Raising capital is one of the hardest things entrepreneurs need to do to build their business. It is full of ups and downs and in essence it is a complete roller coaster. Things can change very rapidly as one morning things could seam to crumble and then all of a sudden a few hours later one may feel like is things heading in the right direction and the company is ready to change the world.
I dedicate one entire chapter on my book The Art of Startup Fundraising (which you can buy on Amazon here), to the different sources of capital that entrepreneurs can use to secure financing. However I thought that putting together a quick and summarized post providing some light on this subject could be useful.
As time goes by and you continue to execute on your business the financing cycles will also vary as seen on the graph below. This means the sources of capital in which you will be tapping into will be different from a Seed stage financing to perhaps a Series A or Series B round of funding. Having a clear understanding of what applies to the stage and size of your business is critical as time is your biggest resource and you don’t want to speed it with people that are not in a position to invest in your business.
Bootstrapping really means launching and growing a startup with resources that you already have, and pulling yourself up with a little grit and sweat equity. Technically you could be bootstrapping if you have a six-figure retirement you can tap. Most are working with substantially less, although it’s also true there are plenty of startups that are now worth billions that were started with $1,000 or less.
As a good example, I like the story of dating site Plenty of Fish. The founder bootstrapped the business by paying operating costs with Google ads and barely raised money from outside large institutional investors. The company was recently acquired for $575 million in cash by Match Group—definitely a one-of-a-kind success story.
Bootstrapping at the start has many benefits, even for those hoping to raise billions in capital later on. But underestimating the cons can be perilous for startups and solo entrepreneurs. From my perspective, the number-one benefit is that you do not need to report to investors who have expectations, and you are not diluting your equity position.
A Spartan lifestyle is the norm for many bootstrapping entrepreneurs. Supplementing a ramen diet with cans of cold tuna and warm hand-mixed protein shakes while sleeping in a car in Silicon Valley isn’t for everyone. Those with a little more in resources can trim the fat from their personal budgets with public transport, creative living arrangements, and forgoing the $10 frothy lattes unless they are meeting with prospects. Master this and you will certainly learn to maximize every dollar in life and business. You’ll also find a new appreciation for everything, including a new level of gratitude for the privilege of being able to launch and run your own business. This is a valuable and prized mentality and spirit when it comes to leaders of all sizes of business.
This spirit and financial wizardry can be appealing to other capital sources and investors. That is providing you can portray that you will continue this level of frugality, and precision when it comes to working with their money. Because the truth is that if your product, service, or business works without money, more capital can add to the profit margins, and top line revenues. If it doesn’t work without money, it may never be sustainable, no matter how much money is poured into it.
Besides cramping your lifestyle it is also essential for founding entrepreneurs to recognize the very real implications, limitations, and risks blind bootstrapping can have on a startup venture. While too much money in the hands of the inexperienced and undisciplined can be a negative thing, too little capital is, unquestionably, one of the most common reasons why businesses fail.
To minimize the amount of outside debt and equity financing needed from banks and investors, companies that are bootstrapping will look at:
- Personal income, savings
- Personal credit card debt
- Sweat Equity
- Joint Utilization
- Operating Costs as low as possible
- Inventory Minimization: fast turnaround
- Subsidy Finance
- Selling: cash-only approach
In order to make bootstrapping work for you, you’ll have to master the following.
- Guerrilla marketing
- Time management
- Growth hacking
Are these your strengths? Are they the strengths of one of your cofounders? If not, long-term bootstrapping may not be for you. It takes time for even the greatest products and business models to scale, build their own capital, and sustain themselves. And if you wait until you go flat broke, that can be a big turn-off to other sources of capital. All you’ve proven is that your idea wasn’t financially viable. Or at least that you don’t have the skills to make it profitable.
So understand the good, the bad, and the ugly of bootstrapping. Embrace it. But respect its limitations.
2. Friends and Family
Raising capital for a startup can be very controversial. On one hand it can be one of the very best sources of early-stage startup funding. On the other hand it can be one of the biggest regrets many entrepreneurs will have to live with. So why do it? How do you minimize the cons?
The pros of fundraising from family and friends:
- Easiest and fastest investors to obtain funding from
- Borrowing or fundraising costs are minimal
- More attractive terms
- More slack when you need it
- Less pressure, which can decrease mistakes
- Helping your friends and family
Raising capital from friends and family is about more than just bringing more money in. It’s about giving, sharing, and strengthening your venture from the ground up. If your friends and family don’t believe in your venture, you are going to have a hard time convincing others to back it, or buy it.
Other investors are certainly going to want to know why your friends and family didn’t want to invest with you, too. If you are on to something great, and you are convinced it will be a success, why wouldn’t you want your friends and family, those whom you love most, to participate in and benefit from your idea? What if a member of your family or close circle of friends launched the next multibillion-dollar startup and never offered you a chance to get in? You’d probably be pretty hurt.
