Raising capital and deciding what sources of capital to pursue is a challenge both large and small businesses share. In the early stages of a company, you lack credibility, which limits your options. Then, as your business matures, you have more choices, but there are trade-offs. So, how do you determine what’s right for your business?
Let’s discuss how you can develop criteria for evaluating sources of capital so you can build a capital raising strategy. Then, we’ll examine the options and how each source stacks up.
Developing Criteria for Evaluating Sources of Capital
There are hundreds of funding sources available to businesses, and it can be challenging to make sense of them. Yet, it’s crucial to find the right balance because your choice of funding will impact your ability to achieve your goals.
So, before diving into a list of options, when I work with clients who want to raise capital, we start by looking at the state of the business and setting goals. This allows us to establish criteria to guide our decisions and narrow our choices to the right mix and types of capital for their needs.
There is much to consider. But, ultimately, I want to get to the bottom of the following questions:
How Much Capital Do You Need and When?
It is critical to be clear about why you need money, what you plan to spend it on, and when you will need it. Not only will potential investors and lenders require this information, but it can help you determine which sources of capital are suitable for you.
If you don’t have these answers, start by building a cash flow forecast. A cash flow forecast will show you how certain costs, initiatives, and seasonality affect your business. It will also help you decide precisely how much capital you need to cover both your short-term cash requirements and long-term growth plans.
How Much are You Willing to “Pay” for Capital?
There is always a cost to raising money. Some forms of capital are cheap, like friends and family or low-interest bank loans. But there are still long-term financial or emotional costs that you must factor into your decision.
Equity capital or grants, on the other hand, can be a huge relief for companies in growth mode who can’t afford to spend money on interest. But there is a significant amount of time involved in securing and servicing such funding. And, in most cases, you must be willing to give up some control.
What Level of Effort or Risk Can You Absorb?
Certain types of capital are easy to secure and manage, while others take time and have more strings attached. That doesn’t mean you should always take the simple route, however. Easy money sometimes poses a higher risk.
If you’ve reached a point of maturity with your business where you have the resources and desire to pursue and manage less risky sources of capital, it may be worth your while. For those who are just getting started, however, this may not be an option.
Answering these questions is challenging for my clients because it requires them to dissect their business and feelings about the capital-raising process. But it also gives them a lens through which they can evaluate the merits of debt vs. equity and any other alternatives they wish to consider.
So, what are the main sources of capital for a business?
7 Sources of Capital to Fund Your Business
Bootstrapping
When someone starts a business using their personal savings and no outside funding, we call it bootstrapping. It’s an appealing option for small business owners who want to maintain control and ownership of their company. Bootstrapping can work famously if you’re disciplined, generate revenue quickly, and then reinvest earnings back into the business.
The challenge, however, is that you can only spend whatever money your business generates or what is in your savings. This means bootstrapping can inhibit your ability to grow if you can’t afford to hire top talent or make big investments, so it’s not a viable option for some business models. It can also strain familial relationships because, if you’re not careful, it can consume most of your time and money.
There’s nothing wrong with bootstrapping. But, for most growth-minded companies, the costs eventually outweigh the benefits, and they need to adjust.
How does it stack up?
- Since you only spend what you have, you can establish a budget and get started immediately.
- The cost of capital is low since you’re not actually raising funds.
- High effort and high risk.
- Best for early-stage businesses.
Friends and Family
Borrowing money from people in your life who know and trust you is the easiest way to fund a business. Yet, I would encourage you to exercise caution because, like bootstrapping, it can put a strain on your relationships.
If you decide to go this route, I’d recommend you only ask people who can afford to part with their money. Then, treat the exchange like a real business transaction.
For example, if you intend to pay the loan back (vs. giving your loved one equity), set an interest rate and establish a payment plan. Then draft legal documents (with the help of your attorney or a service like LegalZoom) that both parties can sign. This way, you will have everything in writing should a dispute arise.
How does it stack up?
- Once you know how much you need, you can get the funds as soon as you find the courage to ask.
- The cost of capital is low.
- The effort and risk, however, can be quite high as these are special relationships, and you may find yourself answering piercing questions at family dinners. If you are transparent and timely with your payments, however, you should be fine.
- Best for early-stage businesses.
