The Complete Guide to Choosing a Startup Funding Model

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Figuring out how to fund your business is almost as important as figuring out how to run your business. Changes in the financial landscape over the last decade have meant more options are open to startups for getting off the ground, while some classic options have taken a turn for the worse.

Specifically, bank lending has gone off the edge a bit. A report on The State of Small Business Lending by the Harvard Business School notes, “The share of small business loans of total bank loans was about 50 percent in 1995, but only about 30 percent in 2012.”

startup funding model

That’s been exacerbated by a consolidation among banks, with small, local banks and credit unions being snapped up by larger institutions. That gives entrepreneurs fewer bank lenders to approach.

Luckily, there are plenty of other traditional funding options still available – as we’ll see – and a handful of more contemporary options – as we will also see. Choosing the right option is all about understanding what your credit looks like, how much you need, how much you want to give up, and who you’re willing to be beholden to.

No company is going to end up using just one of these options. As your business grows, you’ll need new funding, find new ways to make partnerships, and get sick and tired of other funding options. I’m presenting these in rough chronological order based on when a typical business might turn to the given option.

Family and friends

The people who have already given you so much are often the first people to offer up more. Family and friends know you and may have even had some input into the early plans of your business.

When borrowing from these folks, you should be careful not to treat their money any differently than you would treat cash from another source. Make a contract, pay interest, and keep to a regular repayment schedule.

No one want to end up five years down the line fighting with their family because of a misunderstanding. Are they partners, lenders, or owners? Figure this out before you accept any money from them and make sure everything is written down.

Who is this for? People with a strong network of loved ones who are happy to lend. People who need capital for small investments. People who are buying saleable assets and thus not incurring as much risk as hiring an employee. No one wants to lose their friends’ money.

Who should steer clear? People who need a lot of cash – I guess this depends on your family and friends. People who don’t want the hassle of a bank – you should treat these like bank loans. People who are already not enjoying Thanksgiving at Aunt Debbie’s.

Small Business Loans

The classic small business loan. You write up your business case, you show up with your financial statements, you talk to a banker, and they “run the numbers” to see if you qualify.

Borrowing from a bank comes with a series of interesting trade-offs. On the one hand, you’re working with a business that can be incredibly valuable to you as your company grows. Opening lines of credit or having access to short term loans from your bank can help you through tough times and keep you growing.

On the other hand, banks aren’t known for being flexible. Not even a tiny bit. No one cares that things were hard this quarter or that your CFO left with no notice or that the parts you needed were held up in customs. A banking relationship is a difficult one to love because of the power imbalance.

Who is this for? People with good credit. People who have run successful businesses in the past. People who aren’t interested in giving over any control to anyone else. People who like stability.

Who should steer clear? People who have risky businesses or untested business models. People who need flexibility in their repayment terms. People who hate banks.

Crowdfunding

Kickstarter was the first big face of crowdfunding, but the system has grown since its inception. Now, you can raise funds through outlets and offer up equity or tchotchkes. You can give away part of the business, pay out interest for loans, or give access to new features and products.

Crowdfunding was expanded under the JOBS Act, allowing businesses to trade equity for cash. You’ll need to abide by some strict rules if you’re issuing equity, but there are still more traditional crowdfunding options available.

If you make a product, Kickstarter is still a great option. Pebble raised over $20 million for its smartwatch, while a card game called Exploding Kittens – from the mind behind The Oatmeal webcomic – pulled in over $8 million.

Who is this for? People with strong social networks online. People who are making something that the internet would love – no, bedazzled socks don’t count. People who are comfortable with an assorted array of funders, backers, and owners.

Who should steer clear? People who don’t really get the internet. People who need consistency and certainty. People who want guidance and education from their investors.

Credit cards

Credit cards are still a popular option for startup funding, especially in the very early stages. Capterra was built on the back of our founder’s credit cards, for instance. This requires a pretty strong credit score and a supportive spouse, by the way.

The upside of credit cards is their ubiquity, the ease with which you can get one, and the relatively low risk associated with failure – not no risk, but you might get to keep your house.

The obvious downside is the cost of funds. Credit card APRs are still hang out around 15% while business loans can be had for around 7%.

Who is this for? People with great credit ratings. People who don’t need to make purchases credit cards can’t pay for – good luck paying 50 employees with your Visa. People who just need a small bump or access to seasonal lending.

Who should steer clear? People who have bad credit. People who have profitablity timelines that stretch into years. People who need a lot of cash over a long period of time.

