Too often, startups lock themselves into thinking that there are only a few ways to raise capital. But that’s not true. There are plenty of different ways to raise money if your business if promising and if you’re creative. VCs and angel investors might have certain vehicles they return to repeatedly, but there’s no reason you should be beholden to their model if it doesn’t make sense for your business.
For startups with at least some proof of concept, raising capital isn’t that difficult. Particularly at the early stage or “seed” round, there’s money to be had. That doesn’t mean investors will fund any business idea or business team. But the wealthy are looking for the next big thing. If you do your homework and convince them that you can be it, you might be amazed how quickly the money rolls in.
Depending on the type of business you’re starting and your personal and professional track record, not all of these 21 ways will be available to you. And, of course, every startup should consult a group of trusted personal and professional advisors to determine the path that makes best sense for their business.
The 1st Way to Raise Money for Your Business: Kickstarter
In just six years of existence, Kickstarter already outstrips the National Endowment of the Arts as the leading source of distributed funding to startups in this country. If you’ve been living in a cave or have not yet heard of the “internet,” Kickstarter is a platform that solicits backers to provide donations in exchange for products, gifts, or other tchotchkes. Because the platform involves donations and gifts rather than equity or debt, there are no securities laws issues at stake here. This makes the successful Kickstarter campaign a low-cost, low-risk way to launch a business.
There’s plenty on the internet about Kickstarter, and I won’t go into too much depth about it here. But there are a few legal issues to consider before launching any campaign.
If you think that your business might include patentable products or processes, make sure to consult a patent attorney about getting a provisional patent before you announce it to the general public.
Also, make sure you don’t infringe on anyone else’s intellectual property as you launch your product. If you’re going to create a video with Van Halen’s “Jump,” or Weird Al’s “Eat It,” make sure to reach out to the proper licensing organizations to get the rights to use the song.
Finally, while successful Kickstarter campaigns can jumpstart a business, but bad ones can kill it just as easily. Try to solicit feedback from the most brutally honest friends you can find about what you’re offering in your campaign. Usually, the successful campaigns have already dabbled in customer validation before launching. Those that haven’t often encounter embarrassing and demoralizing results.
Pros: Low-cost, low-risk way to raise funds
Cons: Not as easy as it looks to do well
The 2nd Way: Friends & Family
Many startups use the resources of their inner circles to get started. It can be a great way to launch without having to prove your concept to sophisticated investors right away, and, assuming your family and friends believe in you, it helps to have their support along the way.
Friends and family (and fools) investment can either be a tremendous boon or an abject disaster, depending on who they are and their risk profile and understanding of startups.
But first things first. If you’re going to raise with friends and family, for most growth companies, it is imperative to make sure that they are accredited investors within the meaning of 501 of the Securities Act of 1933. Because if you don’t, most likely you will be required to provide disclosures equivalent to those of a public company if you try to raise money using the most common form of private securities exemption, the Rule 506 exemption. If any of this is confusing to you, then this is why you need to work with a lawyer when you’re raising money for your business.
If you raise money using non-accredited investors (without doing proper Rule 504 state-by-state filings), you might as well raise a big red flag and insert it as the first slide in your pitch deck when you talk to sophisticated investors. I recently spoke to a VC about this issue, and what he said was, “anyone who raises using non-accredited investors shows that they are unqualified to run a business using other people’s money.” It’s like misspelling something on your resume. Anyone on the other side of the table is going to think, “If they got this wrong, what else are they going to get wrong?”
Another potential area of concern is that unsophisticated investors may have little understanding of the likely trajectory of a startup business. Experienced investors use the pejorative term “dumb money” to describe these investors. And dumb money can be a real pain. But if they’ve given you money, and they own a piece of the business, you are obligated to appease them, no matter how “dumb” in terms of the nuances of startup businesses they might be.
Again, the wisdom or folly of using friends and family is entirely context-dependent. Your friends and family might be ideal early investors, or they might cause your early ruin. The end result depends on their temperament and whether they are qualified and prepared to be early-stage investors.
Pros: Easy way to raise money; likely favorable terms.
Cons: Many founders get themselves into basic securities laws entanglements, because they assume securities laws don’t apply to close connections (hint: they do). Also, “dumb money” can be an albatross for a small business if the investor doesn’t understand startups and decides to assert influence.
The 3rd Way: Angel Investors
The term angel investor sometimes has connotations related to the size of investment or the investment vehicle, but really it’s just a broad label for an investor who invests on his or her own behalf.
The difference between an angel and a venture capitalist is just a question of whose money they are investing. Noted venture capitalists therefore also sometimes act as angels. To wit: if Brad Feld is investing his own money in a company, he’s an angel investor. If he’s investing it on behalf of someone else, he’s probably acting in his role as a venture capitalist.
Angel investors also frequently organize themselves into angel syndicates, whereby multiple investors make investments in a company at the same time, thereby increasing the size of the investment and influence of the contribution. These syndicates may organize in a variety of different ways, but they frequently do so in such a way as to limit the impact on the company’s capitalization table and to provide a funnel where the company only has to interact with one representative of the syndicate.
Angels vary in size of investment, stature, sophistication, and legitimacy. Just as startups ought to take careful consideration in reviewing the credentials of friends and family investors, they should be equally circumspect in background checks on angel.
Ask for references of prior companies angels have invested in. Then speak with the founders of those companies. Figure out if the angel cooperated with the team or made life a living hell. If your angel investor can’t provide three to five references of companies they’ve worked with, then you know your prospective investor may be new to the game or likely does not have the best track record.
