Last year, The New York Times generated buzz with an eye-catching headline: More Start-Ups Have an Unfamiliar Message for Venture Capitalists: Get Lost. The article profiled a diverse group of entrepreneurs with one thing in common — all of them shunned the trendy VC funding route.
“The tool of venture capital is so specific to a tiny, tiny fraction of companies,” Mara Zepeda, co-founder and CEO of Switchboard, a company that provides development and technology services to nonprofits and educational institutions, told The Times. “We can’t let ourselves be fooled into thinking that’s the story of the future of American entrepreneurship.”
Zepeda is right. While VCs tend to monopolize headlines in the startup world, that route isn’t right for everyone. Yes, it’s an effective fundraising method. But as with any financing, there are pros and cons to venture capital — and alternatives you may not have considered.
Venture capital is the most well-publicized way to raise funding, for good reason: The VC industry deployed $136 billion to almost 11,000 U.S. companies in 2019, up from $27.4 million spread across 4,500 firms in 2009, according to the Pitchbook-NVCA Venture Monitor. Aggregate annual VC deal value grew roughly fivefold over the past decade.
As we enter 2020, VC firms are sitting on enormous amounts of cash in need of investment opportunities. For companies ready to scale rapidly, VC can be a great choice — if you’re willing to give up equity and play by their rules.
VC investors benefit when your company succeeds, which means they’re incentivized to deliver more than just money; in that sense, they’re one of the most supportive financing options. Investors provide sales and marketing advice, insights for running an effective business, industry connections and access to valuable networking opportunities. The exposure of scoring a big deal can help young companies attract top talent and cultivate demand for their products.
Still, while explosive growth and a prominent role in some of the biggest launches of the decade have made “VC” synonymous with “early business financing,” the reality is that VC funding is the exception, not the norm.
Much of that fivefold growth we mentioned is due to the size of the deals, not the number of companies receiving investments. In reality, according to a 2018 survey by Lendio, only about 3% of surveyed U.S. small business owners raised funding from VCs. This can be attributed to multiple factors, with a big consideration being that most VC firms have specific “types” and expectations. For instance, Sequoia Capital focuses on energy, financial, enterprise, healthcare, internet and mobile startups.
However, it’s not just market segment. Investors look for startups that they believe will provide big returns on their investments. In seeking these hot prospects, some evidence shows instances of pattern recognition, where VC firms favor startups with the characteristics of companies and founders that have succeeded before.
As long as VCs continue to focus on very specific features and profiles, the resulting bias makes it difficult for companies outside the mold to get funding.
This emphasis on growth brings up the next point: Many VC firms have a “grow at all costs” mentality. They want companies that are willing — and, ideally, able — to grow exponentially, sometimes at the expense of profitability and sustainability.
This is a high-risk approach that has resulted in the demise of promising businesses like Brandless and Tink Labs. Premature scaling is one of the leading causes of startup failure. Some businesses are simply not ready for hypergrowth, others are not suited for a “blitzscaling” approach. Given the “go big or go home” VC culture, if you’re erring toward “go home,” it’s best to pursue other sources of funding.
If you do decide to go the VC route, check out this ebook from our sister site, Grow Wire. It provides a start-to-finish guide to getting VC funding as a young company. If not, read on.
In many respects, angel investors are similar to venture capitalists. They invest a moderate sum of money — $200,000 or less for individual angels, $200,000 to $350,000 for syndicates — into a company in exchange for convertible debt or equity. Like VCs, only 3% of surveyed U.S. business owners tapped into angel investors for their funding needs. However, there are several crucial differences:
Angel investors can either be accredited or non-accredited. In order to be an accredited angel, a person must have made an overall individual income of at least $200,000 for the past two years or have a net worth over $1 million, excluding the value of one’s home. Otherwise, a person would be considered a non-accredited investor.
A non-accredited investor can be a good partner, but mind the restrictions. Non-accredited investors are protected, and thereby regulated, by the SEC through Regulation D. Under that ruling, a company seeking funding must either be registered with the SEC or meet an exemption. The first of those exemptions allows a startup to work with as many as 35 non-accredited investors. However, the company must have a pre-existing relationship with the investor and provide certain disclosure documents, and the investor must have significant knowledge of the field. This means you can’t use a general solicitation to attract investors.
Because of these substantial restrictions and disclosure requirements, using non-accredited investors is seldom a realistic way to finance growth. That’s part of the reason crowdfunding (which we’ll cover later) has become so popular.
