Traditional Lending Sources
These are the funding sources startups tend to think of first since they are familiar with things like bank loans and here about startup grants from sources like the Small Busyness Association.
Television and movies have led us to believe that an entrepreneur can walk into a bank with a “great idea” and get a loan. While that may have been possible back in the day, current banking/lending laws make it pretty impossible for a bank to do anything close to “relationship banking”.
For a bank to consider lending you money, there must exist:
- Collateral – Banks always require some sort of collateral to secure a loan. They must have something of value to take ownership of and sell so they can recoup their loss if you take their cash and default on the loan. A house is perfect collateral.
- Credit – Your credit needs to be fair to good. 740 – 850 is good. 670 – 739 is fair. Different banks have different requirements and things like having your checking with them can help. Since you are a startup, your business has no credit. It is your personal credit and you would have to personally guarantee the loan.
- Feasibility Study/Business Plan & Financial Projections – If your intention is to take out a second mortgage on our house, you may be better off not even mentioning your startup. If “use of funds” is a required question however, you will need a feasibility study/business plan & financial projections to proof to the bank your idea has merit. The difference between a feasibility study and business plan is that a feasibility study is a more comprehensive document with research to back your claims of market share, how you will promote your product/service, what the operation will look like, how much things will cost, etc.
Grants and other government incentives are typically geared towards capital improvement (buildings) and job creation. They also typically require a match of funds given, meaning if you need $20,000 they will give you half as soon as you come up with the first half. None of this fits the typical startup.
Sometimes there are grants awarded to disadvantaged cities that you may be able to get a piece of to help you open a store front, get a new sign, etc. but these tend to be very “politically intensive” meaning you must know or talk to the right people.
Why loans and grants might not work for you.
You may not possess the eligibility, credit score, and/or collateral typically required by grants and lenders.
Some entrepreneurs or business owners simply may NOT want to borrow money choosing instead to give up a piece of their business in exchange for funds.
Alternative Funding Sources
Before going after Angel Investors and Venture Capital Firms, most startups will utilize some form of alternative funding simply because it’s much easier to acquire. Some are great, some unfairly judged, and some downright scary.
For those with good credit, high limits, and low (or no) interest rates; credit cards are a popular way to fund a businesses. The stigma of “don’t use credit cards” doesn’t come from the credit card… it comes from irresponsible use of the credit card.
A credit card can be used to purchase startup needs and sometimes advance cash just like a bank can make you a loan. The difference is, the bank will be your mom and remind you of each payment, chase you down when you forget, etc. The credit card company actually benefits when you to forget so YOU must be a responsible adult and remind yourself of payments due, etc. If you can be disciplined, there is nothing wrong with credit cards.
This is usually the first source of funds for many startups and typically is an informal loan from a family member. The best are from a parent or uncle who really doesn’t expect to see their money again (or would be surprised if they do). If the loan is formal with written terms, they would be consider a real investor.
When all the “normal” loan routes have failed there are licensed hard money lenders. Hard money is essentially a loan with higher than normal interest rates and a shorter payback time. Most still require collateral and/or good credit but may have less stringent requirements.
Hard money lenders come in all shapes and sizes but here are some typical examples.
Real Estate – Many lenders specialize in lending money for real estate purposes because they can use the property as collateral. For instance “flip” lenders will attach a dilapidated property and loan you the funds to fix it up based on what it will be worth when repaired. Lenders like this control default by releasing small amounts at a time and requiring proof of each step before releasing more money.
Factoring – Factoring is simply an advance on future sales based on historical sales (sales must typically be through a credit card processor).
A restaurant is a perfect example. Say the restaurant has $500,000 in sales over the last 12 months (all by people paying with credit cards) and needs $30,000 loan to make it through the winter. The factoring company will lend them the $30,000 knowing they will likely bring in $500,000 this year just like they did last year. The factoring company will process your purchases over the coming year and automatically take back their $30,000 plus a lending fee.