Angel investors use many of the vehicles described on this list: common stock, preferred stock, convertible debt, and less common instruments. And just as the quality of investors varies wildly, so too does the quality of investment terms. Always consult with attorneys and advisors before moving forward on any deal. Oppressive deal terms can reshape the power dynamics of your company and hinder your growth with the stroke of pen.
Pros: Depends on the angel investor
Cons: Depends on the angel investor
The 4th Way: (VC) Venture Capital
There’s no shortage of information about venture capital (VC) funding on the Internet, whether written by VCs, entrepreneurs, lawyers, or other hangers-on. Almost all of the most successful technology companies receive venture capital funding, but only a minute fraction of aspiring startup companies receive VC funding.
How do you beat the odds? First, you have to be the kind of company they’re looking for. According to Peter Thiel, President of Clarium Capital and early investor in Facebook, because the odds are stacked so far against most startup companies, to justify investment, each prospective company must have the capacity to earn enough money to support the entire venture fund, because every VC knows that most startups will not succeed.
For example, if you’re looking to raise money from a fund with $150 million under management, you must aspire (and provide a compelling case) to be at least a $150 million business, or else you’re barking up the wrong money tree.
Second, you have to be the best of the best. I co-host a meetup with an attorney that represents the Foundry Group, and he said they receive about 65 pitch decks a day. Assuming 250 working days a year, that’s more than 16,000 pitch decks. They invest in a handful each year. By that math, getting VC funding is way harder than getting into MIT and probably a little easier than playing in the NBA.
So, if you’re looking to go that route, make sure it is a plausible option for your company. And then if you think it is, bring your “A” game.
Pros: Prestige, elite network, big money
Cons: Extraordinarily high expectations and demands, remote chance for most startups
The 5th Way: Common Equity
When an entrepreneur talks about an exciting new idea at a bar or a coffee shop, and a friend invests in that exciting new idea, this is usually the form of investment that the two have in mind. “I’ll give you 5% in exchange for $5,000 today. Shake on it?”
This is the simple and easy exchange of money for a percentage of ownership in a business. Another way to describe this type of investment is “common equity.” All that means is that the investors buy in on the same terms as the founders. While most people who invest in this way likely think that their behavior is akin to that of a hot-shot venture capitalist, the truth is that most hot-shot venture capitalists would never consider a common equity investment in an early-stage startup.
An early common-equity investor is almost always a relatively unsophisticated investor. And because of that, early stage common-equity investments often are susceptible to a few common pitfalls.
First, the owner who sells 5% of a business for $5000 just sold a security interest in their company. There are many laws governing such sales, and they’re called “securities laws.” They vary from state to state and there is a comprehensive set of rules governing them at the federal level. Any business owner who sells a percentage of their business without receiving professional guidance will likely find themselves out of compliance with those securities laws. The most common consequence of that lack of compliance is that investors will have a right to a full refund at any time. But, depending on the exact nature of the error, this can also greatly complicate future raises or even put the entrepreneur on a sort of startup no-fly list (or worse).
Second, the business owner who sells 5% of a business for $5000 also just put a valuation on the company. If 5% of a business is worth $5,000, then 100% is worth $100,000. That’s fine if that number reflects your understanding of the business’s value. But if it doesn’t, then you may find yourself in a struggle at some stage to explain the inconsistency. Especially if you need money later and the price changes. This can be problematic for undervalued and overvalued companies. For the undervalued company, you’ll need to provide hard evidence to future investors or suitors to explain why the company is worth more now than in the prior round of funding. If you have sales, revenue, or other data to support your thesis, then you may be fine. But if you don’t, you’ll likely be stuck at the prior valuation. If you initially overvalue your company, you may be forced to do a “down round.” This means selling stock at a lower valuation in a later round of funding. This is discouraging for founders, employees, and investors. Startups are supposed to ramp up and up, and ramping down for startups rarely leads to a happy ending.
Third, early stage startups often give up way too much too early. Many startups give away a quarter or half of the business in exchange for a few thousand dollars. That would be fine if that were all the money needed to grow the business, but most startups need a lot of money as they progress, not just to launch. This means serious dilution is inevitable for founders and early-stage investors. And if the founders end up diluting themselves too much, their financial position becomes untenable to the point where they have no incentive to continue working the business. Failure isn’t predetermined for companies with improper valuations or poorly conceived rounds. But every startup should take the valuation question seriously as they search for funding. Work through the process with your advisors and the professionals on your team to make sure you’ve thought through all the consequences of your early-stage investment.
Cons: Most sophisticated investors wouldn’t be interested in investing on same terms as founders
The 6th Way: Preferred Equity
Whereas common equity is probably the preferred vehicle of the least sophisticated investor, preferred equity is probably the preferred vehicle of the most sophisticated investors. It also is the vehicle that most commonly leads to the worst financial results for founders. As a founder, it’s hard to structure a common equity raise that will completely wipe out the founders’ opportunity for financial gain from their own startup. It’s possible to lessen that opportunity, but you can’t take it away entirely unless the founder sells all of his or her own stock.
But if you structure a preferred equity round without thinking through all the consequences, it is altogether possible, indeed common, to completely eliminate the financial return a founder can expect to receive from their own founders’ stock.