Angel investors also differ from VCs in some key ways: They’re willing to finance earlier-stage companies and are more likely to invest across a broader range of businesses, including those that don’t fit the typical mold or embrace the “grow at all costs” mindset.
Like VCs, angels are likely to provide business expertise, connections and mentorship. Companies like Amazon, Starbucks and Apple all got their starts with angel funding, and these investors often fill the gap between friends and family and more formal venture capital funds.
The disadvantages of angel investments are similar to those of venture capital. Like VCs, angels are taking a risk by financing a young company and will need to realize a high return on investment. Before engaging with angel investors, are you willing to give up some control in your company — usually around 20% or 30%? Will the diluted equity be worth the needed capital?
For those ready to give this investing approach a shot, angels can be found through multiple avenues. Sites like AngelList, Angel Investment Network, Gust and the Angel Capital Association are all great places to start your search.
The method that raised over $54,000 for a man to make potato salad has been the starting point of many successful businesses. Online crowdfunding platforms have allowed entrepreneurs to raise both money and awareness. Thanks to the passage of the 2015 JOBS Act, both non-accredited and accredited investors can participate — though there are some limits based on salary.
There are non-tuber success stories: Oculus, which was purchased by Facebook in 2014 for $2 billion, got its initial financing in 2012 through a highly effective crowdfunding campaign. In fact, 2% of surveyed business owners in 2018 cited crowdfunding as a source of cash, and given the method’s explosive growth, that number has likely grown significantly.
Crowdfunding can take a multitude of forms; however, four are most prevalent:
Dan Demsky, co-founder of Unbound Merino, opted for the crowdfunding route in financing his apparel brand.
“We made the conscious decision to forego VC funding in order to remain fully in control of the businesses and remain our own bosses indefinitely,” he said. “We launched solely via Indiegogo and were able to raise over $350,000 in pre-orders alone for our compact travel hoodie.”
Despite the popularity, there are issues to consider. As of this writing, Kickstarter’s company website lists 476,717 launched projects. Of those, 177,440 have been successfully funded. This 37% success rate underscores the need for a business to be eye-catching and provide a product or service that investors believe anticipates and meets market demand.
Simply put, a project must connect with and interest people. A stroke of social media luck doesn’t hurt, either.
For businesses that feel they have what it takes, setting up a successful crowdfunding campaign is a time-consuming process with no promise of success. You must be sure you’re ready to put in the time and effort to have a campaign succeed in an accelerated timeframe. And, make sure you can deliver to funders what you promised.
Also consider the site’s terms. For instance, if your campaign is successful, Kickstarter collects a 5% cut plus a 3% to 5% payment processing fee from your funding total. If it is not successful, all money is returned to backers. It is a true “all or nothing” situation.
In a speech at the New York Times DealBook Conference in New York, Elon Musk said, “Creating a company is a very difficult thing. A friend of mine has a saying: ‘Starting a company is like eating glass and staring into the abyss.’”
That’s a rather intense simile that is also inherently true: Starting a business is hard and uncomfortable at times. Which brings us to accelerators and incubators. Startup accelerators and incubators are designed to ease some of the difficulties behind launching a company by providing a support ecosystem. In addition to business development opportunities, they can also be sources of capital.
Companies that become part of an accelerator cadre can access educational programs, mentorships, networking opportunities, connections and recognition among investors. They also get a pre-seed or seed investment ranging from $10,000 to over $120,000. Upon completion of the fixed-term cohort program — typically three to six months in length — accelerators host a “demo day” where businesses pitch their ideas to hundreds of investors to jumpstart the fundraising process.
The terms “incubator” and “accelerator” are often used interchangeably, which is why it’s important to discuss incubators as well. While they are similar in intent, the two concepts have several major differences worth noting.
First, incubators are more open ended; memberships usually last between one and five years. Like an accelerator, an incubator provides support in the form of education, mentorship, events, connections and networking. Incubators also emphasize giving young businesses access to co-working space, which is not always the case with accelerators.
However, it is very rare that an incubator will provide funding. Instead, they are usually run by universities, foundations and economic development programs.
If your focus is on financing, an accelerator will likely be a better bet versus an incubator. However, there is a catch: Accelerators aren’t free. In exchange for their money and efforts, accelerators usually request 7% to 10% equity in your company.