Opportunities like these can be life-changing for friends and family. It’s not just about making them rich. It’s about setting them up to be able to provide for their families.
So why do so many hold back from throwing this lifeline to those they care about most?
No founder launches a startup believing it will fail. Statistics Brain shows that small business failure rates have declined as of 2015. Research compiled from the University of Tennessee, Bradley University, the Small Business Development Center, and Entrepreneur Weekly shows that as many as 58 percent of businesses in some industries are still operating after four years. That is in stark contrast to a decade earlier when over 90 percent of small businesses were expected to flop soon after launch. But losing investment capital given by friends and family can be devastating for relationships. And relationships are far more valuable than any amount of funding. They are priceless. No entrepreneur wants to sacrifice them.
Just imagine how awkward Christmas dinners could be. They could become more of a shareholders’ meeting than a proper dinner with the people that you love.
On the bright side, asking for assistance from family can help entrepreneurs to really put their all into their ventures. And it can increase the number of individuals invested in making a startup work. If properly approached, any risk of tension can be lowered, too.
New Jersey–based fund manager Fuquan Bilal says that he crosses this bridge by proving his theories work and producing results with his own money first. Only then will he permit friends and family to participate, with amounts small enough so that any disappointment won’t cause them to stop talking to him.
In order to stay organized and businesslike and protect everyone involved, document everything clearly and make sure everyone understands and is comfortable with the risks. Make sure you tell them there is a high probability of them not seeing that money ever again and ask them if what they’re willing to give is money that they can really afford to lose.
While some individuals are just now discovering crowdfunding, it has been online since at least 2008. Since then crowdfunding has evolved to funding some of the most notable new startups and technological developments, and has been used by some of the world’s best-known brands, like Hard Rock.
In reality the principles of crowdfunding have been around for hundreds and possibly thousands of years. It is really about individuals coming together to finance a project or business startup. The roots of crowdfunding go back to Ireland in the 1700s and Jonathan Swift, “the father of microcredit.” In the times of the Tudors, kings and queens of different European nations came together to combine their resources for various campaigns. Hundreds of years before that time, the great empires of history brought together various crowds to conquer new territory, build roads, craft merchant fleets, construct colosseums, and more.
Today most notable developments and businesses are the product of some form of crowdfunding. Even Warren Buffett’s investment juggernaut Berkshire Hathaway, and the companies it owns and operates, is effectively a form of crowdfunding.
What most people refer to as “crowdfunding” today is online web portals that facilitate and streamline project promotion, and the raising of capital. There are now hundreds of crowdfunding platforms supporting different forms of crowdfunding, and different niches. Some specialize in real estate, others in well-vetted startup investments, and others in raising money for personal items like food and weddings. Two types of crowdfunding are donation crowdfunding and equity crowdfunding.
Donation crowdfunding is epitomized by platforms like Kickstarter. These crowdfunding portals allow promoters to raise money in the form of donations in exchange for unique perks.
Via donation-based crowdfunding, donors or backers do not enjoy any ownership or participation in the ongoing profits of a campaign or business launch. Most individuals donate to facilitate the development of things they care about, to support causes, and for the prestige of being among the first to launch a new product. The most-funded Kickstarter as of the first quarter of 2015 was the Pebble smartwatch. Between two campaigns Pebble raised over $30.5 million. Not bad for giving away products and keeping all your equity.
In the event you are able to raise money without giving equity away, I would absolutely encourage you to go this route. Donation-based crowdfunding is used nowadays to presell products. It works particularly well if you are selling hardware products or something tangible that you can give in exchange for the contributions.
Some of the benefits of donation crowdfunding include the following.
- Access to capital
- A great marketing tool to obtain additional exposure
- Obtaining proof of concept
- It allows to crowdsource the feedback process from potential customers
- Potential free PR
When backers decide to back a campaign they have arrived at the most important step in the process. This is called the act of impulse, in which the investor takes out his or her wallet and pledges money to your campaign. This act of impulse is the result of the following:
- Backers connect to the greater purpose of the campaign
- Backers connect to a physical aspect of the campaign, like the rewards
- Backers connect to the creative display of the campaign’s presentation
However, in the event you are operating a tech-enabled company, it is going to be a little bit complicated to go via this route, as there is only so much that you can offer in exchange for the contributions. Beta test, early access, and T-shirts are definitely not so appealing to this crowd.
Equity crowdfunding is a completely different tool altogether from donation-based crowdfunding. The mechanics of equity crowdfunding platforms appear very similar to donation crowdfunding sites but they are two completely different animals.
Equity crowdfunding enables individual investors, angel groups, and other capital funds to invest in the securities of private companies, and participate in their rising value and profits. Startups and small businesses are able to use these platforms to raise funds from a much broader crowd online, while increasing visibility and credibility, generating buzz, testing the waters, and proving the demand for their product or service.
