Let’s face it, starting a business takes money. How you choose to fund your business has many consequences for you personally and for your business. The right funding source for your business will depend on your personal financial situation (maybe you’re independently wealthy, maybe you have a rich uncle, or maybe you’re buried in student debt), the industry you are planning on operating within (there is a big difference between a heavy manufacturing business and a software company), your growth projections (a local business serving the local community versus a technology company looking to revolutionize a whole national or global market segment), and your exit strategy (planning for an ESOP is different than planning for a sale to a private equity firm). If you have an existing entity for your startup (e.g., a corporation, limited liability company, etc.), that will also influence the funding source that is the best fit for your specific situation. Below is a summary of some of the more common ways to finance a startup ranging from the most straightforward (bootstrapping) to the most complex (joint ventures).
Bootstrapping
If you are independently wealthy or your business has a relatively low upfront cost, then you may be able to pay for the startup costs of your business with cash and credit cards. The benefits to bootstrapping your business include not diluting your ownership interest in the business, allowing you the flexibility to utilize a simple and tax advantageous business structure (a single-member limited liability company), and reducing the cost of setting up and administering your business. The drawbacks to bootstrapping your business include putting your own money and finances at risk. Starting a business takes substantial time and effort. By bootstrapping your business’s startup costs you are doubling down on your business’s success, because you are devoting money (either savings or credit card debt) and time that could be used to generate income from another source (e.g., a job with a third-party employer). While bootstrapping can be an appealing way to finance your new business, you can limit your downside risk by getting third-party funding from one of the sources described below.
Grants
Depending on the industry in which you will operate your business, there may be government and private grants available that could be used to cover the startup costs of your business. These grants are often highly competitive and may come with certain strings attached (e.g., an interest in any inventions developed by your business while utilizing the grant money, etc.). These grant applications can often be completed on your own, but it is critical you know what you are signing up for before submitting each grant application. We highly recommend you consult legal counsel before applying for any grants to ensure you understand the strings attached to each grant.
Bank Financing
If you are planning on starting a business that is asset heavy (i.e., the business owns equipment, the business owns real estate, the business will have a large physical inventory, etc.), then bank financing may be the right source of financing for your business. While not bank financing, you may be able to finance or lease assets right from the manufacturers or sellers of the assets that your business needs on substantially similar terms to a traditional bank loan. It is worth exploring whether this is an option because you may be able to borrow more from the manufacturers or sellers of the assets that your business needs than you would be able to borrow from a bank.
Banks offer different types of loans based on your business’s needs. Term loans are loans in which you repay a fixed amount over a defined period. These types of loans are good options if you are buying a large asset with a long-life cycle. You may also be able to get a line of credit from a bank, which gives you the flexibility to draw down (or take from the bank) only the money that you need to operate your business up to some predetermined cap.
The benefit of bank financing is that it is non-dilutive (i.e., you typically do not need to give up an ownership interest in your business to secure the financing). The drawbacks to bank financing are that you will need to repay the loan with interest. Additionally, you will typically need to provide collateral or security in exchange for the loan. If the business has valuable assets that have a value that exceeds the amount of the loan, then the bank may be okay just taking a security interest (i.e., a lien) in the assets. In most cases, however, the bank will also want a personal guaranty from you to secure repayment of the loan by the business. Granting a personal guaranty to a bank puts at risk all of your personal assets if the business defaults on the loan. Similarly to bootstrapping, providing a bank with a personal guaranty significantly increases the amount of risk you are assuming in starting your business.
Venture Capital Financing
While often the most complicated of the financing options, founders are frequently attracted to raising money from third-party investors to help share the risk and cost of starting a business. If you know that your business is going raise money from third-party investors, then you will want to consult an attorney from the outset to make sure you are setting up your company to easily take on investment from third-party investors in the future. Specifically, you will probably want to form a C corporation through which to operate the business. Despite common perceptions, operating a C corporation does not need to be costly or complicated, especially early on and if there are not many shareholders. We’ll discuss entity choice for your business in a separate post.
