An introduction to startup funding

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Although investment is an important tool, it can be a real pain in the neck, if the investor/investment is not chosen wisely

Should you get external financing for your startup?

This is probably the most widely discussed topic in the startup world, globally. It is a fact that venture funding plays a key role in a startup’s joinery. Experts, however, cautions that no entrepreneur should take external investment unless he/she has exhausted all his/her available options.

Although investment is an important tool, it can be a real pain in the neck, if the investor/investment is not chosen wisely. Venture funding, or any investment from a third party or individual, would clip your wing for the worse. Infusion of funding means you will have to share the ownership of your company — that you have painstakingly built, giving your time, sweat and blood — with someone else. As a co-founder, you are accountable for each and every penny you take from an external source. In effect, a venture capital can make or break your company.

A majority of entrepreneurs feel that VC investment can guarantee them success, but statistics tell otherwise. According to Micah Rosenbloom, a venture partner at Founders Collective, historically only one out of 10 companies getting investments succeed; whereas some others like Tomasz Tunguz, Partner at Redpoint Ventures, feel that typical portfolio company failure rates across the industry — defined as either shutdowns or returning capital — are roughly 40 per cent to 50 per cent.

Having said that, external investment (angel/seed/venture/debt funding/crowdfunding) is a vital tool for a startup that is looking to scale and grow the business. When you are run out of money, external investment can save your business from being shutdown. It gives you the much-needed breathing space when you hit a deadlock.

This article is about the different types of funding a startup can look for to grow their business.

Personal financing or bootstrapping

It is hard for first-time entrepreneurs to raise funding, as no investor would be willing to risk their money and time, unless you are an alumnus of Ivy League. In this situation, personal financing/self-funding/bootstrapping is the best option. Here, you can pool in money from your relatives and friends. This requires less formalities/compliances. You may return the money to them with a decent interest as your business grows.

Also read: Bootstrapping your startup? Here are 7 tools you can use to make launch and growth easier

Crowdfunding

Crowdfunding refers to taking small amount of capital from a large number of people through an online platform. It is the fastest way to raise finance. A key advantage is that it can be a valuable form of marketing that could result in media attention. More over, you receive real-time feedback on your product and expert guidance on how to improve it. Crowdfunding also enables investors to track your progress.

There are different types of crowd-funding — equity-based, reward-based and debt crowdfunding. Of these, equity crowdfunding is the most-preferred route for startups to raise money.

With equity-based crowdfunding, the crowd becomes part-owners of the company that raises funding. Some of the leading equity crowdfunding platforms include Kickstarter and Indiegogo. In Southeast Asia, especially Malaysia, early-stage startups rely on crowdfunding, as traditional finance is too complicated, time-consuming and involves a lot of paper works.

Rewards-based crowdfunding means individuals forms a crowd to give money to a business in exchange for a reward, whereas debt crowdfunding refers to borrowing money from the crowd. Here the investors receive the company’s legally binding commitment to repay the loan at certain time intervals and at a certain interest rate.

Angel investment

Angel investment is the most common form of investment. Angels are affluent individuals who infuse capital into startups in exchange for ownership equity or convertible debt.

Early-stage startups rely on angel investment in the initial period to kickstart the business. Angel investments bring in a lot of advantages for startups. The terms would be more favourable compared to other lenders.

However, startups should be sensible enough to choose the right a gel to back their project/business. If the investor has no clue about your product/service, the funding will become a pain and could lead to friction between you and the investor.

Also read: The angel investor’s cheat sheet to successful portfolio building

Venture Capital

As per Investopedia, venture capital funds are investment funds that manage the money of investors who seek private equity stakes in startup with strong growth potential. They inject large amount of money in return for equity stake in the business, and get returns when the business goes public or is acquired. VCs invest only in companies that have the potential of providing good returns on their investment.

These, however, are high-risk/high-return opportunities.

Most venture capital comes from wealthy individuals, investment banks, endowments, pension funds, insurance companies, various financial institutions, and corporations.

Venture debt

Venture debt is a form of debt financing for venture equity-backed companies that lack the assets or cash flow for traditional debt financing, or that want greater flexibility. It is a form of specialty debt financing provided to companies that are not serviced by traditional lenders such as banks. The financing is usually structured as a combination of a loan and limited equity investment rights (warrants). Companies in the technology, consumer or healthcare domains — that typically do not possess any hard assets or collateral that can be used to get a traditional term or working capital loan — opt for venture debt funding.

Venture debt funding means you dilute less, and alternatively take a little bit more money. If properly used, venture debt financing can reduce dilution, extend a company’s track or accelerate its growth at a limited cost to the business. If misused or under unfavourable conditions, debt can reduce a company’s flexibility or become an obstacle to future equity poses.

Types of venture debt financing

There are two types of venture debt available in the market: Equipment financing and Growth capital.

Equipment financing is a great tool for hardware companies. They can use this tool specifically for the purchase of equipment and here the equipment acts as your collateral. The availability of equipment financing is linked to the actual purchase of equipment and, therefore, if less equipment is purchased than originally planned, less financing can be used.

Growth Capital, which is more common, is a great tool for companies looking for loans for corporate purpose. Long-term growth capital loans are secured by a lien on a company’s assets, which may or may not include a lien on intellectual property.

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