The most successful offerings will be those that find the right platform match for their offering, which connects them with serious, qualified investors. (Data shows that crowdfunding has now become a common precursor to obtaining sizable venture capital and offers from venture capital firms.)
Keep in mind that right now, equity crowdfunding platforms are acting as fillers on offerings. This means that most of the time, the offerings that are shown on the platforms have an offering with terms that have been established by an offline investor. As of today there is a great amount of the offerings that are raised offline with the online financing being a small portion of the total amounts raised. If you are interested in raising capital online I would recommend using 1000 Angels, the company I cofounded, which is a private investor network that connects startups with investors. Note there are no fees for entrepreneurs on 1000 Angels to raise capital.
4. Angel Investors and Super Angels
High net-worth individuals make up the bulk of the ranks of startup investors. These individuals are often referred to as “angel investors” or “accredited investors.” The term angel investor comes from investors who financed Broadway shows in the past century.
While an angel is normally an accredited investor, this isn’t always true. And not all accredited investors are angels. Together, these individuals both have the finances and desire to provide funding. And for many reasons, they are among the most appealing sources of funding for startup founders.
While there are various levels and definitions of “high net-worth” individuals, accredited investors are defined as those with a net worth of $1 million in assets or more (excluding personal residences), or they have $200,000 in income for the previous two years, or a combined income of $300,000 for married couples. This is all according to the definition established by the Securities and Exchange Commission (SEC).
Angel investors are individuals who invest in startup businesses, normally in the early stages. This tends to be on seed rounds of financing and also Series A rounds. Super angels are those that invest checks north of $500,000 on Series A and up.
Angel investors fill the gap between friends and family, and more formal venture capital funds. Some invest purely for profit. Others look to make an impact with their funds by investing in causes and industries they are really passionate about. This can range from sustainable farming to education and healthcare startups.
Angel investors invest their own money, where the typical amount raised ranges from $150,000 to $2,000,000. Since angel investors are very often individuals who have held executive positions at large corporations, they can often provide fantastic advice and introductions to the entrepreneur, in addition to the funds. A Harvard report provided information on how angel-funded startups had a higher chance of survival.
Angel investments are high risk, which is why this strategy normally doesn’t represent over 10 percent of the investment portfolio of any given individual. What angel investors look for is a great team with a good market that could potentially return 10 times their initial investment in a period of five years. The exits, or liquidity events, are for the most part via an initial public offering or an acquisition.
According to the Halo Report, angel investors particularly like startups operating in the following industries: Internet (37.4 percent), healthcare (23.5 percent), mobile and telecom (10.4 percent), energy and utilities (4.3 percent), electronics (4.3 percent), consumer products and services (3.5 percent), and other industries (16.5 percent).
Data collected by the Kauffman Foundation shows that the best estimate for angel investor returns is 2.5 times their investment, even though the odds of a positive return are less than 50 percent, which is absolutely competitive with venture capital returns.
Reaching nearly $23 billion in 2012, angel investors are not only responsible for funding over 67,000 startup ventures annually, but their capital also contributed to job growth by helping to finance 274,800 new jobs in 2012, according to the Angel Market Analysis by the Center for Venture Research at the University of New Hampshire. On the contrary, venture capital firms invest in only 1,000 new companies per year.
While angel investors contribute about five times less capital to startups than VCs, individual investments in startups grew by 36 percent from 2008 to 2012, while venture capital investments dropped by 8 percent, according to Dow Jones VentureSource. The average angel investment grew more than 20 percent from 2011 to 2012, from $70,690 to $85,435, according to the Center for Venture Research.
The dominating geographic area, in terms of number of angel investments, is Silicon Valley; however, Silicon Alley is catching up quickly.
The following list gives six reasons these high net-worth investors are an attractive source of capital for you.
- They can lend additional value via advice from experience
- Ability to raise more money through fewer investors and contacts
- Fewer restrictions on raising money from accredited investors
- They may put in more money later on
- “Birds of a feather flock together”—angels can potentially give referrals to other angels
- Flexibility in terms
Note that a Stanford study reports that 90 percent of all seed and startup capital comes from angel investors. Wether you are interested in raising capital from angel investors or institutional investors (like Venture Capital firms) you will always need a pitch deck. I created a free pitch deck template that you can download below.
ACCESS FREE PITCH DECK TEMPLATE
ACCESS FREE PITCH DECK TEMPLATE
If you want to dig deeper into the pitch decks topic I would recommend reading my blog posts 14 Slides You Need To Raise Capital, Study Reveals The Pitch Deck That Will Land You Millions, and 38 Startup Pitch Decks From Companies That Changed The World.
Furthermore, angel investors are increasingly combining to form and join angel groups. According to historical data and the Angel Capital Association, the number of angel groups multiplied by from just 10 in 1996 to over 330 in 2013.
