There are several ways to raise capital for your startup or more mature business — so many, in fact, that the options can seem overwhelming and confusing.
This guide will help you understand the options so you can make a more informed decision about financing your startup or growing business while limiting unnecessary risk.
Debt vs. Equity Financing
Before we dive into specific financing options for your business, let’s define the two types of funding available to you: debt and equity financing.
Traditional debt financing is borrowing money from individuals or institutions to fund your business. This can include funds from family or friends, banks, and agencies such as the Small Business Administration.
Borrowing against retirement plans, insurance policies, and other forms of personal equity is another type of debt financing.
Loans have varying interest rates and are paid back over time, presumably as your revenue grows. Debt financing, combined with funds from personal savings, is a common funding option for startups and is not based on the startup’s potential success. Instead, it’s based on the founder’s personal financial resources and reputation.
Equity financing, on the other hand, involves investors who take a stake in your business in exchange for funding. These include angel investors, venture capitalists, and sometimes certain family members or friends who are interested in eventually assuming some portion of ownership in your startup.
Typically friends, family members, angel investors and Pre-Seed / Seed Investors provide startups with funding via convertible debt or SAFE instruments. These types of investments don’t require the founders and investors to establish the fair market value of the startup — which is nearly impossible to do, given the startup’s business stage.
Equity financing provided in Series A, B, and C rounds are typically obtained once your startup has an established product and customers who want to do business with your startup. Once product market fit (PMF) is clear and the business model is developed, the startup’s value can be determined. That’s when preferred and common stock may be exchanged for the cash needed to fully scale the business.
SBA & Government Loans
Loans are a major source of capital for many small business owners, however they are not typically offered to startups unless it involves an acquisition of an existing business.
The Small Business Administration (SBA) offers a variety of loans for funding small businesses. Their most popular program, 7(a) loans, can provide funding if you meet the agency’s requirements, including their size standards. If your business qualifies, you can borrow up to $5 million with a 7(a) general small business loan.
Keep in mind that collateral—in the form of personal or business assets—is typically required when taking a loan from a government program or an agency like the SBA. Be careful about the collateral you choose to use when taking out a loan; you risk losing it if your business doesn’t make it.
Many small business owners apply for loans at a financial institution such as their local bank. Bank loans are convenient and come in a variety of types and options. One benefit of a bank loan is that you won’t have to share company ownership or profits, however you will be obligated to make regular installment payments with interest towards paying off the loan. If you want to keep as much equity as possible when financing your business, a bank loan may be an attractive option.
One downside to getting a bank loan is the lengthy application process. When applying for a business loan through your bank, you’ll need to know your credit history and provide a solid business plan.
Finding a trustworthy, business-savvy banker to work with you while launching your business is a great idea. Choose a banker who is local, so you can meet with them face-to-face as often as you need, and one who is supportive of your vision for the company. An accessible banker who has the expertise to advise you on your financing strategy is a valuable asset.
Loans from Family & Friends
As noted above, many small business owners look to friends and family for “launch money” to help get their new company up and running. If a friend, parent, or sibling has expressed an interesting in supporting your startup, there a few things to consider before accepting this type of loan.
If your family funder wants to become a minority stakeholder in your business, be sure to discuss with them the risks associated with investing in a small business. If you both agree on the specific terms of the loan, make sure you have your attorney draft a formal, written agreement for the loan, convertible debt or SAFE instrument.
It’s also important to note that taking loans from family and friends can place a strain on your personal relationships. Before proceeding, think about the implications your successes or potential failures may have on your personal relationship with the investor.
Borrowing from Your 401(k)
If your 401(k) plan has a loan provision available, your retirement plan can be a tempting source of short-term funding for your growing business. However, keep in mind that if you’re looking for long-term financing, a low-interest bank loan may be a more viable and less-risky option for your business. 401(k) plans are designed to help you grow your assets and save for retirement, so consider the potential consequences of borrowing from your plan if your business doesn’t make it.
By definition, grants are somewhat different from loans. Grants don’t require collateral like loans do, but they tend to be smaller. Local and state organizations typically offer grants for specific purposes or kinds of businesses, such as those located in economically disadvantaged or rural areas, or minority-owned companies.
However, don’t let the idea of a grant mislead you when you’re deciding how to finance your business. Many grants can be very similar to business loans and should NOT be thought of as “free money.” Visit www.grants.gov for more information about small business grants available to you.
Angel Investors & Venture Capitalists
Angel investors and venture capitalists offer value to your company in two forms: money and expertise. They can give you much-needed capital and reliable business advice, but it does come at a price. These investors will expect more equity as you continue to seek multiple rounds of funding, and accordingly, your stake in the business will be diluted.
Crowdfunding regulations have changed significantly in recent years. Crowd funders may contribute small amounts of their own money which is pooled to provide your startup with the cash it needs to launch and it’s all done on an online platform.
Sharktank’s Kevin O’Leary, aka Mr. Wonderful, is behind the StartEngine crowdfunding platform. This may be a valuable financing option for your business if you’re still in the early stages of launching your startup.