Outside of the equity, accelerators require another valuable thing from you: time. At least three months will be spent following the accelerator’s schedule, including meetings with mentors, attendance at events and networking. All are wonderful opportunities — but is your leadership in a place to embrace them? If not, you could be throwing away valuable time in your company’s early lifecycle.
Last note: Top-tier accelerators are quite competitive; Y Combinator and Techstars accept around 1% to 3% of applicants. Applying for a less-popular program could be a good idea, but keep in mind that not all accelerators are created equal. The startup development space has flourished over the past several years. Some accelerators will be institutions at this point, with the recognition, connections and successful programming that comes with experience. Others won’t have developed a reputation for success, which means they’ll have trouble attracting investors, and their programming may not be “tried and true.”
Do your due diligence to ensure a lesser-known program is worth your time and equity.
Nothing in life is free, but grants come pretty close. Federal, state, local and private groups give sums of money to growing businesses. These funds are intended to stimulate innovation, entrepreneurship and economic activity.
On the surface, there aren’t many negatives to essentially free money. After all, grants don’t need to be repaid, and you don’t dilute your equity. However, there are several significant pain points worth noting.
First, many grants are intended to aid non-profits, community-focused businesses or entrepreneurism in a specific demographic. They also focus on innovation, technological advancement or initiatives that help solve a widespread problem. If your business does not fit within one of these categories, it may be difficult to find a grant opportunity.
The application process tends to be intensive, competitive and time consuming — to the point where some companies hire professional grant writers. Many have stringent requirements and restrictions regarding eligibility. You must state what the money will fund, and oftentimes there are strict rules around how it can be spent. Extensive reporting may required to ensure funds are being used properly.
There’s no way to pin down how much money is out there. Grants come from many different organizations, are often designated for very specific populations and trend up and down based on the economy and government spending priorities. Expect to spend some time researching.
If you’re up for that, eligible for a grant and able to deal with a significant amount of paperwork and compliance, go for it — just don’t structure your financing plan solely around the possibility.
How’s your public speaking? If you’re a passionate, articulate business owner with an idea that you’re eager to share, pitch competitions could be your pathway to funding.
The difficulty of cutting through the noise of an increasingly competitive marketplace gave rise to pitch competitions. These events are designed to provide a platform — and perhaps some capital — for emerging companies. The prize purse can range from several thousand to a million dollars, with many being equity-free. Notable pitch competitions include Y Combinator Demo Day, MIT $100K Entrepreneurship Competition and TechCrunch Disrupt.
Pitch competitions can be intimidating, but remember: Win or lose, you still benefit. These events provide an excellent opportunity to network, create strategic connections, hone your pitch and receive feedback from judges and other participants. They also provide valuable exposure for your company through the event and its media coverage.
Sarah Tuneberg, CEO and co-founder of Geospiza, a first-of-its-kind software company dedicated to improving disaster outcomes through data, took a shot on a pitch competition and caught the eye of an investment manager for Motorola. Her story is worth a read, especially if you’re not sure you’re ready to put your idea out there.
When embarking on a commercial venture, getting a business loan is the obvious go-to for financing. And when you think of loans, you likely think about going to the bank. That is still an option — if you qualify. But that’s a big “if.”
The 2008 financial crisis hit small-business lending hard, and we’re still feeling the ramifications today. Because of the increased risk and decreased profit associated with these loans, banks are far less likely to lend to small businesses. According to a survey by OnDeck, an online small-business lender, there is an 82% chance that a small-business financing application will be denied. To beat those odds and qualify for a business loan or bank line of credit, you need a detailed business plan, a strong credit score and incoming revenue and collateral. This automatically disqualifies many early-stage businesses.
To provide some relief for small businesses seeking financing, the Small Business Administration (SBA) provides several types of loans, the most common being 7(a), CDC/504, microloans and disaster loans.
The SBA guarantees these loans, and they are issued by participating lenders, mostly banks. SBA loans have many attractive traits: low interest rates; a range of amounts, from $500 to $5 million; and longer repayment terms. SBA FY19 total loan volume reached over $28 billion, with more than 63,000 approved loans.
Once again, though, there’s a caveat: SBA loans are hard to get. Borrowers need to meet a multitude of eligibility requirements that are dependent on the type of loan. According to a survey of Fundera customers, most approved applicants had over $180,000 in annual revenue, at least a 680 credit score and over four years in the business.