Super Angels and angel groups clearly often have much more capacity. And the reduced risk they enjoy as they pool money theoretically aids startups in negotiating terms.
During the past 15 years, angel investors have joined different angel groups in order to get access to quality deals. If you are not a Reid Hoffman, a Ron Conway, or connected somehow to one of the founding members of the startup, it was certainly very hard to gain access and participate unless you were affiliated with one of the angel groups.
Some of the biggest angel groups that are most active include the New York Angels, Houston Angel Network, Alliance of Angels, Golden Seeds, Launchpad Venture Group, Robin Hood Ventures, or Tech Coast Angels, amongst others.
5. Family Offices
Family offices often go unnoticed or unrecognized by many entrepreneurs and startups. But they are a very significant force in the investment world and capital markets, so much so that they effectively lobbied Congress to provide an exemption to family offices under the Dodd-Frank Act. In the Wall Street Journal report “How to Bank Like a Billionaire,” family offices are revealed to cost as much as $1 million a year to run, and until recently have been the exclusive domain of the $100-million-plus, high net-worth crowd.
We’re talking about Rockefeller-level money. Now affluent families with $5 million to $10 million to invest may participate as a part of a multifamily office for efficiency and cost savings. This is a lot of capital that is waiting to be invested, and a source that is often neglected by others.
In my experience, family offices always have a good amount of capital to be invested in high-risk investments like startups. These types of entities make decisions and move very quickly.
6. Venture Capital
Venture capital (aka VC money) is perhaps the most commonly sought-after type of capital by entrepreneurs today. It can also be the most difficult to land, and takes the most amount of work. Definitely an area where you need to nail it on your pitch deck and use the concepts that I outlined above. If you want to have a clear understanding of the dynamics behind venture capital firms you should read carefully chapter 7 of my book “Understanding the VC Game”. As I mention above you can buy it on Amazon here.
The rewards of getting funded by a big venture capital fund can go far beyond the cash and ego boost. But it does normally require investing in a good pitch, pitching materials, getting out to make personal connections, and a lot of time in prospecting. For some this is nothing more than a huge and costly distraction. For others it is the ultimate goal. Getting financing from a VC takes time and multiple conversations.
The Small Business Administration (SBA) describes this type of equity capital as being essential for “successful long-term growth for most businesses.”
True venture capital differs in that it is provided by organized funds and entities. These entities pool the funds of angel investors, family offices, sovereign funds, high net-worth individuals, and others. They primarily seek early stage, high-growth potential investments. While the percentage of funding that VC firms offer may actually be far less than that of individual angel investors, these companies generally seek to make investments in at least the $1 million–plus range.
The National Venture Capital Association says that around 600 to 800 of the 2,000,000 businesses launched in the United States each year obtain VC funding. In turn this is said to be responsible for more than 10 percent of national private sector jobs, and over 20 percent of GDP.
Finding a good match in a VC firm is critical. Pitching the right matches makes all the difference in terms, and the amount of resources expended before securing funding.
Paul Graham of Y Combinator notes that there is a massive disparity between VC firms. The largest and best known can be tougher to negotiate with, yet the mere association can help catapult success. Other lesser-known firms may be easier to negotiate with, to acquire better terms. But Graham warns that some firms may tie up founders without providing funding, or can attach negative connotations to a venture. The most successful startups will raise venture capital from multiple VCs.
I would like to caution entrepreneurs here. You do not want to raise venture capital money at an early stage where you are still trying to figure out product and market fit. The reason behind this is mainly due to signaling issues if VCs invest in your seed round but then decide not to invest in your bridge round or Series A round. That would send a very negative message to the market that could ultimately cost you the business.
When you bring onboard VCs that means that you know that if you invest X, you will be able to produce XYZ. If you are not sure, then do not take the money and instead delay until you have a little bit more certainty on the horizon.
We will dive deeper into how VCs work later on.
7. Venture Debt
Venture debt is effectively borrowing to raise working capital and growth capital. This is a valuable source of funding that doesn’t mean giving up more ownership or diluting equity.
Venture debt financing differs from other sources of money in that it is normally provided by specialist entities and banks that offer their services to funded startups and growing businesses. They understand the dynamics of a startup, and will often lend, even though asset collateral may be weak.
These lenders offset risk by tying loans to accounts receivable, equipment, or rights to purchase equity in a default. A healthy startup can find venture debt attractive in order to allow more time between equity funding rounds so that more notable milestones can be achieved. These funds can also help speed through milestones to reach the IPO stage faster. However, it is critical for founders to ensure their early funding term sheets allow for venture debt to be used as they grow.
All of the above sources of capital can be used by startups. It is normally not a matter of choosing one or two, but rather putting them in the right order to maximize funding, venture potential, and achieving the best exit or IPO.