is when a company raises funding by selling shares in their own stock. Essentially, you’re selling off little pieces of your business in order to raise the money you need. Most startups will opt to use this kind of funding during the very early stages of their business, as debt-based financing is hard to receive without 2+ years of operational history – additionally, equity financing doesn’t require the business to repay anything, only to share their profits. Equity funding can take a few different forms:
Angel Investments
Angel Investors are wealthy individuals who provide capital for a business in exchange for an ownership percentage. They can be prominent business people specifically searching for early startups to invest in, but it’s more likely they’ll be your friends and/or family, wanting to help you off the ground. While equity-based investing isn’t the only way that angel investors operate, it is one of the most common, as it allows the investor to have more say over how their money is spent. Typically, an angel investor will sit on the board of directors for a company they’ve invested in, or even enter a leadership role as a managing director or chairperson.
VC Firms
Similar to angel investors, but multiplied tenfold; venture capital firms are collections of investors that find businesses with a high growth potential to offer their capital to. VC firms likely won’t want to have a direct hand in company management the way an angel investor might, but their equity stake gives them the authority to have a say in major company decisions.
IPO
An Initial Public Offering (IPO) is when a company offers its shares to the general public for the first time. This allows the company to raise capital from public investors rather than the private sector of angel investors and VC firms. Hitting the stage where you’re willing to launch an IPO is a big moment for startups, and is never taken lightly. It’s a lengthy process to reach that stage, but once a company becomes publicly traded they are able to raise massive amounts of capital.
Crowdfunding
With the modern revolution that is crowdfunding on Kickstarter and similar websites, many venture capital firms saw an opportunity to create similar processes for capital raising. Whereas a Kickstarter is traditionally aiming to build, produce, and ship a single product by asking for upfront cash from the public, equity crowdfunding websites like Equitise, VentureCrowd, and OnMarket instead sell small numbers of shares – similar to angel or VC funding, but smaller in scale – to the public. In this way, investors can buy-in at much lower prices while still having a voice in the company’s direction. It’s also a great way for startups to gain awareness and social proof to attract more funding in the future.
Debt
Debt financing is the process of funding your startup through loans. Where equity financing causes startups to give up a degree of ownership over their business, debt financing causes them instead to give up on future profits, as the loans they use in initial funding will need to be paid back with interest. Often, banks and similar financial institutions will also be reluctant to offer loans to businesses without proven growth potential or a few years of financial records that prove they’ll be able to repay the debt. There are a few different kinds of debt financing:
Term Loans
Term loans are what most people typically think of when thinking of business loans. They operate the same way as traditional loans – ie, a business borrows money for a stated purpose and then proceeds to pay that money back over a fixed period of time at a fixed interest rate. If the borrower hasn’t been in operation for long enough to prove their ability to repay the loan it can be difficult to acquire, and they may need to provide collateral or pay additional fees to secure the loan. If a startup has to make a large purchase (like property, a vehicle, or specialised equipment), it’s often easiest on their finances to take out a term loan as they can essentially turn that one large purchase into a payment plan.
Line of Credit
In a similar setup to a credit card, a line of credit (or LOC) is a pre-set borrowing limit that a company can tap into at any time. The borrower can take money out as needed until the limit is reached. As the money is repaid, it can then be borrowed again. Using a LOC allows a startup greater flexibility with their spending at the cost of typically lower loan amounts and higher interest rates.
Merchant Cash Advance
Merchant cash advances (MCAs) are a form of financing that’s popular with retail or product-focused startups who are too young or don’t have the assets to provide security on a traditional term loan. MCAs are received from the same institution that processes payments for you, typically whoever supplies your payment terminal (if you have one). This company will supply your startup with a loan and then automatically take a fixed percentage of all sales made through their system in order to repay that loan. Similar to lines of credit, this form of financing can come with fixed borrowing limits and high interest rates, but they allow for fast and easy access to funds and removes the stress of worrying about repayments and cash flow problems.
This was just a quick overview of the more popular ways that startups can access the capital they need in order to grow their businesses. If you’re interested in more ways that Fractal can help your startup grow, check us out at fractal.com.au. Talk soon!