Sources of Funding For Startups?
So you have a great business idea, you are eager to get started, but you do not have enough of your own capital to launch your business. What now? Fortunately, there are numerous ways to obtain the funding you need to launch your business. The most common sources of funding for startups involve a form of debt or equity. Depending on your circumstances, you may also be eligible for a grant. These sources of funding for startups are described below:
3 Common Ways to Finance Your Business
How it Works: Debt funding involves borrowing money in the form of a loan, most commonly from a bank or lending institution. The loan is then repaid with interest over a specific period of time (i.e., the “Term”). While eligibility requirements can vary depending on the type of loan you are seeking, most lenders and loan programs require you to use some of your own money as an owner contribution.
Traditional bank loans usually require a 20% owner contribution or more, while other loan programs require less (for example, some Small Business Administration (SBA) loans only require 10%).
Pros and Cons: If you fund your business through debt, then the amount of your loan repayment will be determined by three factors: the amount of the loan (also called the “Principal”), the interest rate, and the term. In other words, whether your business earns $100 thousand or $100 million in revenue will make no difference in how much you owe your lender.
However, this also means that if your business fails, you will still owe the same principal and interest to the lender, which can increase your risk of bankruptcy if you do not have enough personal cash or collateral that you can use to pay off your loan. To reduce the risk of bankruptcy, lenders will sometimes require you to list personal assets you are willing to put up as collateral before they approve your loan if you default on it.
How it Works: Equity funding involves procuring investment from a person or organization that receives a percentage of ownership in your business in exchange for their investment. Venture capital (VC) firms and angel investors are some of the more common sources of investor funding for startups, although anyone who is able and willing to invest their money into your business can potentially be an investor.
If you are pursuing an investment through a VC firm or other formal channel, then the terms and conditions of your investment will be negotiated before the investment is granted; they will also be detailed on a document known as a “Term Sheet.”
Pros and Cons: Unless otherwise specified in your Term Sheet, equity funding does not require you to repay the funds you receive, let alone with interest like debt funding, because it is an investment, not a loan. Instead, because the investor owns a fixed percentage of your company, the amount of their return on investment (ROI) will vary in direct proportion to the growth of your company.
The investor is hoping that over time, your business will increase in value due to its success and that they will earn a substantial ROI as a result of your business’s increased valuation. However, they are also assuming the risk of losing some or all of their investment if your business fails.
How it Works: Various government agencies and other institutions offer small business grants, most of which have specific eligibility requirements. For example, some grants are specifically for minority-owned businesses, while others are specifically for businesses in rural areas.
A specific institution’s requirements are usually listed on its website, along with details on how to apply. In addition to meeting eligibility requirements, you will usually be expected to demonstrate in your business plan how the grant money will be used and why it is needed for your business’s launch. Additionally, an institution will usually want you to demonstrate how the success of your business will benefit those who the institution serves.
Pros and Cons: Grants can be very appealing because they are basically gifted to your business, meaning you do not have to repay them, nor does the institution receive any ownership in your business in return. However, as previously mentioned, most grant institutions have specific eligibility requirements, and they will pay close attention to your grant application, business plan, and any other requested documents to ensure that you meet their requirements.
Additionally, most grant institutions only offer so many grants during a specific time period, so you will likely be competing with many other entrepreneurs for these grants. If you receive your grant from a government agency, then you may also be required to file legal documents to show that the funding was used properly, and you may be subject to audits as well.
More information about the specific loan, investment, and grant options, along with other funding sources, can be viewed at the SBA’s website here: www.sba.gov/funding-programs.