Additionally, applicants must provide copious amounts of time and documentation to get through the process.
Because of the standards and competition involved with bank and SBA loans, private business lending has become increasingly popular. Platforms like Upstart, LendingClub and Funding Circle provide alternatives to the traditional loan process. These sites are characterized by easier applications, less-stringent criteria and accelerated decisions. However, that ease of use and accessibility come with some drawbacks. This financial model is still relatively new, which means that there isn’t much regulation (read: protections) in place. Interest rates could be high, particularly if you have a low credit score. Lastly, fees, which vary by site, could add up quickly.
In the realm of private lending, don’t overlook revenue-based financing.
Revenue-based funding allows for a business to raise capital from investors without giving over any equity. Instead, investors receive a percentage of the enterprise’s future gross revenues on a monthly basis until the loan is paid back. This approach allows companies to be more flexible with repayments, since the amount is dependent on that month’s revenue. It also doesn’t require the same asset base as a commercial loan, which makes it ideal for early-stage businesses. Revenue-based financing firms like Lighter Capital and Decathlon Capital offer this option for companies.
Of course, as with most loans, the amount paid back is more than the amount borrowed. In the case of revenue-based financing, the cap is usually 1.3 to 2.5 times the amount financed. This often is more expensive than bank financing. Borrowers should have the revenue and strong gross margins in place and be comfortable with a percentage of each month’s profits being taken to fulfill the repayment terms.
The most common source of debt financing for startups isn't a commercial lending institution. Instead, contributions from friends, family and coworkers reportedly constitutes more than 20% of startup funding. Friend and family financing can be a useful option for businesses that lack a credit history. However, it’s a delicate situation when interpersonal relationships are on the line. Should you choose to pursue this option, ensure that terms are clearly defined and reports are kept as clear and professional as possible.
When Sara Blakely decided to start her own business, she opted to use her own savings of $5,000 to get the company off the ground. That company? The Spanx apparel line. Now, the well-known brand and its founder are each worth $1 billion. And, to this day, Blakely still owns 100% of Spanx.
This entrepreneurial self-funding spirit isn’t uncommon. In fact, it’s given the rather appropriate name of “bootstrapping” in the business space. Many entrepreneurs tap into personal savings and, if applicable, cash from the company’s initial sales — 77% of surveyed small-businesses owners in the U.S. cited personal savings as the way they funded their growth.
When we asked company founders about the benefits of bootstrapping, most echoed the same conclusion: It allows you to slowly and organically grow your business while ensuring that the model is financially viable in the process.
“We funded our first business with an accelerator, then raised about $500,000 via angels and a venture capital firm,” said Ryan O’Donnell, co-founder of the sales platform Replyify. “The business model didn't work. We used the cash to build, test and pivot and were locked into a business that didn't work because we chose to take money prior to proving out the concept.”
Proponents of bootstrapping advise against “skipping steps” and recommend focusing on profitability over growth. A company can then see if a business model is self-sustainable without forfeiting any control or direction.
Museum Hack, a museum tours company with $2.8 million in revenue, is 100% bootstrapped. The co-founder, Michael Alexis, reinforced the benefits of staying agile and independent. “We don’t have to compromise with the product or mission of the company,” said Alexis. “The closely held structure means that the owners are directly involved with the decision-making and operations of the business.”
Bootstrapping does come with limitations that may make it difficult, or even impossible, for some companies to pursue. Most notable is the need to be lean. Starting a self-funded business requires strict financial discipline, a significant time investment, a minimalist structure, an initial cash pool and the ability to reinvest preliminary profits back into the business.
Suitability also greatly depends on your market. For instance, startup costs associated with being a software provider are notably less than those of a manufacturing business.
Bootstrapping can make growth more incremental, which can be a positive, as mentioned previously. However, there’s a fine line between growing at a slow pace and becoming stagnant. If bootstrapping is consistently keeping you from your goals, it may be time to consider a new strategy.
Venture capital’s exponential growth and newsworthy moves over the past decade have made it front-and-center in the business financing realm. However, that doesn’t mean it’s the best fit for your company. Fortunately, there are plenty of other opportunities to pursue capital.
Use the chart, below, to evaluate your circumstances and desired path — and determine the best financing fit for you.
Megan O’Brien is Brainyard’s business & finance editor, covering the latest trends in strategy for CFOs. She has written extensively on executive topics as a former content creator for Deloitte’s C-suite programs. Reach Megan here.