Finance

Startup Funding: How Does It Work and What Are Your Options?

Money. It’s a part of entrepreneurship, and at some point in your startup journey, you’re going to find yourself asking, “How can I get more of it to grow my business?” Startup funding may seem like a fancy, far-off world where Stanford dropouts pitch billionaires for veritable stacks of cash, but it turns out there are a lot of options for the rest of us.

Stop Googling “what’s a convertible note” and “what’s the best funding source new business don’t have connections help.” Sit back, relax, and scroll. We’re going to lay out everything you need to know about startup funding.

What Are the Startup Funding Options?

Every new small business needs money to operate. Before you can decide what kind of startup capital works for you, you need to know your options for potential investors and working capital. These are the most common sources of startup funding:

  • Friends and Family Funding
  • Seed Funding
  • Venture Capital
  • Grants
  • Crowdfunding
  • Business Loans
  • Business Credit Cards

Tips to Help You Navigate Startup Funding Like a Pro

Follow these 3 steps to navigate startup funding like a seasoned entrepreneur.

  1. Know your funding options: You have to know what all your options are in order to make an informed decision. This guide will give you a great starting point. You can bookmark it and keep it as a reference to navigate through the funding process. Before you decide to go down a single funding path, you’ll also want to spend some more time researching details like specific interest rate ranges or how to negotiate equity agreements.
  2. Know your business financials: In order to secure funding from any of these avenues, you’re going to need to know your business financials. No one wants to give you money if they think you don’t have a plan for it or can’t manage it successfully. If business finance is new to you, you might want to check out our course on Finance for Founders.
  3. Get financial advice: Ideally, you want to get advice from someone who is licensed to give it. Guides like this are great for informational purposes, but a licensed financial advisor can help you look at your specific business and financial situation and make suggestions about the best route for you.

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Understanding Each of the Startup Funding Types

There are costs and benefits for each of the 7 most common types of startup funding. Let’s break them down.

Friends and Family Funding

Many entrepreneurs choose to fund their startups with capital from their friends or family. The benefit here is that the funds are often easier to acquire through this route. You typically won’t have to complete several applications to get money from your parents, for example. For this reason, friends and family funding can be quick and easy… at least to start.

The same “handshake deal” vibe that can make this one of the fastest funding options often makes it one of the messiest. If terms aren’t clearly defined, the business relationship can get complicated, adding tension and strain to important personal relationships. To avoid the headache (and the heartache), put everything in writing. While it may be tempting to say “You’re my family—I trust you” or “We’ve been friends for years—we’ll be fine,” those sentiments tend to change when the business either does really well or really poorly.

If you received the money as a de facto gift, and then the business is wildly successful, the friend or family member who invested during your nascent stages may later request equity. If the business goes belly up (sorry, but it does sometimes happen), without a written term sheet, you risk your friend or family member declaring that the investment had always been a loan and they now expect repayment.

Friends and family funding is incredibly popular. A 2014 survey by the Kauffman Foundation found that 40% of startup funding came from friends and family. We’re not here to knock it. This funding approach is built on the strength of your relationships. Protect those relationships by clearly putting everything in writing. If you receive an investment from a friend or family member, you want to outline the total investment amount, any repayment expectations (and relevant terms), the equity the person will have, if they’ll have a board seat, and so on.

Angel Investors

Angel investors are independently wealthy private investors who invest in early-stage startups in exchange for equity. The funding-for-ownership model makes angel investors similar to venture capitalists but they differ in a couple of important ways. Angel investors tend to invest with their own money rather than through an established venture capital firm. An angel investment is typically awarded to an early-stage startup, and angel investors typically tend to show more patience with the entrepreneurs they finance. They don’t expect to see you immediately succeed and scale. They understand that there are hiccups to starting a business, and they typically don’t expect a return on their investment as quickly.