How is that possible? There are lots of answers to that question. Preferred equity doesn’t have a pre-determined meaning. The only way to know for certain what rights and obligations attach to a preferred equity investment are by reading the details of the investment documents themselves. But as a general rule for startups, you can likely assume that any preferred equity investment is going to have some sort of liquidation preference. A liquidation preference is the amount that must be paid to the preferred stock holders before distributions may be made to common stock holders. So practically speaking, if investors put $1,000,000 into preferred equity with a 1x liquidation preference (a liquidation preference equal to the size of their investment), if the company is sold for an amount equal to or less than $1,000,000 or liquidated with less than that amount in assets, then the common stock holders don’t get a dime.
Sounds simple enough. But not all liquidation preferences are created equal. Sometimes investors ask for 2 or 3x liquidation preferences, or participating preferred liquidation preferences. A participating preferred preference ensures the investors get their money back first, and then allows them to start over again and participate pro rata in any subsequent proceeds of a sale or liquidation.
You can see how this would start to add up. And for companies that raise many millions of dollars, all of the sudden the startup needs to hit a grand slam just to get any return from their years of hard work.
A few months ago when I was doing a presentation on this subject with another startup lawyer, he said something along the lines of, “be careful of the terms of a preferred equity raise early on with your startup, because whatever terms your early investor gets, your later investors are going to want the same terms that the early investor got, and more.”
This is sage advice. And it’s part of the reason that I discourage companies that work with me from raising with preferred equity in the earliest stages of growth.
Unless, of course, the investor seeking the investment is a superstar. In that case, the attendant benefits of having that investor on board (literally or figuratively) likely outweighs the potential negative consequences of giving away preferred equity early on in the process.
Pros: Investors love it
Cons: Can lead to dangerous results if consequences not understood or used incorrectly
The 7th Way: Convertible Debt
A convertible note is one of the most popular ways of raising money for startups. A convertible note is a debt instrument that provides a simple rate of interest and a means for the holder to convert both the debt and the principal into equity at a later date at a discount to the price paid by the investors who come later.
Sound a bit complicated? Let me walk you the logic of it first, and then I’ll walk you through the logistics. In the early stages of startups, it’s next to impossible to determine with any accuracy what they are worth, but there are plenty of investors with cash who like the idea of investing in them. Particularly at the earliest stages when there are little or no financial metrics on which to base a valuation, setting a price for company stock is a bit akin to a monkey playing darts. The founder monkey aims for high numbers and the investor monkey wants low numbers. For high-growth startups, the reality is likely binary. Either the company is going to be worth nothing, or the company is going to be worth a lot of money. But each side knows (or should know) that, pre-revenue, and it’s impossible to know which, and so the valuation question is a ridiculous exercise.
With convertible debt, there’s none of that posturing. Both sides express agnosticism at the current valuation of the company. The investor invests a set amount of money in a debt instrument that only converts into an equity stake if there is a triggering event at a later date (acquisition, sale, or subsequent round of funding). The convertible debt kicks the valuation question down the road until the business has had time to become more fleshed out.
So now that we understand the logic behind convertible debt, how does it work in practice? First, there is a set interest rate. This is usually set between 5-10%, with 6% being the most common I’ve seen. Second, there is a discount rate. This is the discount the convertible note holder will pay to the next round of investors. The standard rate here is 20%, but I’ve seen as high as 40%.
So, if on day one, a company sells $100,000 of convertible debt with a 20% discount, and on day 100, the company has a preferred round where investors pay $1.00 a share, the investors who bought the $100,000 note on day one will convert their $100,000 investment, plus accrued interest, into equity in the company at a price of $.80 a share (thus the 20% discount).
Starting to make sense?
There are lots of other variables I won’t get into now, such as valuation caps, maturity dates, voluntary conversions, acquisition premiums, and other nuances, but hopefully now you’re starting to get the gist. Skip the valuation question and offer the investor upside and downside protection. Everybody wins.
It does have its downsides. Most notably, what happens if the company hasn’t been acquired or raised another round of financing by the time the maturity date rolls around? Could get ugly. Plus, what startup has the cash to pay interest on a convertible note? That money should be going back into the company, right? The answer, is that 99% of the risk associated with these problems can be eliminated by the way these notes are drafted.
Convertible notes allow startups to raise money without having to sacrifice too much equity when they’re desperate for cash. That makes them a winner in my book.
Pros: No valuation question; no immediate equity sacrifice.
Cons: Interest, risk of being called at maturity.
The 8th Way: SAFE, KISS and Convertible Equity
I suppose I could have changed the title of this series to “23 Ways to Raise” and broken these three instruments down individually, but to me, the pluses and minuses of these three instruments are closely aligned. They were all motivated by the same concerns and they all face similar issues with adoption.
These three instruments have been created by various attorneys who work in the startup community. The idea behind them is simple: create a convertible debt-like instrument, while eliminating some of the negative elements of convertible debt. Convertible debt has two noteworthy problems. First, it is a debt instrument and therefore causes the company to accrue debt and interest at a time when it’s raising money. Second, it is a debt instrument and has a maturity date. At that maturity date, if the startup has not raised a subsequent round and investors were to call the note (that rarely happens, btw), it would likely be the death knell of the company.
SAFE, KISS and convertible equity all address these issues. Which brings us to the question. Why are they not more popular?
