Starting a business can be an exciting venture, but it's no secret that it can also be expensive. From rent and salaries to research and development, the costs can add up quickly. This is where business financing can help.
In this guide, you will learn how to finance a business, including bootstrapping, angel and venture capital funding, and government grants.
Whether you're just starting out or looking to expand your existing business, understanding your financing options can help you make informed decisions and set your business up for success.
Some basic considerations related to business financing include risk vs. return; equity (i.e., stock ownership) vs. debt (i.e., a loan); “smart money” vs. “dumb money”; “free money”; and dilution.
A few words on dilution
Remember that scene in Social Network where Facebook’s co-founder realizes his share in the company had been diluted, so he lost the power to influence the company’s policies and actions?
This situation is very common in startups that accept outside capital.
A substantial outside investment at an early stage in a startup’s life (when the company is valued low) is likely to dilute the founders’ share in the “pie” much more, compared to accepting the same dollar amount at a later stage (when the startup’s value soars and that investment accounts for a smaller percentage of the company’s capitalization).
The most important decisions in a company’s life are made by the owners of the majority stake.
Therefore, keeping track of your ownership percentage is essential to ensure you have a say in important decisions that impact the future of the company.
Friends and family
Friends and family are a common source of funding. Before accepting the money, be aware that failed business dealings (or late repayments) can have an adverse impact on close relationships. Some family members not directly involved in the transaction may feel jealous or become concerned about their inheritance.
Accepting money can suggest to the lending person that they are entitled to have a say in the life and business of the borrowing family member. This can undermine the borrowing family member’s independence and the ability to say they “made it on their own.”
We strongly advise against pressuring your relatives into giving you money or taking money that family members need to provide for basic needs. We recommend making sure that your family members are offering money that they can afford to lose (so they should not be taking the money out of their retirement, education, or emergency funds).
As friends and family tend to trust you personally and are not always sophisticated investors, you should make a full disclosure of the nature of the business, risks, and rewards. You can provide formal financial statements and the detailed business plan.
Finally, decide ahead of time what role, if any, the lender will play in the business. Once you’ve disclosed all financial details and discussed everybody’s role, put all agreements down in writing and have everyone sign. A licensed attorney can advise you of all the necessary legal considerations and help you negotiate the documents.
Traditional bank loans
Traditional bank loans are different from investment in your company because they require a cash repayment with interest at a set future date and do not lead to the bank owning a part of your company. The cost of borrowing money from the bank may be less than attracting equity investors, but a good credit score and a detailed business plan will be required.
Frequently, bank loans will involve a personal guarantee by persons in the business (which means that they will be personally liable for the debt if the company doesn’t pay). Another way the banks prefer to guarantee the repayment is by a security interest in the company’s assets (such as real estate or intellectual property). This means that if the company is unable to pay, its assets will be sold to repay the debt.
The U.S. Small Business Administration (“SBA”) helps small businesses get funding by setting guidelines for loans and reducing lender risk. These SBA-backed loans make it easier for small businesses to get the funding they need.
Grants are only available under limited circumstances. They are typically offered to businesses that are engaged in research and development.
Grants are considered “free money” but should not be mistaken for “easy money.” Grants do not have to be repaid; however, those who administer the grants typically retain ownership of intellectual property.
Grants are typically submitted in response to a specific request for proposals (“RFP”) from a government agency, such as the Small Business Innovation Research (SBIR) program.
The SBIR program requires that there be a principal investigator — typically, but not always, a PhD — who will dedicate at least 50% of their professional time to the company. Many government grants require that the company be majority-owned by U.S. persons.
Angel Investors are individuals or groups of individuals who are interested in providing funds to start or grow a company. There are three types of angel investors.
The first are those with “smart money” which means that the investor has experience in your company’s industry. They add value to the company through management expertise, technical expertise, knowledge of channels of distribution, contacts in the industry, or in other ways. The investor may or may not want to have the ability to have a direct input into the company through a board seat or otherwise.
The second kind of angel investors offer “passive money” which means that they do not have the industry contacts or industry experience. Typically, these investors will not try to give their direct input to the company.
The third type of angel investors offers “painful money” which means that they want to have a significant input in the company’s business but do not have any business expertise or contacts in the industry to add value to the company.
You can find angel investors through networking in the industry, personal contacts, or referrals from your attorney or others. There are many legal requirements for structuring an angel investment properly to protect the founders from personal liability.
Venture capital funding may be available to companies that have the potential to grow large very quickly. However, venture capital is difficult to obtain, is very costly, and is only available to certain types of businesses, such as startups commercializing a technology. Venture capitalists will seek a very high return on their investment to reward them for the greater risks they are taking. The level of investment will typically be significant. A venture capital firm will often want significant control and input in the business, for example, they may want to ensure that professional management is in place. Venture capital investment can be a good way to grow a company quickly.
There is a variety of ways startups and small businesses can obtain financing. Most have complex legal implications. Startups greatly benefit from legal advice because an attorney can assist in identifying appropriate funding sources and preparing a credible presentation to lenders and investors. An experienced attorney can also help refer first-time business owners to venture capital firms, bankers, and private investors. Finally, an attorney is indispensable when reviewing and negotiating the funding terms to make sure that your business’s interests are protected, and you get a good deal that works with your long-term goals.