Crowdfunding
One of the more interesting, but perplexing, sources of capital that stems from the rise of social media is crowdfunding. Crowdfunding is when an organization pursues funds by pitching its idea to a “crowd” of investors on a platform like Kickstarter or Fundable. Most businesses offer equity or discounted products in exchange for the funds, but there are also donation-based options where you can raise money for special causes.
While crowdfunding is fascinating, it’s not exactly cheap or easy to pull off. A crowdfunding page doesn’t automatically attract thousands of investors. You need to drive them there, and that requires a marketing machine.
Crowdfunding does work for some, such as low-price, high-volume product-based businesses. But it is not a sensible option for most endeavors.
How does it stack up?
- Some companies are successful, but many flop – wasting time, effort, and money.
- Contrary to popular belief, successful crowdfunding can be expensive.
- Best for early-stage businesses.
Debt Financing
Most businesses raise at least some funding using debt capital. Put simply, debt financing is when you borrow money and pay it back over time with interest. Before agreeing to the loan, the lender will check your credit and review important financial documents (like your income statement and balance sheet). Then, they will often require some type of security (rights to an asset should you default on the loan) and your acceptance of certain “covenants.”
Covenants are rules about how you will run your business for the duration of the loan. They protect the lender from business practices that could result in a failure to pay. There may be reporting requirements, for instance, or maintenance of a certain level of profitability. So, make sure you understand the lender’s expectations and can adhere to them.
The main benefit of debt financing is that you don’t have to give up equity in your business. Also, the interest you pay is tax-deductible as long as it’s a business loan, not a personal one. Interest rates can vary though, and there are some shady companies, so be sure to shop around.
The bottom line is, as long as you’re capable of meeting the terms of the loan while continuing to run and invest in your company, debt financing is a sensible source of funds.
Below are some options to consider:
- Credit Cards – The advantage of using credit cards is that payments can be very flexible, as long as you make the minimum payment each month.
- Bank Loans – Typical loans for businesses include unsecured personal loans, cash advances, microloans, and term loans.
- Government-backed loans, such as Small Business Administration (SBA) loans.
- Alternative and non-bank lenders – These institutions are more flexible but be careful because the loans can be costly.
- Specialized loans like equipment or real estate loans.
- Invoice Factoring – Instead of waiting 30 to 90 days for customers to pay, get access to working capital quickly by selling outstanding invoices to a 3rd party for a discount.
- Revenue-Based Financing – Some lenders will provide you with capital in exchange for a percentage of your future revenues. Although there is technically no interest, you make payments until you pay off the “loan,” and then some.
How does this source of capital stack up?
- If your company has a good credit score, you can borrow the money you need quickly.
- Bank loans are inexpensive but watch out for companies that prey on desperate business owners with high-interest loans.
- You can apply for a loan easily as long as your finances are in order. But you’re on the hook for payments, so there is a risk.
- Suitable to all types of businesses.
Equity Financing
Equity capital is an enticing, yet challenging, source of funds to pursue. This is when you invite people or companies to invest in your business, but instead of repaying the money, you agree to give up a certain percentage of ownership.
Many find equity financing attractive because you get the funds you need to grow without negatively affecting your cash flow. Yet, it is not a decision to take lightly. Equity capital raising is a serious undertaking that can consume a great deal of your time and resources. You must be ready to deal with increased levels of governance, legal requirements, and administration. Furthermore, it means you will no longer have complete, autonomous control of your business.
As stakeholders, investors will have a keen interest in how you run your company because they want a return on their money. Some investors take a purely financial interest in the company and require little more than reporting. Others, however, are strategic. Strategic investors may partner with you and become deeply involved in your decision-making. And shareholders have certain legal rights that differ significantly from lenders, including the right to elect the Board of Directors, information rights, dividends, and more.
What are the main sources of equity capital?
Angel Investors
Sometimes referred to as high-net-worth individuals (HNW), private investors, or seed investors, angel investors provide financial support to startups. You can find angel investors among your community – the rich uncle or wealthy friend, for instance. And some angel investors form groups to pool their resources and diversify their risk across multiple investments.
Business Accelerators and Incubators
These are organizations that fund and support startups. In addition to money, they offer advice, training, affordable office space, and other resources fledgling companies require to succeed. These organizations can be especially helpful for startups whose founders have limited experience in launching new ventures.
Crowdfunding
This is a unique form of equity financing where a company can pitch its idea to a “crowd” of investors through an online platform.