The biggest problems with their adoption is threefold: 1) First, investors – even investors in early stage startups – tend to be risk averse. And while the very nature of the startup community attracts those who are early on the adoption curve, investors don’t want to be the guinea pig in a new investment vehicle; 2) These instruments aren’t quite as favorable to investors. They are company-friendly documents. And it is rare in an early-stage investment when founders have leverage in the negotiation, 3) Not that many lawyers are as familiar with them yet. While they are by their nature simple documents (particularly FACE and KISS), if either the company or the investors’ lawyers are unfamiliar with them (usually true), they may actually add to the transaction costs of a round.
These instruments are innovative and can be an effective way to raise money under the right circumstances. The question is whether their popularity will grow over time to overcome the initial inertia that’s keeping them from being used more commonly.
Pros: Simple, Company-Friendly
Cons: Not as well known; Lack of wide-scale adoption
The 9th Way: Equity Crowdfunding
In 2012, President Obama signed into law the Jumpstart Our Business Startups Act (JOBS Act). For the first time in 80 years, it was legal for startups and private companies to raise money from large amounts of strangers by giving equity in their businesses in exchange for capital.
Many pundits predicted that this would create a tectonic shift in how startups raised money. I don’t think that’s happened. There are a few different reasons for that.
First, even if you remove the legal and regulatory hurdles associated with equity crowdfunding (which are considerable), it isn’t easy to raise capital from complete strangers. Some have pulled it off, but most who try fail. There is a relatively small subsection of the population that are qualified to invest in startups (as accredited investors) and interested in doing so. Those who fit into both categories find many startups competing for their attention.
Second, equity crowdfunding involves significant legal, regulatory, and shareholder-related expenses. There are now four separate titles associated with the JOBS act, and the regulatory framework associated with these laws is constantly evolving. Most founders don’t have the time or the inclination to understand the nuances of these laws, which are already predicated upon very complex and nuanced securities laws. That’s fine, but most founders are also parsimonious in outsourcing this work to a qualified attorney. Put the two together and you get a recipe for near-certain securities law violations. The consequences of those violations range from an investor right of redemption to a prohibition on raising additional capital to jail time for the most serious offers.
Equity crowdfunding is a real option for some startups. But, be forewarned, there are many things as a startup that you can do on your own. Unless you have a background in securities law, equity crowdfunding isn’t one of them.
Pros: Access to lots of potential investors
Cons: Get it wrong, and you’ll turn off potential acquirers and big investors
The 10th Way: ROBS Transaction
A ROBS (RollOver for Business Startups) transaction, while not as well-known as some of these other methods, can be just as valuable. A ROBS transaction is a form of self-funding, based on an exception in the Internal Revenue Code (IRC) that allows current or prospective business owners to use their 401(k), IRA or other retirement funds to fund their business.
A number of providers tout the merits of a ROBS transaction and while one may dismiss these providers as exaggerating the benefits of the goods they hawk, there are significant, valid benefits that should not be overlooked.
ROBS is tax free, confirmed by the IRS. Contrast that to other funding options such as liquidating personal assets at a gain, or withdrawing directly from a 401(k) (unless the 401(k) permits loans). Taxes for a 401(k) usually range from 30% to 40% of the amount and there is also a 10% withdrawal fee. And, in contrast to a loan, with ROBS there is no interest and no time schedule to pay off as long as your business remains operational. In comparison to traditional loans that typically take weeks to approve, a client can receive money from their ROBS transaction within three weeks. However, one may now obtain a loan through a P2P online lender in minutes, so if time is a factor, then an online P2P loan may be preferable. Furthermore, credit is not an issue with ROBS, since you are essentially borrowing money from yourself–per the SBA.
ROBS also allows you to store a portion of your business earnings as savings for yourself. This money is put away as pre-tax dollars, which provides a two-fold benefit: you save money for your retirement and your business also pays less in taxes. You will likely end up paying fewer taxes on your savings since the taxes are deferred until you are retired, when you are often in a lower tax bracket.
And, using ROBS, you avoid selling your personal assets. Rarely does the optimal time to start a business coincide with the optimal time to sell personal assets. For example, rapid commercialization is often imperative to successful monetizing a software app. But, it is unlikely that the app developer’s fundraising stage corresponds with the ideal time to sell his personal assets.
Despite the benefits, not all businesses are ideal candidates for a ROBS transaction. Generally, if you intend to use less than $50,000 in a ROBS transaction, then a ROBS transaction does not make sense because of the costs associated with it. These costs include an initial setup fee, usually $5,000, plus annual maintenance fees. The average monthly maintenance fee ranges from $90 to $120 per month, depending on the ROBS provider.The initial setup fee we charge is, in general, lower than what standard providers charge.
The 11th Way: Loans
Fifty years ago, if you were looking to start a business, this was the only recourse available to you. As startup financing has grown in popularity and dimension, there are now the other options available, as outlined in this series, but that doesn’t mean that a simple loan isn’t an option anymore.
It isn’t for everyone. If you don’t have a history as a business, a traditional bank won’t lend to you.
That means you’re probably going to have to personally guarantee the loan on the business with whatever personal collateral you might have. And since part of the attractiveness of starting a new business is to separate the personal liability from the professional liability, that makes this option a non-starter for many entrepreneurs.
But if you have confidence in your plan and you’d rather take on some risk with a loan rather than give away equity, it’s an option.
Even SBA loans, which are more commonly used for small businesses than for startups, require personal collateral until the terms of the loan are met.
In the startup culture where the typical modus operandi involves succeeding big or failing quickly, a small business loan won’t appeal to many. But not every startup is alike. For businesses that don’t have quite such a binary trajectory, small business loans are another option to consider.