The three most common types of venture capital financing are summarized below:
Convertible Promissory Notes
Traditionally, startups would often get their initial financing from third-party investors in exchange for issuing convertible promissory notes to such investors. A promissory note is a document that evidences a loan. A convertible promissory note is a document that evidences a loan that could be converted into an equity investment in the company if certain predetermined conditions are met. Typically, a convertible note will convert into equity (i.e., stock, if a corporation, or a membership interest, if a limited liability company) on a subsequent financing that exceeds a previously agreed-on threshold. Investors prefer convertible promissory notes when making early-stage investments because they provide the investors with greater downside protection than an equity investment. If a startup fails, investors holding convertible promissory notes will have a preference over the equity holders to any cash the startup receives when it liquidates its assets.
Simple Agreement for Future Equity (SAFE)
Just as common today as convertible promissory notes are SAFEs. SAFEs are similar to convertible promissory notes, but they do not evidence a loan. Instead, a SAFE is a contractual commitment between the issuing company and the investor pursuant to which the company will issue equity to the investor if certain predetermined conditions are met. Similarly to convertible promissory notes, SAFEs typically convert into equity on a subsequent equity financing that exceeds a previously agreed-on threshold. SAFEs are preferable over convertible promissory notes for issuing companies because the holders of SAFEs do not have the same preference as holders of convertible promissory notes in the event the companies fail.
Equity Financing
Traditional equity financings often occur once a startup has shown it has some level of viability (e.g., a proof of concept, initial customers, etc.). Companies usually structure larger financings as equity financings. When a company does an equity financing the company issues to investors shares of stock, if a corporation, or membership interests (sometimes referred to as “units”), if a limited liability company. The investors become either shareholders, if a corporation, or members, if a limited liability company, of the issuing company. The issuing company can determine what rights investors get when they become shareholders or members of the issuing company, but typically investors require certain standard rights, privileges, and preferences. These may include certain voting rights (including consent rights over certain actions by the issuing company), a liquidation preference (i.e., the investors may have a right to get any cash from the issuing company on a liquidation up to their investment amount before the other shareholders or members (i.e., founders, employees, etc.) receive any cash), preemptive rights to participate in future financings, ant-dilution protections that protect investors in the event the issuing company later issues securities at a lower price per security, the right to elect a member of the issuing company’s board of directors, registration rights, information rights, and a right of first refusal and co-sale rights if other shareholders or members try to transfer their equity interest in the issuing company. Negotiating the nuances of these rights and completing due diligence of the issuing company is what typically drives up the cost of equity financings compared to financings in which the issuing company issues convertible promissory notes or SAFEs. The biggest downside to equity financings is that existing equity owners’ ownership interest in the issuing company is diluted (i.e., reduced) each time the issuing company completes an equity financing.
The type of investors you are targeting will greatly impact the type of investment and the terms of the investment. A traditional venture capital investor is looking for at most a five – seven-year investment horizon. This means a startup should have a clear plan to either sell or go public in five – seven years when the startup is targeting traditional venture capital investors. If a five – seven-year investment horizon does not fit into your business plan, then you want to be upfront with investors about that at the outset. Additionally, you may want to target non-traditional investors, including impact- and mission driven-investors. While such non-traditional investors are often great options for companies, it is important to understand that documenting investments from such investors often costs more because such investors frequently negotiate additional protections and rights, because they are making an investment that is intended to last for more than seven years.
Joint Venture
While not the most common source of funding, you could also explore forming a joint venture with an existing business to fund your new business. Unless you have an existing relationship with a business, this is an unlikely funding source for most startups. The upfront documentation costs of forming a joint venture are also typically high compared to the other financing options described above. There are many different types of joint ventures, ranging from contractual arrangements between two parties to forming a new separate entity through which to carry out the joint venture. Joint ventures also come with their own set of unique issues including who owns any intellectual property rights developed by the joint venture, who is responsible for funding the joint venture, and who runs the joint venture.