Venture Capital / Private Equity
Venture capitalists are investors that offer funds and/or services to businesses with high growth potential in exchange for a minority stake in the business. By limiting their investments to highly promising companies, they reduce their risk and increase the possibility of a significant return. People that offer venture capital often do so as part of a private-equity firm or investment bank (organizations that assume a majority stake of certain companies), but they can also function on their own.
Initial Public Offering (IPO)
An IPO is when you decide to sell ownership of your company through the public stock market instead of private equity sources. However, this is only a viable option for companies with a high valuation – upwards of a billion dollars. It’s appealing because you gain access to a whole other source of capital and can sell or buy shares to access more funds or affect your company’s value. An IPO can also boost your reputation, empower you to buy out private shareholders who wish to exit the business, and allow you to compensate your employees in different ways. But it also means you will be subject to strict regulations.
How does equity financing stack up?
- Raising equity can be simple if you personally know the investor and you agree to very simple terms. However, the more capital you need, the more complex the process becomes and, therefore, the longer it could take. For example, series A rounds can take 6-9 months from start to finish.
- Equity financing is more expensive than debt because you are giving up a piece of the company, which might be worth a significant amount down the road.
- This is a high-effort source of capital, but it is less risky than bootstrapping, taking on debt, or involving your loved ones. And you don’t have to repay the money.
- Certain types of equity are available to early-stage companies, while others are more suitable to mature organizations.
Hybrid Financing
Considering the dramatic difference between debt and equity financing, it should be no surprise that there’s a middle ground. Hybrid financing promises a better risk/benefit balance for businesses, investors, and lenders with deal structures that combine elements of both.
Hybrid structures have simpler terms and, therefore, are easier to implement (i.e., faster and less expensive in terms of legal fees). More importantly, when companies are starting out and growing quickly, it is often difficult to determine the valuation for a priced equity round. Using a hybrid instrument provides significant flexibility since you are deferring the valuation discussion to a later date.
As you might imagine, there are a variety of alternatives. Here are a few examples.
Convertible Debt
A great option for early-stage companies that don’t know how to price their equity, convertible debt allows a business to borrow money without agreeing to a rigorous payment schedule. Instead, you pay a modest interest rate now and convert the debt into discounted equity at a future date.
SAFE Notes
Similar to convertible debt, SAFE stands for “Simple Agreement for Future Equity.” In this case, however, a SAFE is actually not debt at all. You pay no interest and agree to convert the investment into equity when a subsequent equity fundraise occurs. SAFE holders are not legal shareholders, so this is not an equity instrument either.
KISS (Keep It Simple Security)
KISS securities can use either a debt model (interest rate and maturity date) or an equity model (no interest or maturity date). However, these deals often favor investors and leave business owners vulnerable. So read the terms carefully before signing.
How does it stack up?
- Once you know the amount of money you need, you can obtain hybrid financing quicker than traditional equity capital.
- The costs are low, but you must give up some ownership.
- There’s risk involved in some types of hybrid financing, so be mindful of the fine print.
- Best for early-stage businesses that don’t have a good sense of their value.
Applying for Grants
Companies in certain sectors, such as those that do medical research, develop environmental solutions, or perform services for the greater good (educational institutions or charities, for instance), may be eligible for grants. Governments, organizations, and even high-net-worth individuals can offer grants, and they are a wonderful source of capital because, well, it’s free. Unless you fail to meet the terms of the agreement, you don’t have to pay it back or give up equity in your company.
This doesn’t mean grants are easy to come by, though. Organizations award grants for a specific purpose, so first, you must find suitable grants for your needs. Then, you must go through an application process that can be quite lengthy and competitive to the extent that companies will hire “grant writers” for this purpose. If grants are an option for your business, however, it’s worth the effort.
How does it stack up?
- If you qualify, grants are great, but it takes time to apply, and it’s competitive.
- The costs are very low, although you may need a grant writer.
- High effort, low risk.
- This is only a viable option for certain types of businesses, often non-profits.
What Source of Capital is Right for You?
Over time, your company will develop what we call a capital structure – a balance of debt, equity, and retained earnings that empower you to run your business and fuel its growth. The right mix for you will depend on how much capital you need, when you need it, and the amount of effort, risk, and cost you can absorb. A good fractional CFO, such as those found at The CEO’s Right Hand, can work with you to create this balance. Contact us directly to discuss your questions and explore options.