Pros: Don’t have to give up equity
Cons: Personal guarantee likely required; traditional bankers/SBA not great at dealing with startups
The 12th Way: Licensing IP
Coming up with good and potentially profitable business ideas is relatively easy. Executing on those ideas? Not so much.
Some inventors are well equipped to come up with ideas, but have neither the ability nor the inclination to develop the ideas into businesses. For those who fit that description, licensing may be a cost-efficient alternative to setting up a new business.
Licensing refers to the process of granting or transferring the rights to some idea or intellectual property in exchange for various forms compensation. Instead of taking an invention and bringing it to market yourself, you take the invention to another company that is better equipped to bring it to market, and they take it to market instead. That company might pay you an up-front fee or a royalty on any sales related to the invention, and if the invention is successful, you will likely get paid well.
Exclusive or non-exclusive licenses
One of the first things to consider when granting a license is whether to make the license exclusive or non-exclusive. Exclusive licenses means the licensee is the only one with the rights to use the invention, including the inventor. Non-exclusive licensees have the right to develop the invention, but might have to compete with other licensees or the inventor while doing so.
Typically, the terms associated with exclusive and non-exclusive licenses are very different. Consult with a qualified attorney about the differences.
Before licensing a product or invention to another person or entity, the inventor should probably obtain a provisional patent on the invention, or, at a minimum, consult with a patent attorney about the possibility. A provisional patent application is a type of placeholder patent application that provides an initial reservation on a concept of a patent. It’s a stake in the ground where an invention sits that puts other investors on notice that the concept belongs to one inventor. You should file the application before marketing the invention to the public, because the patent system works on a “first-to-file” system.
Licensing agreements vary considerably by industry, type of license, and relative leverage of the inventor and the licensee. But there are a few broad concepts to keep in mind when licensing.
First, many licensing agreements require the licensee to pay an upfront fee to the licensor. For a first-time inventor or entrepreneur, it will be hard to negotiate a large upfront fee. But repeat inventors with a track record of success or inventors who can already show traction for the invention may be able to get a good amount of money right away.
Second, and perhaps most importantly for those providing exclusivity for a license, is the concept of maintenance. Maintenance, or frequently, a minimum annual payment, refers to the amount of money paid to the licensor to maintain the license. Inventors who provide exclusivity should always insist on a minimum annual payment or similar arrangement in any licensing deal.
The minimum annual payment specifies the amount of revenue the licensee must generate for the licensor each year. If the licensee does not generate the minimum annual payment, the licensee, typically, must either make up the difference with a cash payment, or the rights to the invention will revert back to the inventor.
Why is this so important? Because if you give someone an exclusive license and then the licensee does not generate revenue on the invention, and the inventor has no recourse to recuperate the rights to the IP, then you’ve essentially given away your intellectual property for free. There are many business reasons why a licensee might want to acquire the rights for an invention and not develop it. Businesses do this for both cynical and non-cynical reasons. But regardless of the licensee’s motivation, the responsibility lies with the inventor to ensure that the downside is protected, and the inventor gets the rights to the invention back if the idea is not pursued or fully developed by the licensee.
Third, the investor must negotiate a royalty. This is hard to talk about in the abstract, because terms vary so drastically across industries. I’ve seen deals ranging from a fraction of a percent on net sales to 40% on gross sales. The details matter in terms of how gross and net sales are defined, and what rights the inventor has to verify the numbers and details of royalty payments. Suffice it to say these are all industry-specific and this must be scrutinized very carefully.
Licensing is a great option for many inventors. There’s a lot of romance and narrative built around the joys of building a startup, but there’s much to be said for letting someone else do the heavy lifting. Licensing is a great way to make that happen.
Pros: Leverage resources of another entity to bring your idea to profitability
Cons: By licensing, you often outsource much of the upside potential of your business
The 13th Way: Government Grants
I was a kid, there was a TV commercial where a guy with a purple suit covered in yellow question marks yelled at the TV. He talked about how, every year, millions of dollars of government grants and resources go unused because people never bother to apply for them. The man with the purple suit with yellow question marks was selling a book. I never bought the book, but I do know this: There’s some truth to what he was saying.
Governments provide mandates and incentives to create all different types of businesses and products. And governments are almost never equipped to do much of anything themselves. So what they typically do is offer financial incentives to entrepreneurs who can help them with their agendas and make them look good in the process. They want more local jobs. They want more recycling. They want better health care. If your startup has any benefit that connects to any government or bureaucratic official’s agenda in any way, there’s a good chance that there’s grant or loan money to be had. You just have to figure out where it is and how to get it. And then you have to deal with the government once you do get it.
I have worked with a few startups that received their initial funding through grant money. It isn’t always an easy process. Government officials aren’t always the best at providing clear instructions, allowing the company to own its intellectual property, or responding quickly to requests. In a sense, the “free” money comes at the cost of time.
But there is money to be had. And the government isn’t going to take equity in your company when it does it. Just make sure you read the fine print on all the grant details and have some time on your hands to deal with possible audit requests or other hassles once you get the cash.
Pros: Free Money!
Cons: Working with government officials can be time consuming and stressful
The 14th Way: Consulting/Side Jobs
Time is money.
If you want to launch a startup, you need both. Time and money. Time enough to design, build, and test your prototype. Money enough to build and distribute your product. Money is where it gets trickier. Everyone has time, the same amount each day. Not everyone has money, and those who do have different amounts.
