To many people, starting a business may be a bit overwhelming. Entrepreneurs not
only need to define their value proposition but they must also setup operations,
offer economically viable solutions, gain credibility, build a customer base and
generate revenues. Although entrepreneurs face a number of challenges when they
commercialize their business ideas, raising startup capital (seed investment) to
fund their business efforts is the most challenging of all.
Although the pool of capital available for startup companies is not significantly
larger today than a decade ago, the variety of financing options is larger. The
large variety of financing sources makes raising funds for different ventures easier.
However, every specific source of financing is associated with certain obligations
that entrepreneurs must understand before raising capital. The more educated entrepreneurs
are, the more likely they are going to succeed in raising startup capital.
The following are the major sources of funding for entrepreneurs:
- Personal finances
- Friends and family
- Angel Investors
- Debt financing
- Equity financing
- Customer financing
- Government–sponsored programs
People start companies at different points in their lives. Some entrepreneurs start
companies during the early stages of their career. A majority of entrepreneurs start
companies at later stages in their lives and these entrepreneurs often have personal
assets that they could use to finance their ideas. It is important for entrepreneurs
to invest their personal savings in their business ideas as it indicates that the
entrepreneur is confident about his or her own idea, thereby encouraging other investors
to look at the idea more seriously. After all, who would want to invest in a company
wherein the founder does not want to bet on the idea? Additionally, entrepreneurs
who do not put their personal savings into the venture can find it hard to raise
money from friends and family. Entrepreneurs should think thoroughly before investing
their personal finances. If the business idea is not feasible, the entrepreneur
Friends and Family
Friends and family are important sources for financing startups since they would
like to see the entrepreneur succeed. Such loans can be obtained quickly as this
type of financing is based more on personal relationships than on financial analysis.
However, friends and relatives who provide business loans sometime feel that they
have the right to offer suggestions concerning the management of the business. Their
suggestions might be orthogonal to the entrepreneur’s strategy and might create
fissures in the relationships. It is important to minimize the chance of damaging
important personal relationships. Therefore, entrepreneurs should plan on repaying
such loans as soon as possible even if the business idea fails, thereby ensuring
that relationships are maintained.
A large number of individuals invest in a variety of entrepreneurial ventures. They
are affluent people such as successful entrepreneurs, lawyers, physicians, etc.
who have moderate to significant business experience. This type of financing is
called as informal capital because these individuals do not make such investments
in established market places. Such investors are called business angels. They represent
the oldest and the largest segment of the U.S. venture capital industry. On average,
a typical angel investor invests more than $200,000 a year. Angels frequently put
their mind share in a company’s strategy and assist entrepreneurs in taking their
companies forward. Although angel investment is easier to acquire than some of the
more formal types of financing, angels can sometimes be very demanding. Entrepreneurs
should therefore define their relationships with the angels before finalizing the
terms of the agreement. It is imperative to emphasize that any angel investor would
be skeptical to fund a company, wherein the founders do want not invest their personal
Entrepreneurs can also raise capital from banks through the debt financing route.
Although some angels provide debt capital, commercial banks are the primary providers
of debt capital to small companies. Bankers tend to make business loans through
lines of credit, term loans and mortgages. A line of credit loan is the largest
amount of money that the borrower can obtain from the bank at any one time. An entrepreneur
must work with a bank in advance to obtain a line of credit before the company needs
the money because if banks do not know the specifics of their investment, they will
refuse credit. Attempts to obtain line-of-credit loan instantaneously are generally
ineffective. In addition to the line-of-credit load, banks issue five to ten year
term loans that are generally used to finance equipment. Since the economic benefits
of investing in equipment extend beyond a single year, banks are generally open
to lending money to buy equipment that generate revenues, which match the interest
to be received from such a loan. Finally, entrepreneurs can also obtain a mortgage
to provide funding. Mortgages are loans for which certain items of inventory or
other properties serve as collateral. Debt financing has its own set of advantages
and disadvantages. Although debt financing increases the potential for higher rates
of return on investment (ROI) and allows entrepreneurs to retain much of the board
control, it also puts entrepreneurs at greater risk. Irrespective of the startup’s
outcome, banks make sure that they will get their investment back along with interests.
To accomplish this, banks structure their agreements accordingly.
As opposed to debt financing, equity financing transfers the risk from the entrepreneur
to the investors, but has its own set of drawbacks. Equity financing is when entrepreneurs
can raise money only through selling common or preferred stock to investors. This
implies that an entrepreneur gives up some of his or her voting rights to investors.
Although most angels offer equity financing, institutional venture capitals make
the biggest equity financing investments. Institutional venture capital firms usually
manage large funds - anywhere from $25 million to $1 billion - and invest in high
growth companies. When a VC firm invests in a company, the firm generally takes
a seat in the board of directors. VCs assist the entrepreneurs in taking the companies
forward. The very same VCs do not mind firing everyone, including the founders and
shutting down the company if they determine that it is economical. In addition,
raising venture capital is generally a long shot. Venture capitalists will not even
look into a business plan unless the company meets some of firm’s criteria.
At times, large corporations or potential customers finance the entrepreneur through
debt or equity routes. Large corporations provide financial and technical assistance
to smaller businesses because as larger corporations downsize their operations for
tactical reasons, it becomes important that their suppliers, frequently small firms,
stay healthy. Examples of large corporations that have historically invested in
smaller firms include giants such as JCPenny, Ford Motors, Motorola, Micron, and
Several government programs provide financing to small businesses. The federal government
has a long history of helping new businesses get started, primarily through the
following federal programs:
- Small Business Administration (SBA)
- Small Business Investment Companies (SBIC)
- Small Business innovative Research (SBIR)
- Small Business Technology Transfer (STTR)
Recently, Congress has voted to increase the size and scope of the above programs.
Apart from the federally sponsored programs, state and local government are also
becoming increasingly active in financing new businesses. The nature of financing
varies, but each program is generally geared to augment other sources of funding.
Although it is possible to raise money with low interest rates and equity through
this route, entrepreneurs must have the patience to go through the time-consuming
government bureaucratic processes.
Although there are a number of financing sources, it is important that entrepreneurs
plan their strategy to raise capital. The decision to use debt or equity financing
depends to a large extent on the type of business, the firm’s financial strength
and the current economic environment, e.g., whether lenders and investors are optimistic
or pessimistic about the immediate future. The entrepreneur should start pitching
his or her idea as soon as the business plan is ready to meet the investors’ eyes.
The entrepreneur should then determine the best suitable capital sources for his
or her business idea and focus on those sources only. Entrepreneurs should allow
ample time for raising capital, since it generally takes more time than most people