Equipment Lease Buy Back – Similar to real estate loans where the lender owns your property until the loan is paid back, some lenders will buy your equipment for cash and then lease it back to you for the fee that acts as the loan payments. Equipment must be large or attached like roller coasters or ovens. Things that can easily disappear overnight like cash registers and computers are not good collateral.
The key difference between a loan and an investor is that an investor gets equity (ownership) in your company in exchange for the money they give you. How much they give you is typically based on how much you prove you need. The percentage of equity they receive for their investment is negotiable but typically based on a future value of the company when it “exits” via sale.
Investors can also lend you money of course or even combine debt and equity financing.
Investors come in three main forms; friends and family, angels, and venture capital.
Friends and Family
For some, all they need to get started is to partner with a family member who has money. This can fund an entire business but typically is a small amount that starts the ball rolling.
Angel investors are typically wealthy individuals who invest their own funds. Occasionally they organize themselves into groups. Angels tend to invest below $1million and often like to see the entrepreneur, or friends and family, invest first.
There are no requirements to be an Angel investor so they can come in all flavors; from Silicon Valley serial investor to first time lottery winner. They are individuals and can have any number of personality traits. They can hover over every move you make or not be involved at all. Some are okay when things go bad and some can fly off the handle at the slightest stress.
Some can also be “wanna-be” investors that run you through all sorts of due diligence and will never invest… in anybody. However, a good angel investor, or angel group, is the back bone of early stage capital. These are the men and women that can invest bigger money that friends and family cannot.
VC firms manage the pooled money of other investor in a professionally-managed fund that invests in companies. VC funds tend to invest $1million of more and can specialize in startups, industries, investment stages, etc.
VC firms are usually very professional. They have formal agreements, expertise, and professionals to help you stay on track. Unlike the average angel, VC firms may insist on control over key issues despite having a minority stake in the company. These can include raising more money, hiring C-suite executives, or selling the company. The tradeoff for assistance, expertise, and support is usually worth it though.
Types of Investments
The terms of an investment can be as unique as the investor, entrepreneur, and business. But most investments are straight equity, straight debt, convertible debt, royalties, or some combination of the above.
The investor simply gives you a sum of money in exchange for a percentage of your company. This is pretty simple for the first round of investing as you give up say 5% to each of 3 investors for 15%.
The second round can start to complicate the math a little as new investors come in and take a percentage of all 4 of you. For example a new 10% investor would dilute each of you by 10% so now your 5% investors each have 4.5%.
The math can be further complicated with different valuations (the company would presumably be worth more in the second round and effectively give less equity for the same investment). Non-dilution clauses and classes of stock can further complicate the math.
There are plenty of professionals who can do the math and “cap tables” so don’t let it scare you!
This is a loan just like from the bank or your friends and family, just from an investor. The only caution is to make sure you understand the terms of the agreement as they might be unique.
The investment starts as a loan to be paid back with interest if the rest of the money needed is not raised within a prescribed time period. If all the money needed is raised within the specified time frame, the loan converts to equity. This is very popular for early investors who are concerned you will spend their money “trying to lunch” before you have enough to do it properly OR if your valuation is impossible to nail down.
Royalties have been made famous by Kevin O’Leary, aka Mr. Wonderful, on Shark Tank and given a bad name by his fellow sharks that knock it every time he suggests it.
With royalties the investor would give you cash and be paid back with a certain dollar amount or % of each sale. This could be for a prescribed time period, amount, or in perpetuity (what gets Mr. Wonderful in trouble).
This method of investing gets a bad rap when it’s in perpetuity because it feels like the investor makes a one-time contribution but gets paid back forever. It feels unequitable because everyone thinks their company is going to be worth a gazillion dollars. In reality though… the investor with the perpetuity deal is likely the only one who could actually get you close to that fantasy so there is nothing wrong with a perpetuity deal, just do the math and try to be realistic.
Type “angel investors” in any search engine and you will be swamped with angel networks, advice, expos, and finder companies. For example, National Startup Association has a huge list with location, industry preference, etc. When you seriously start looking, finding them isn’t usually the problem… its convincing them to invest in your company.
