Startups are often confronted with the questions: How big and how fast? If business owners want large startups at a faster rate, external funding may be necessary. External funding may also be necessary to keep up with competitors or to just cover daily operating costs. But external funding may be followed by certain consequences. It might not only interfere with the way a business is run, but it may also be pointless seeing that 90% of startups fail. According to current research done, 21.5% of startups fail in the first year, 30% in the second year, 50% in the fifth year, and 70% in their 10th year. This article will explore the different types of external funding and when, or if, they would be necessary.
Types of external funding
- The owners’ personal savings
When individuals are self employed, many proceed to use their personal savings as funds. These savings are often in the form of money, investments or retirement savings. This may be wise as it prevents them from having to pay interest rates which accompanies loans. This happens often in sole proprietorships. For entrepreneurs looking for more information about this business form, Incorporation Rocket is able to offer more information here. But some entrepreneurs choose funding from their credit cards or bank loans. This is a viable source of funding, but it is risky seeing that the business owner would have to be held personally liable for the repayment if the business fails.
- Business Loan
Business loans are another form of funding, which banks offer for a specific amount at a specific interest rate accompanied by specific repayment terms. Typically, business loans are used to cover startup costs, but many businesses use it to cover ongoing operating expenses or if specific assets, equipment, personnel and intellectual property is required. The entrepreneur is protected by these types of loans as it does not use their personal property as collateral in the case of bankruptcy.
- Family and Friends
Using funds from family and/or friends is a common practice in startups. The funding can be seen as a loan, which has to be repaid with interest unless the business fails and is forced to declare bankruptcy. The funding can also be seen as an investment, where the investor receives a portion of the profits once they have been produced.
- Angel Investors
Angel investors offer funding to startups and in exchange require a share of the business. These investors are known to invest small amounts while possibly offering mentorship and guidance. Some may even demand to have a percentage of control over business decisions. Since 2014, angel investing has become a popular trend. Successful tech firms have been seen to create a pool of angel investors. They would then each contribute a small sum, which adds up to a large amount for the businesses. This technique is dangerous, because if every investor wants to mentor, guide or have control in the business, the entrepreneur may become overwhelmed.
- Venture Capital Funds
Venture capital funds are created when many individuals invest into a fund, which then invests the funds in a range of businesses in exchange for equity. Although this is a less-used technique of funding, it has proven to be successful. Similarly to angel investors, venture capital funds may offer mentorship and guidance, or even a certain degree of control over the startup.
When is the right time for external funding?
Entrepreneurs should aim to not gain external funds at all if this is possible. By doing this they limit debts, as well as allowing the startup to survive the initial state of flux. This, which is an idealistic goal, may not always be possible. Before pursuing external funding, businesses should try to have meet the following conditions:
- The business has been able to successfully reach and cater to customers. Once customer traction has been proven, funds to up-scale the startup may be pursued.
- The business owner is concerned that without external funding, the business may not be able to maintain growth. Business growth may be threatened by competitors, imitators or businesses which are better-funded.
Startups, such as high-growth startups, will require external funding if they plan to scale rapidly or if they require assets, equipment, personnel and intellectual property quickly. High growth startups, which often have an innovative business model and/or a large potential customer base, will use the external funding to establish the startup ahead of competitors in the market. But not all businesses are able to be high growth startups, such as lifestyle businesses and traditional small businesses. These businesses grow slowly with their main purpose being able to support the entrepreneur and possibly their family.
Business owners need to carefully consider before pursuing funds. By gaining external funding, possible consequences follow, such as the dilution of the owner’s equity, a gradual loss of control over the business, and conflicting goals amongst shareholders and investors.
Other options
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The bottom line
Traditional small businesses and lifestyle businesses often do not require external funding, and should rather consider bootstrapping, where the business fund’s itself with the revenue produced as it grows. But businesses, such as high growth startups with a large potential target market, would be a better recipient for external funding. Business owners need to be aware and prepared for certain risks and liabilities which come with acquiring external funding.
Infographic created by Donnelley Financial Solutions, an SEC reporting software company