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For early-stage startups, the amount of capital you have can be a defining factor in reaching success. It takes money to research and develop your business idea, and you might not always have enough personal funds to grow your ideas. This is where external funding comes in. There are many different types of funding to choose from to help you have the capital you need to grow and scale your startup.
In general, different types of funding may be dilutive or need to be paid back. Dilutive funding means that your investor will take equity, or ownership of a share of your company. Funding types that are loans will need to be paid back, often with interest and by a certain date. The table below shows a quick overview of the 9 common types of funding for startups.
Bootstrapping
Bootstrapping is when you fund your startup with your own personal savings. In other words, you don’t take any external funding and instead invest any profits back into the company itself to grow and scale. For more information about bootstrapping, check out our article Bootstrapping or Funding: Which is Right for You
Grants
Yes, for-profit startups can receive grants too! The best part about grants is that you don’t have to pay them back, nor do they take any equity. But, this free money isn’t easy to get. In order to receive a grant, you’ll have to meet specific eligibility requirements set out by each grant program, and prepare an application which is often lengthy and time-consuming. Grants can be difficult to find, so you’ll have to do lots of research to find the one that’s right for you. They’re also highly competitive, so you’ll need to decide if it’s worth investing the time and effort into creating a strong application.
A great grant program for tech startups in the US is the Small Business Innovation Research (SBIR) program that encourages the research and development of technology with the potential for commercialization in line with the goals of federal agencies, such as healthcare and homeland security. You can also search for state grants from the Economic Development Association. Or, for women-owned startups, check out the Amber Grant.
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Small Business Loans
Small business loans allow you to borrow a set amount of money to be repaid with interest. However, similar to personal loans, you’ll often need to prove your/your company’s ability to repay the borrowed amount. This means that in order to qualify for small business loans, you’ll typically need to have been in business (have had revenue) for at least six months. The standards for traditional banks and credit unions to make small business loans for startups are usually quite high, as startups are considered risky ventures.
In the United States, the Small Business Administration (SBA) has a number of loan programs where they guarantee loans for small businesses (including startups). The SBA approves individual lenders and are often able to get small businesses lower interest rates. The most popular SBA loan is the 7(a) loan program, which guarantees loans of up to $5 million. However, there are a number of qualifications required, and in general, these loans tend to go to business owners with strong industry experience. There are also microloans, which allow startups to borrow up to $50,000 and can be more accessible.
While this option is not impossible, it’s a risky, long, and difficult process for early-stage stage startups and first-time entrepreneurs, and as a result, is not recommended.
Incubators/Accelerators with Funding
Some incubator and accelerator programs will offer seed money to help you kickstart your business. Check with each program to see what the terms of the funding are, as they will often take an equity stake in your company in return. However, programs that offer funding are notoriously difficult to get into, with acceptance rates often falling in the single digits.
One of the most famous programs with funding is Y-Combinator’s accelerator, which provides $500,000 in seed funding in addition to its intensive 3-month program that culminates in a demo day. Other programs that offer funding include Techstars, Alchemist, and AngelPad.
These programs are great for early-stage startups with strong ideas but need more structured guidance on how to develop and execute, since aside from receiving cash to fund their development, they’ll have access to the program’s expert, alumni, and investor networks.
Friends & Family
Friends and family tend to be more informal investors at the very early stages of starting a company. But, don’t get it wrong. Just because your investor is a close relation doesn’t mean you should forego any formalities. To be sure both parties are aligned on the terms of the investment, you should still sign a formal agreement.
When raising money from friends and family, it’s important to be clear on whether the money is a gift, a loan, or an equity investment. A gift is the most straightforward: your investor gives you the money expecting nothing in return. You’ll be expected to pay back a loan, and investors who you’re familiar with may be more likely to give you a low interest rate. If you choose to take a loan from friends and family, set up a repayment plan too. An equity investment will be similar to a typical angel investment, where your investor will take ownership of a portion of the company.
The biggest risk of fundraising from friends and family is having business affect your personal relationships. There’s an added pressure to perform well when you’re operating on money given to you by the people you know and love. Make sure your friends and family are fully aware of the risks they’re taking by investing in you, and be transparent with them about your work along the way.
Crowdfunding
Crowdfunding allows for multiple people to invest small amounts of money in your venture. In general, most crowdfunding campaigns start with a call to action, where you introduce your startup and what you hope to achieve with the funding. People can then contribute money in two ways: as a donation or for a reward. (We’ll go into equity crowdfunding later.)
In donation-based crowdfunding, you’re not obligated to give anything in return for the money they give you. This type is usually most successful in impact-focused startups or non-profits. In reward-based crowdfunding, you offer a reward in return for contributions. You may set dollar amount tiers that correspond to different types of rewards. For instance, if someone contributes $50, they can get early access to your product. If they contribute $100, they can get early access and bonus merchandise. Just make sure you’re calculating the costs of your rewards well so that you’re not spending too much to reward people and end up not raising enough capital to meet your needs.
Most commonly, we see crowdfunding campaigns for consumer products being launched on platforms like Kickstarter and Indiegogo. Consumer products are a great candidate for this type of fundraising because they effectively allow you to sell your products as the reward before you’ve even built them.