For the entrepreneur who wants to fund their business idea without sacrificing too much equity, consulting and side work can provide enough to get started. However, unlike other financing methods like preferred equity or convertible debt, consulting does not offer quick money. It can take a lot of time working as a consultant, or a creative idea to spin into a side business, to fund enough to launch.
In that time, a competitor may have already swooped in with their product. Furthermore, working on the side can, well, sidetrack you from your core idea. Instead of developing your product, you might spend more of your time working to finance your project. Your side business can become your business.
On the other hand, successfully raising money through side work shows demand for your skills along with a certain amount of self-reliance and ingenuity. You have demonstrable value to future investors. Working a side job also conserves valuable equity. You have saved the whole pie; you have more for yourself and more to divvy up to future investors.
Airbnb used this method to raise money in 2008. Capitalizing on election year fever, the co-founders bought generic cereal in bulk, hired an artist, and designed two cereal boxes–Cap’n McCain and Obama O’s. They sold 800 boxes at $40 a pop (a steep price, but now worth it to those who held on to their boxes). They netted $30,000 in profit and attracted the attention of Y Combinator.
Consulting and side work also extends your runway. Because you are not beholden to investors who have ponied up sizable sums in hopes for a fat payday, you don’t feel pressured to launch before you feel ready. The only one with skin in the game is you and your cofounders if you have any. You dictate the speed of development and decide when to launch. But, remember time is money and in the time it takes to finance your idea through side work, competitors may have introduced their product.
Pros: Provides Longer Runway, Shows Demand for Skills, Conserves Equity
Cons: Distracts from Core Business, Perhaps shows lack of faith in core product/business
The 15th Way: Accelerators
Accelerators are a resource devoted specifically to mentoring and nurturing aspiring startups.
A handful also give cash to their startups. Depending on their quality, accelerators can be a great network for programmers, designers, and entrepreneurs. Some accelerators, like Y Combinator (YC) in Silicon Valley and TechStars, here on the Front Range, also have tremendous prestige that give startups a huge boost as they launch.
The competition for entry to these top accelerators is fiercer than the Ivy League. TechStars accepts just 1% of its applicants. YC rejected Drew Houston, founder of DropBox, the first time he applied. Drew’s credentials? MIT grad, programmer since 5, perfect score on SATs. It’s tough.
For those who do get in, here’s what YC offers: a 3 month program, structured around startup events and individual office hours. $120,000 in exchange for 7% equity. The 120k, YC hopes, is enough “for the founders to run their business and pay their living expenses for at least 6 months, and sometimes longer.” Compared to the overall startup ecosystem, YC grads are immensely successful. In the “real world”, an estimated 80-90% of startups fail. Since YC started in 2005, only 21% (177 out of 833) of their startups have dissolved and the total valuation of their startups is around $65 billion.
Of course, YC only accepts the best of the best, so it is hard to determine exactly how effective YC is. Some accelerators, such as DreamIt and Plug N’ Play, offer a more modest cash prize in reward for entry.
The best accelerators don’t guarantee success, but they’re as close to a sure thing as there is in the world of startups. Get in there, and you have a huge leg up on the competition.
Pros: Learning Experience, influx of Cash, Network, Mentorship
Cons: Very competitive. Not that much money. Usually money comes with equity component on terms less favorable than could be obtained elsewhere.
The 16th Way: Revenue-Based Financing
Def: Offering a Percentage of (usually top-line) revenue to finance future growth
Traditionally, if you want to raise money, you do it in one of two ways: through debt or equity financing. But angel investors who want to lend a new business money at a reasonable interest rate are rare (for good reason), and those who want to do it for a piece of the pie typically want a bigger chunk of the company than entrepreneurs want to relinquish.
Perhaps there’s a third way.
Some innovators in the startup community have developed a new way to raise money: revenue-based financing. Instead of giving away a piece of your company, a lender receives a cut of all top-line revenue the company receives. If the company grows faster than expected, the loan gets paid back faster. And vice versa.
It may be structured in a number of ways. A couple years ago, blogger and author Seth Godin posted about revenue-based financing and suggested that the investor would receive a stream of revenue forever. Others who use revenue-based financing implement a hard cap when a certain dollar amount is reached. The latter strikes me as fairer to entrepreneurs.
The risk profile for an investor falls in between that of an equity or debt investor. An investor stands to gain more than they would normally for loan, but not quite as much on the upside as is possible for equity. That said, unlike with a pure equity investment, the downside isn’t quite as severe, as the investor would automatically receive compensation from every dollar the company receives.
This approach makes sense for a company with some operating history and income. From an investor’s perspective, it would likely be too speculative for a brand new entity.
Pros: Lower risk than equity, No equity sacrifice. Usually a time limitation
Cons: Not many startups have revenue early on to justify this method. Lower upside from investor’s perspective. Few standardized document instruments available to public
The 17th Way: Product Presales
Sales of Product may be used to fund product’s creation and distribution.
It seems a little counterintuitive. Most startups looking for financing don’t have a product, or at least not one ready for mass production. Which begs the question: How do you sell a product without a product? The answer is through a prototype or a minimum viable product. If buyers are able to easily visualize what your product can do from the prototype, and if it looks cool enough, product presales can finance that product’s creation and distribution. The internet is a great place to broadcast your prototype, either through an established medium like Kickstarter or Indiegogo, or on your website. (Though you should always consider the patent ramifications before you do.)