Angel investors

Ah the angel investor. The budding entrepreneur’s dream made manifest in cold hard cash. Angel investors are the wealthy, business-savvy individuals who swoop in early on in the life of a business and give it the cash it needs to get off the ground.

We’ll talk about venture capitalists next, but know this – these things are similar, but distinct. Angel investors are usually individuals instead of funded organizations. Angels offer less money, they come along earlier in the life of a business, and they ask for better terms – coming in earlier means accepting more risk.

Angel investors are great assets not just because of the cash they bring along. Like venture capitalists, a good angel investor can give you excellent business insight. They have connections that can help you get your first big break and they are personally invested in your success.

You give up equity to these folks and they stick around until you can go public or sell the business. According to the Rockies Venture Club, most angels have a three to five year investment timeline.

These people don’t care about your widget business. They’re looking for huge returns, in much the same range that venture capital is searching for. Angels are part of the new wave of investing, in many ways – they’re not actually new, but they fit that high growth/yield internet model.

Who is this for? People who have a proven business plan or a finished product. People who need help understanding the market and making inroads to the first big sale. People who are planning to go the full venture capitalist route later on.

Who should steer clear? People who want to keep their business all to themselves. People who aren’t interested in the extra pressure an investor looking for a 10x return brings to the table. People who have no desire to go down the venture capitalist route.

Venture capitalists

Here they are, those kingmakers of the modern age. Venture capitalists have taken on an almost mythical standing in modern America. In reality, they’re just investors. As a matter of fact, they’re pretty bad investors. You might not notice it because, as Harvard Business School’s Shikhar Gosh has said, venture capitalists “bury their dead very quietly.”

Most investments made by venture capitalists don’t beat the market and, by some accounts, most just fail. Venture capitalism is a big deal because when it wins, it wins big.

With all that background, you might start to realize that having a venture capital firm invest in your business doesn’t mean you’re going to succeed. It does mean something, though. These people don’t always win out, but sometimes that not due to lack of a good idea or even good sales, it’s just that the bar for a winning return is really high.

With a good VC firm, you’ll get access to great minds, new sales opportunities, strategic planning for an IPO or private sale, and insight into how to make your next business even better. That’s right, we can start thinking about the next big thing at this step.

Venture capital wants to invest in a proven plan, exciting technology, and a business just on the cusp. After the angels have had their fun, it’s time to see some VCs.

Who is this for? Serial entrepreneurs. People who could be sitting on The Next Facebook. People who need help managing the business side of the successful thing they’ve thought up.

Who should steer clear? Chefs, widget makers, furniture manufacturers – unless that furniture is also a teleconferencing system – and slow growers need not apply. If you like having even a semblance of control over the business, this might be a bad choice. If you’re not thinking about going public or selling to IBM, look elsewhere.

Equity sales

You’ve made it to the top of the Pops and your business is a real, actual thing. Time to cash it out. This is not a bad thing. You’re not “selling out” when you sell out – you’re freeing you and your hard-earned cash up to do other things. Before the big sale, you’ll likely have lots of smaller equity sales.

A seed round is often the stuff you raise from friends and family or from angel investors. This is the money that gets you off the ground given in exchange for capital.

After a seed round, businesses can go through Series A, Series B, and so on to raise more cash in exchange for equity. VC can come in at different points, with some firms looking for early stage businesses and some preferring to work with later round investment – the further along the less time the VC is going to have to wait to cash out.

At each new round, you’ll be able to revalue your business, which means you’ll be building hype for an eventual sale to a private company or for a public offering.

Equity is the tried and true way for big companies to get bigger, but you give up control and literal ownership. For every awesome success story, there are a dozen nightmares associated with equity sales.

Who is this for? If you want to run a public company or sell your business to a massive existing company, this is the road for you. I’ve focused on the VC path for equity sales, but keep in mind that you can sell equity to family or friends or even franchise owners. You don’t have to go public to sell equity.

Who should steer clear? Again, if you want to maintain total control of your company, don’t sell it, which is what issuing equity means doing.

Final thoughts

Find someone you trust, get a recommendation, get a lawyer, and get a good accountant. None of these funding systems should be undertaken without a lot of forethought – even financing with a credit card. You need to know what you’re getting into and what risks you’re assuming by taking a path.

From the outside, business seems to be all about the money that people can throw at a thing and how they can turn that money into more money. When you get inside, you realize that business is all about the relationships you can build. A trusted advisor is worth their weight in gold.

Let me know in the comments below how your funding has played out and if you met some good folks along the way. Good luck.

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Andrew Marder

Andrew Marder is a former Capterra analyst.

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