How to: Startup Financing 1
People can rarely build a business out of thin air and accordingly most founders need money to grow their product. Only a fraction of founders out there, regardless of the business they are trying to build, are able to introduce their product or service into the market without any capital. Even when you’re on your own and using only a minimum of resources to start off your business, you will need to eat and sleep somewhere, don’t you? If you’re not lucky enough to have built a considerable nest egg for yourself (or can occupy your parent's garage for ages), you will sooner or later face the question: where to find the resources to develop a product into a thriving business?
Most of the time, the answer is: outside capital. But with financing your startup, there are tons decisions to be made, many of which bear the potential of being regretted later on. So make sure to thoroughly think through who you will get into funding-bed with for what might be one of the most exciting times of your life.
Here in Germany, almost 400,000 people set up their own business in 2016. 14% of these people founded a startup, looking to quickly scale their business (as per the definition of a startup). Almost none of these people were able to just have an idea and earn money from it. Luckily there are numerous ways to finance a startup and make it grow.
The most common ways will be depicted in the following sections of this article, with emphasis on Venture Capital as the probably most complex and also most gainful means of startup financing.
All with a little help from my friends.
Or a bank. Or some rich dudes...
The following numbers were drawn from a study by the German Startup Monitor, but similar tendencies are arguably true for other countries as well. Among the most important sources of capital, founders rely on their own savings (84%), family and friends (30%), private investors (Business Angels, 23%) and Venture Capitalists (VCs, 19%). But 35% also go for government grants and a mere 15% fall back on bank loans. How they combine the above options is not really transparent.
Some people are able to approach their startup phase confidently. No matter if they were born rich, have saved up considerable amounts from earlier jobs or closed a profitable exit with another project: everyone should consider how far they can get without any outside capital – which depends on their own reserves – and when it’s time to pull the plug in favor of private financial health.
Bootstrapping can be a nice alternative for self-financiers or if your assets are a little smaller or there are other reasons to not go for any loan capital. With Bootstrapping, you try to get your business out and operating as soon as possible to earn your first revenue. While many startups take years to even validate a first prototype, you’ll need to be much faster when bootstrapping. A fancy office, a large team and costly infrastructure are strictly off limit, as well as a lavish lifestyle. On the other hand, risks are a lot lower in case of failing and you keep all the shares of your business to yourself or your team. Plus, if things are kicking off well and you still want to expand, you can get your hands on capital at much better conditions, given a business case that’s already proven to be sustainable.
Borrowing money from a bank. Well, that has a funny taste to it for most founders. I mean, you are getting the money but you will also be left alone with the risk, so you’d better be super certain about your business idea. Especially if it’s your first time founding a business you need to be cautious as you lack serious experience regarding the numerous challenges and risks involved in the journey towards a thriving business. From legal and financial to personal unpredictabilities, there is a lot that you will master a lot better when doing it the second or third time. Many of the mentioned aspects even broke the entrepreneurial neck on the most experienced founders. So when instead of that fancy Porsche you will see the bailiff out your front door, you know you are screwed. But relax, for this to happen you would need to be granted the loan in the first place. And given the risk involved in founding a start-up, chances are you won’t.
VCs and Business Angels
Now we’ve gotten to the core of startup financing. If you really want to scale your business effectively from the first day on, you will need a lot of cash. Acquiring large sums requires resilience and the willingness to give away parts of your company – at least financially but also operationally. Those people who fund a startup don’t do so because they like to spend money but because they count on their investment to multiply after a successful market entry of the product. Business Angels and VCs are typically involved in different phases of your startup.
And there are hybrid forms of both, like Crowdfunding, where many private investors team up in once place (you might know Indiegogo or Seedmatch) to gather many portions of smaller sums which are then invested in startups. The latest craze are ICOs (Initial Coin Offerings), like you see them a lot (!) in the Blockchain network Ethereum, which kind of are sam same, but different...go look up ICO funding on the almighty internet if you want to learn more.
Angels here, VCs there...
Business Angels are private individuals who tend to lend out capital to startups in their early phases of fundraising, enabling them to hire staff, pay rent and buy or lease materials like computers and servers. All measures aim at increasing product development speed and effectiveness. The first phase is called seed phase. Apart from Business Angels you will likely find money from friends and family going into a young businesses in this phase, as well as equity capital and government support. This is possible because the amounts needed are not yet very high (probably ranging from somewhere between 30,000 to 100,000 Euros).
In the first financing round following the seed phase, many Business Angels remain active and invest some more to finance more complex product testing, marketing measures and more staff. With most startups, the product has already launched by that time and many challenges need to be addressed upon exposure to harsh reality – which is mostly different from what you imagined it to be for your product. The real life users often have slightly different demands than you imagined and you need to reiterate quite a few steps of your development process to meet them. This takes time and time consumes money. As your product hasn’t yet made a proper market fit, the risk remains high for your Angel and the offered conditions remain rather poor for your startup.
The structure of a Venture Capital company is essential to understanding its goals and methods. Most of the time they are a Limited Liability company (Ltd.) with an associated fund. Large investors – sometimes only one, but often mor –, or numerous smaller investors (called limited partners) invest in this fund. Of course, they aim at making maximum profit from this. Therefore Venture Capital Fonds mostly have a portfolio of startups they are invested in rather than only investing in one. They do that to distribute risk more evenly. Large fonds backed by many investors tend to already invest in the earlier startup phases after the seed phase as they can also distribute the higher risk implied with younger startups among the large number of investors – while speculating on bigger profits with early engagement. This is also a reason why they don’t only invest once but often continue their engagement in the same startups in consecutive funding rounds. Good VCs take great care of supporting their investment with expertise rather than just money.
Don't get chosen – choose them!
That’s why Business Angels as well as VCs can be so much more than just a source of capital...and actually should be more than that. As a founder and a startup in a more advanced state, you should aim for a close partnership with your investors. Business Angels have often been founders and entrepreneurs earlier in their lives and have great experience as well as large networks they encourage you to make use of. VCs are a little more complex in structure and the larger ones have people who are there only to support the startups they are invested in to supply them with valuable strategies, contacts and wisdom. With such a strong partner you can avoid costly mistakes, distribute your product more quickly and, generally, make better decisions based on an extensive professional background.
Not only investors are in the position to choose and possibly turn down applicants. You should most definitely do so, too. Go for people who have a strong background in your industry and show interest in you personally. Of course, if you cannot find such an investor, it's better to try with a not-quite-perfect partner instead of just letting go on your dream. But at least make an effort to acquire the investor of your dreams.
But beware. There's much more to building a startup than 'just' financing. At Railslove, few things get us more excited than breaking new ground. We love agile processes, fresh ideas, acting flexibly. Therefore, we gladly work together with entrepreneurs. Because if we are convinced by an idea, we make it our project and work for you as if it was our own company. We are partners through a difficult start and until the idea is established in the market and the business is running. And even if resources are limited, we get the most out of the idea.