To illustrate the pros and cons of this financing method, I looked at M3D, a company that raised $3.4 million on Kickstarter almost entirely through product presales on the Micro, which it marketed as a consumer friendly and affordable 3D printer. For around $300, buyers would receive the Micro about 6 months after their contribution.
The video from their campaign is very well made and shows a product that seems ready to roll off the shelves. But, it wasn’t. The product in the video was a prototype, handmade by the co-founders. In order to fulfill the 10,000+ orders that funded their project, they had to begin mass production. And that was fine for M3D, as it is what they always planned to do. In response to a skeptical commentator, they said “eat 3D printed ninja stars” if they didn’t ship on time. Well they didn’t and they didn’t.
They shipped 50 Micros to beta users six months after their Kickstarter, a bit behind schedule. This step was crucial though and allowed M3D to work out assembly processes before mass-production while the beta users provided product feedback.
However, there were still issues with production, suppliers, and printer quality that the beta step didn’t resolve. There were problems shipping overseas. It took them a year to match the printing quality achieved by their prototype. They changed their method of production from a batch process into assembly line. Some of the later shipments were delivered about 6 months behind schedule.
The product presale route forced M3D to be productive, or transparent when they were not productive. All their work went towards the goal of delivering 10,000 good printers to their contributors. Both the company and their backers were a bit frustrated that they fell behind schedule. But, production snags are to be expected with any new process. After a year, M3D could see the light. “By the end of April, we will have delivered the majority of your rewards. When that happens, we will shift our focus towards any remaining issues as we want to get back to our roots and move forward in our mission.”
Without their product presales, it is highly unlikely that M3D would have achieved the same scale of production as quickly. However, producing and shipping their orders was exhausting and all-consuming. There wasn’t much room for the cofounders or company to focus on anything else.
Pros: No cost in terms of equity or debt – founders keep the whole pie
Cons: Puts serious pressure on founders to deliver product under uncertain conditions. Disclosures must be clear or legal consequences may result
The 18th Way: Strategic Alliances
Strategic Alliances are common in business. Think Starbucks and Barnes and Noble, or Uber and Google Maps. These relationships are symbiotic. Without Google Maps, Uber would be forced to develop its own navigation software or use another (probably inferior) technology. Uber gives Google Maps more traffic. When Starbucks partnered with Barnes and Noble, Starbucks was still a young company struggling to expand beyond the Pacific Northwest. Now, Starbucks is helping Barnes and Noble stay relevant.
Of course, the above examples describe companies all well past the early startup stage.
For a startup, a strategic alliance with a larger corporation may seem one-sided. A larger company will have the resources to improve a startup’s marketing and distribution, and their implicit endorsement can go a long way to establishing your company’s credibility. Perhaps most importantly for the startup, they provide an exit opportunity, especially if a startup’s growth accelerates under their support. And to the point of this series, they can also provide financial resources well beyond what most early-stage startups possess.
Obviously, a major corporation will not just give you all this without something in return. They will probably want equity and perhaps revenue or some other lop-sided term.
But, it is important to remember that as a startup, you too are bringing something to the table. Your intellectual property and an influx of new talent and energy. Established corporations want to stay relevant. They do not want to go down like Blockbuster. Companies like IBM and Coke essentially have their own in-house startup teams. And, just turn on the TV to see GE’s new (and painfully awkward) commercials, aimed at young developers.
For a startup looking to work with a major corporation, tech conferences and business networking events are good places to start. But, before you jump in bed with your sugar daddy, a startup needs to make sure that the relationship with a larger company makes sense. There should be a concrete reason for alliance. Both companies should benefit from the relationship. And when you’re dealing with a sophisticated organization, it behooves you to work with competent professionals who are capable of measuring up.
An alliance is not an acquisition. It is important for your startup to retain control over your IP, otherwise you might as well exit already. If the larger company truly values your startup, they will allow you to maintain control over most every aspect of your business while providing you the resources to achieve traction.
Because the power dynamic between a startup and established corporation is skewed, a startup does not have much leverage negotiating with a larger company. It is important to articulate the terms and details of your contract before agreeing to such a relationship. And, you should perform your due diligence about the larger company. Talk to former employees and research online. Find out what they’re about and determine if it would be a good fit.
A larger company can provide the resources, financial and otherwise, your startup may need to tap into a larger market. But before you agree to such an alliance, make sure you’re not signing away your company. And who knows, with the support of a major corporation, maybe you’ll grow into a heavyweight like Starbucks.
Pros: Major resources provide huge leg up to early startups
Cons: Startups do not have much negotiating leverage against large company – must be very careful in how to proceed
The 19th Way: Hackathons
Hackathons can provide cash and notoriety serving as launch pad for startups.
One of the more creative ways to raise money for your startup is through a hackathon. It is also one of the hardest. The competition is tough and the payouts are often low.
A hackathon is a competition for developers. The competition is centered on something, whether a programming language like Java, a platform like the iPhone, or an issue like traffic safety. As the word suggests, a hackathon is a test of endurance as well as ability for a developer. They can last anywhere from a day to a week, and involve little sleep and lots of caffeine.
Like an ultramarathon, a hackathon attracts only the most hardcore of its constituents; developers who live and breathe code. At a hackathon, a developer can expect to work alongside a number of extremely talented and experienced colleagues. You come away with a real sense of how you stack up.
Hackathons are not geared towards companies; their purpose is to create new ideas, not work on old ones. However, if your goal is to raise money for your company and you are a gifted developer this can be a way to make a little dough. Additionally, working on another project can free up your creative juices and allow you to approach your startup from a different perspective (after you have caught up on sleep).