Venture Capital

Venture capital is a form of private equity and financing for entrepreneurs. A venture capital firm will typically invest later in the process, once the business has been established. The benefit of venture capital is that it gives you a lotta moola (technical term) and prestige. A venture capital fund won’t invest in your business unless they think it has the potential to deliver a substantial return on investment. Because of this, they tend to look for innovation that is poised to “disrupt” an industry (a term they seem to love to throw around).

So what’s the drawback of venture capital funding? A venture capital investor is looking for a return on their investment—sooner rather than later. Once you take on this form of funding, there will be extreme pressure to grow and perform. The ultimate goal for venture capital-backed startups is either an acquisition by a larger company or an Initial Public Offering (IPO). The pressure to grow quickly can be a boon for some companies, but it can also be too much, as we’ve seen with many a tech startup.

Grants

Small business grants can be an amazing opportunity to fund a new business, especially for aspiring entrepreneurs who may not have traditional access to other forms of funding. You don’t have to return a small business grant, so it’s essentially free money to give you the cash flow you need to make your dreams come true. Grants are especially well suited for businesses owned by traditionally marginalized entrepreneurs—women, People of Color, LGBTQIA+, and entrepreneurs with disabilities— and there are many grant programs specifically for different demographics. There are also specific grant programs for veterans and service members.

Mission-driven organizations are also well-suited to pursuing grant funding, as there are more and more grant programs popping up to support sustainable and socially conscious businesses that have the potential to fuel a regenerative economy.

The downside of grants is that they are highly competitive, and it’s often time-consuming to apply. If you decide to seek out grant funding, choose a grant program that matches your business. It’s better to take a targeted approach rather than casting a wide net. You may also want to consider hiring a consultant who specializes in grant writing to give you the best shot of securing a grant. If you go this route, make sure to ask the consultant for examples of grants they’ve secured for other businesses. You may even want to ask what the grant amounts were relative to what the consultant billed for help writing the grant, so you can decide if the investment is worth the return.

Crowdfunding

Crowdfunding is the process of raising capital for a startup by funding small amounts of money from a large amount of people. An entrepreneur can create a campaign that anyone can contribute to. A common framework is to start a crowdfunding campaign around the launch of a product, where purchasers receive the product and other early adopter perks if the campaign hits its goal. The benefit of crowdfunding is that it gives small businesses owners the capital to move their product into production without giving up any equity.

The blessing of crowdfunding is also its curse. The orders give you the capital you need, but in exchange you have to fulfill a lot of orders… all while navigating your specific supply chain needs and challenges for the first time. And while crowdfunding gives you an initial sales boost, it’s not a guarantee of future business.

If you’re interested in using crowdfunding for your startup, start by researching which crowdfunding platform best suits your needs. Look for:

  • What types of campaigns the website was designed for
  • Whether you have to hit a goal to receive the contributions
  • Cost of using the crowdfunding platform
  • How the platform integrates with social media

Business Loans

Business loans provide you with a sum of money that then has to be repaid to the lender with interest. Business loans allow you to maintain equity and control of your business without having to worry about answering to an investor or giving up equity. The downside of business loans is that they come with a short-term cost of capital that needs to be repaid and depending on what type of business loan it is, that cost can get high.

A bank or lender typically makes their decisions based on 3 factors: your time in business, your revenue, and your personal or business credit score. Because a startup by definition doesn’t have much time in business and doesn’t have established business credit, your loan options are more limited.

The Loans You Might Qualify For as a Startup

SBA Loans

SBA loans are backed by the US Small Business Administration, which means the government agency guarantees the loans with the lender in case you default on the loan (think of it like having the US government co-sign your loan). In terms of startup loans, you’re not going to find better terms or interest rates than an SBA loan. There are several different SBA loan options, but the most common is the SBA 7(a).

The tradeoff of these rare and majestic loans is that they come with government-level paperwork and they’re highly competitive. If you choose to go the loan route, it’s worth rolling up your sleeves and trying for an SBA loan.