Equity Crowdfunding
In equity crowdfunding, also known as regulation crowdfunding, people receive a small portion of ownership in your startup when they contribute money. This is also usually facilitated through a crowdfunding platform, like AngelList or StartEngine. One of the perks of equity crowdfunding is that it’s accessible to non-accredited investors, so it can be a great way to formally facilitate equity-based contributions from friends and family while also reaching a greater audience. The dollar amounts also tend to be much lower, sometimes as low as $100, so the barrier to entry is also lower.
You can raise multiple rounds of equity crowdfunding, though there is a limit of raising $50 million in a 12-month period. By opening up your pool of potential investors, you can also naturally expand your network since your new investors now have a stake in your company and will be motivated to see it succeed.
Note that most equity crowdfunding platforms will usually accept a small commission of whatever funds you raise. Though 5-15% may not sound like much initially, it can make a big difference in how much capital you’re actually able to walk away with. You’ll also still need to put in the work to build momentum and convince prospective investors you’ve got a viable business model and a strong business plan. And, like any other fundraising type, once you’ve given someone a stake in your company, they now have a voice in future business decisions.
Angel Investors
Angel investors are private individual investors that usually invest in early-stage (pre-seed or seed) companies in return for ownership equity. They use their own money to make high-risk investments with the hopes of a higher return on investment (ROI) than traditional investments. Finding a credible, experienced angel investor can also help build your startup’s credibility and bring in a voice of expertise.
While it’s not a requirement, it’s smart to ensure that your angel investor is an accredited investor. The U.S. Securities and Exchange Commission (SEC) recognizes accredited investors as those who have either a net worth of over $1 million or an annual income of at least $200k in each of the last two years. By making sure that your investor is an accredited investor, you can also lower your risk of being scanned. In addition, the SEC makes it much simpler to accept funding from accredited investors than from others. If your angel investor is not an accredited investor, proceed with caution and check state and federal laws to make sure that you’re filing all the necessary paperwork for the investment.
Angel investors are more likely than venture capitals to invest before a proof of concept is even produced, and typically offer smaller funding amounts. Some angel investors will be very hands-on, actively exercising their ownership rights and personally participating in the activities of the startup. However, some angel investors may also fall on the opposite side of the spectrum, staying hands-off after having already determined the management team to be strong enough to carry the company to success.
Venture Capitalists (VC)
Venture capital deals typically consist of a large investment in return for a large portion of equity. Aside from money, they’ll also often offer technical support and managerial expertise. With a venture capital investment, it’s not any single person investing in your company. Rather, it’s the firm as an entity, which means that the multiple people of the VC firm may all get a say in your company. It also means that it can take a while to go through due diligence and that investments are made very carefully.
Venture capital firms search for the companies that have the potential for fast and high growth, and support those companies until they exit either by acquisition or going public. This goal is important to keep in mind, as it will motivate the way they exercise their stake in your company once they invest.
While it’s the most talked about form of private investment for startups, it’s not actually the most common. Research shows less than 1% of startups successfully obtain VC funding.
A Note on Convertible Notes & SAFE Notes
When it comes to forms of funding that require you to give away equity in your startup, you might run into the issue of how to valuate your startup (determine how much money your startup is worth) when you’re in the early stages of development. An early stage startup will likely have a much lower valuation, which would mean you have to give away more of your company for just a little bit of cash. However, a startup that’s been valued too high for the sake of maintaining more ownership will seem unreasonable or unrealistic to your potential investors.
An early stage, pre-revenue startup can only ever have an estimated value. This is where convertible notes and SAFE notes come into play. They allow startups to access funding and go through the valuation process later, once they’ve been able to build and prove their value. Convertible notes and SAFE notes can be used for any type of dilutive funding, including angel investors, venture capital, friends and family, and equity crowdfunding.
A convertible note is technically a short-term debt that is converted into equity as the form of repayment later on. The convertible note will automatically turn into equity once a specific milestone is reached (dependent on the terms of the note). Similar to a debt, however, a convertible note may include an interest rate that gets added on top of the initial principle when it executes (turns into equity). Repayment is required by an agreed upon date, which means that if the convertible note is not paid off in time, your startup may be at risk of bankruptcy. There will usually also be a valuation cap, which places an upper limit on how much the company can be valued at when their convertible notes execute. A lower valuation cap benefits investors, because it means that they’ll be able to secure a higher percentage of the company.
Convertible notes can get complicated, so Y Combinator created Simple Agreement for Future Equity (SAFE) notes. SAFE notes are not a form of debt, but they are similar to convertible notes in that they will turn into equity later on and have a valuation cap. SAFE notes effectively offer your investor future stock at a discounted rate for being an early investor. However, unlike convertible notes which can have varying terms for what milestone is reached for execution, a SAFE note will only execute during your next round of financing or in the case of a company sale or IPO. Notably, SAFE notes can offer a provision called pro-rata rights, where investors are given the option to purchase shares in the future to maintain their proportion of equity in the company. For instance, if an investor currently has 10% in the company, they’ll be given the option to purchase shares in future funding rounds to maintain their 10% share.
With so many different types of funding, it's important to carefully consider your startup’s unique needs and goals to choose the right one for you. There’s no one-size fits all option, as each comes with its own pros and cons. You’ll likely even end up using a combination of different fundraising types in order to meet your funding goals. Also remember that each country may have different policies when it comes to fundraising, so be sure to check with your local laws to make sure that you’re fundraising properly to avoid any problems later down the road.
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