You will also have the opportunity to meet and exchange ideas with other talented developers. These are people who don’t worry about networking or appearances, they are simply passionate developers. Talking to these hackathoners might provide invaluable and straightforward insight into your product.
The biggest hackathons are often sponsored by universities, like Michigan and Penn. Additionally, startup media companies and incubators like TechCrunch and Galvanize (here in Colorado) host them. In September 2015, Galvanize Boulder hosted a hackathon centered on a smartwatch. The state of Colorado has also hosted a few hackathons lately. You can find hackathons on Meetup and college campuses, CU Boulder in particular for those on the Front Range.
Hackathons can be useful to a startup, or at least they can’t hurt. If you win, that is justification of your ability and free publicity for you and your company. Plus, you might walk away with some money. But, you have to be good and you have to be willing to work single-mindedly on one task for a long amount of time. But, you should be used to that. You’re in the startup game after all.
If you do decide to work on developing your hackathon idea into a business, something that you should immediately address is the IP issues surrounding who owns your startup. If some of the hackathon participants want to take the idea to fruition and some don’t, it is essential that the team comes to an agreement on the issue immediately.
Pros: Free money. Good publicity.
Cons: You better be good. Not likely sufficient funding to take startup all the way. Can lead to complicated IP assignment issues.
The 20th Way: Leveraging Assets
Def: Using items of value owned by business or owners to fund the business
At first glance, this method might not seem like the best fit for a tech startup. What property or equipment does a startup have other than a few MacBook Airs? A startup’s value is typically in intellectual property and human capital, not personal property. But if your intellectual property is valuable, one way to raise money is to license or sell your IP. I covered most of this in Post 12 of this series: Licensing IP, but I’ll provide a few quick examples here to illustrate how licensing IP can help you.
This may seem a bit paradoxical. IP is the lifeblood of a startup, and if a startup doesn’t own its own IP, it doesn’t own much. Still, every business is unique, and you have to come up with creative solutions to difficult problems. There are situations where you may want to sell or license your IP to raise money for your business. For example, if a particular aspect of your startup, say your sorting algorithm, is underused or incidental to your core business, you may be able to market that aspect of your startup to other companies to fund the greater business. Or, if you have a patent for a product that you can’t finance, you can license or sell that IP to another company in return for royalties or a lump sum. But you must be very careful about exactly how you sell or license the IP. Do it wrong, and you could endanger your startup’s ability to raise capital or move forward with business.
Some investors may want the company’s IP as collateral for their initial investment. If this is the case, make no mistake, your investment round becomes a bet-the-business decision, where the investor gets the business if the time for the next round comes along and you don’t have a profitable business or additional investors.
Some startups have valuable assets apart from IP. For startups with heavy machinery, this equipment can be used as collateral to secure a business loan. Similarly, your company’s financial assets can be used to secure a business loan (see revenue-based financing, Post 16), much in the same way savings act as collateral for a home mortgage.
If you own office space you can use that as collateral. You can even use your house or baby grand piano as collateral for a business loan. However, you should consider the consequences of using personal property as collateral if you are unable to repay your loan.
For a startup, leveraging assets for a loan is generally an unappealing way to raise money for your business. As a startup, you likely don’t have many valuable assets, and if your assets become tied up as part of a loan, it might discourage future investors.
Pros: No equity, No immediate cost to startup
Cons: Few businesses have assets, May discourage future investors if it ties up important assets
The 21st Way to Raise Money for Your Business: Bootstrap!
The first way to fund your early-stage startup is to use your own money. Serial entrepreneurs who have the resources to fund their businesses with their own money usually do so. Why? Because investor money comes with time, control, and financial consequences.
Most startups have no choice but to allocate huge time resources to raising capital and then answering to the people from whom they raise. According to colleague Nicole Gravagna, author of Venture Capital for Dummies, most startups should expect fundraising to take between five weeks and eighteen months. That’s a big range and a big chunk of time! And that’s for the companies that get the funding. Most never do!
Every minute you spend working on your pitch deck is a minute you’re not spending on product development and traction. And it’s not as if the time demands from investors end when the money comes in. Once you get the cash, one of, if not the biggest roles of the CEO and the founders, becomes appeasing investors and making sure they’re on board with what the company is doing.
In that vein, as soon as you take investor money, you give up control. How much depends on the deal. But frequently, founders find that investors’ vision for the company may not match their own. There is a cachet that comes with doing a big raise that gets announced publicly. But with that money comes responsibility to those who gave it you. That may seem obvious enough, but it’s something that many founders don’t fully appreciate until they are in the throes of that attention.
Finally, raising capital comes with financial sacrifices as well. Again, the degree of sacrifice varies on a deal-by-deal basis. But there’s a cost associated with taking someone else’s money to help you grow. There are plenty of horror stories of founders who have built successful companies with high valuations without personally profiting from it because of their investor terms.
That’s not usually the way things play out. Depending on the investor or VC firm, the costs of investment may be far outweighed by the benefits in terms of mentorship, resources, and leveraged networks and opportunities, but if you don’t need the money, you can obtain many of those same benefits through networking, and you won’t have to give up a big percentage of your baby to do it.
- You won’t be beholden to anyone or anything
- Major time saver not having to cater to investors
- Vast majority of major tech companies use VC money to grow
- Only works if you already have the runway to do it
- May lose valuable mentorship and network opportunities