Short Term Loans

Short term loans are best used when your burn rate is going to put you into a short-term bind. You can use a short term loan to cover inventory for large purchase orders or to make payroll while you wait on payment from a client. Short term payments come with pretty high interest rates because they’re designed to be repaid quickly and that structure allows the lender to still make money from the loan. This small business loan type can be an asset if used wisely, but if you wait to pay it off it can get very expensive very quickly.

Line of Credit

A line of credit allows you to borrow against a predetermined amount of money, repay it, and borrow again as many times as you like over the term of the loan. A line of credit can be a tremendous asset for a startup founder. It gives you the capital you need to finance your startup growth, and you only pay interest on what you borrow. That gives you flexibility and control.

Equipment Loan

An equipment loan is specifically for equipment and can be used for anything from computers to an espresso machine to Square card readers to robotic mining equipment. Because the loan is secured by the equipment itself, this loan is easier to qualify for than other small business loans, and it typically comes with lower interest rates.

Business Credit Cards

Okay, this might surprise you but business credit cards can be a pretty solid way to bootstrap a startup, especially if your capital needs are on the lower end of the spectrum. Business credit cards can be used to finance everything from office supplies to equipment purchases. If you need to make some large purchases and know you’ll have the funds to repay them within 6 months to a year, you could consider a 0% introductory APR credit card. These cards don’t collect any interest during the introductory period, which can make them a clutch option for entrepreneurs, especially those who don’t qualify for other forms of funding.

Understanding Startup Funding Stages

What the heck is a seed round? Will you need a Series A, B, and C? This financial mumbo jumbo (technical term) can feel intimidating for an aspiring entrepreneur, but it doesn’t need to be. The multiple funding round structure has become more common in recent years, especially in the tech industry. But as tech startups have seen wild success, the model has also spread to other industries as well.

You may not need to know anything about how a Series B works. Many small businesses find the funding they need without going this route. You’ll likely only encounter this if you plan to seek out external investors like an angel investor or venture capitalist.

Seed Funding

Seed capital is an outside investment in a startup during the nascent stages in exchange for equity in the company. The typical investment made during seed funding ranges from $10,000-$2,000,000. Seed funding is especially popular in tech. The benefit of seed money is that it gives you quick access to larger amounts of capital, allowing you to grow and scale a startup quickly and gain more traction. In the seed stage, these investments often come from friends and family members

Because the company doesn’t yet have a straightforward valuation, seed round investors typically receive a convertible note. A convertible note provides equity as repayment rather than interest or stock.

Series A Round

Series A funding is usually the first funding round to come from outside investors. A Series A typically comes after a startup has begun to generate revenue but isn’t yet profitable. In return for their investment, Series A investors are usually given preferred stock (which gives no voting rights to shareholders) that can be converted into common stock at a later time.

Because Series A investors are taking on substantial risk—the company isn’t’ profitable yet and a lot of startups fail—their stock will typically give them a pretty substantial payout if the company is successful.

Series B Round

Startups that seek a Series B round are more established. They’ve gone through the seed round and the Series A. They have either broken even, or they’re close, but they’re generating enough revenue that they carry a solid valuation. Series B investors again tend to receive preferred stock in return for their capital investment. Because there is (or theoretically should be) less risk during Series B funding, investors during this stage typically receive a smaller return than Series A investors.

Series C Round

Series C funding comes when a business is in the later stage of the funding cycle and growth process. It works similarly to the Series B round. Typically, investors want to see a higher valuation in the Series C than in previous rounds. That shows that the company is healthy, profitable, and growing. Because there is the least risk associated with Series C investment, it gives investors the smallest payout for their investment.

You Know Your Way Around Startup Funding. What’s Next?

You’ve rocked your intro to startup funding. Which topic are you going to tackle next? Check out our free training on everything from launching an ecommerce business to growing your online platform and making a killing with YouTube ads.

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