Winning an Investment
Investors invest in both the horse (business) and the jockey (you). They look for 10 fundamental pieces of information before they even consider looking more deeply or conducting due diligence. Just remember:
- They get approached by everybody
- They don’t have time for your life story
- They look for reasons to NOT invest or like you
- There are dozens of triggers that will send them running
- Not having your story together is one of them
A quick and articulate description of the business. If you say “it’s fast, red, and has zebra stripes” people will stop paying attention to the rest of your pitch while their brains try to figure out what it is you just described! If you say “it’s a car… and its fast, red, and has zebra stripes” people might think you have horrifying taste but they can picture it and their brains are ready for the next piece of information.
Management team bios showing they’re capable of running the company. If you do not have all the expertise you need, be sure to hire a consulting firm or temp to fill that need OR explain how/when you will add that person (assuming you don’t need them right away).
A clear customer problem must exist and be solved by your product/service. Build it and they will come does not give investors’ confidence. A cure for cancer does. Make sure you articulate the problem or gap or improvement very well. This is one of the biggest areas of intrigue!
If the investor got this far, they want a little more detail on the actual product or service. How will you make it or do it, what are the wholesale and retail prices, etc.
You must identify and quantify an addressable target market whose problem you solve and who can afford you. Hint: Never say everyone. An addressable target market is a market that might actually be interested in your product or service. Quantifying them is one of the hardest parts of a business plan but can usually be figured out during a proper competition analysis.
You must show how you intend to get your share of this market. How will you promote and/or sell your product or service. Be as specific as possible, describe the strategy to actually bring money in the door and back it with research.
You must show your operational business model including distribution, vendors, operational plan, etc.
You must identify all competition direct and indirect. Failing to do so indicates you are not realistic and/or prepared. Hint: Never say no one. Also, treat competitors broadly and learn from them.
Now that you have identified your competition you must prove why you are better at solving the customer problem than they are.
Show all income, expenses, cash flow, etc. for all months till cash flow breakeven and annually for at least 5 years. This should show how much you will make, how much startup costs are, how much COGS is, expenses, employee salaries, etc. All assumptions should be backed her and/or somewhere in the plan. This should also show your valuation calculations if you are asking for an equity investment.
How much do you need, what will you use it for, and what are you valuing your company at?
How much equity you give up in exchange for an investment is based on the value of the company. This can be tricky for a business that has generated little or no revenue.
There are many ways to value a startups future value but they all start with a ten year proforma showing the projected net income over 10 years. The income in the year you plan to exit will typically drive what the company is worth.
This is valuing the company on just the EBITDA for a future year. If the company is projected to make $10million in Earnings Before Interest, Taxes, Depreciation, and Amortization in the 5th year, then a $1million investment would be worth 10% equity in the company.
Multiple of EBITDA
If a company is truly netting $10million a year you wouldn’t sell it for $10million you would sell if for a multiple assuming the new owner would enjoy making $10million a year for years to come. For that reason it is fair to use a multiple of projected revenue to value a company. Multiples vary by industry and the economy but are typically in the 2 to 5 range. For example a 3 time multiple of $10million is $30million meaning a $1million investment would be worth 3.33% equity in the company.
Price per earnings ratios are preferred and can be used in place of multiples to value a company that is in an industry found on the stock market. If the P/E for a similar industry is 5, the value of our company would be $50million.
When it comes to valuing a company that hasn’t made a dollar yet, this is the best. Showing a history of similar companies to yours being purchased by bigger fish or competitors and showing an average valuation of those deals (sale price/revenue) is the easiest way to sell investors.
Of course everyone including the potential investor knows both your proforma and valuation are guesses. The key is that they be VERY well educated guesses and thus believable.
Seasoned and fair investors will acknowledge a fair valuation but will likely try to negotiate a higher percentage of equity anyway. Some investors want a controlling interest and will just look to dismiss and or punch holes in your valuation.
Either way, your best stance is to calmly defend your financial assumptions with the research and data you used to come up with them.
Beyond all that, know that investor relations and negotiations are an entire other primer and you should likely seek help from experts if you really want a chance at getting other people’s money.