Funding, a word that is not of a recent origin as it is known to the people. Especially if you’re from the finance field but if you’re not, then one would perceive it in a quite different way.
The actual meaning of the word may serve a different purpose to many people as per their needs, But in the world of Business, it serves a distinct specific purpose. It is a fuel to keep the firm afloat, No doubt it is the most essential element. Funds are the bloodline of a business.
Now without wasting much of your time, let’s dive further to understand what it really is?
What is funding?
Now that we’re here you must be eager to know the meaning. So lets us break it out to you
Funding is nothing but the act of providing resources to finance a project, a need, a particular purpose, or a program. Which is usually in the form of Money. Many startups choose to not raise funding from third parties and are funded by their founders only (to prevent debts and equity dilution). However, most startups do raise funding, especially as they grow larger and scale their operations.
Why is it important?
A startup requires funds for one of the many purposes since its commencement, in the initial stage, the fund consumption is at the peak because of constant development of the idea to make it a successful money-making Business and to satisfy the investors, which is the end goal ultimately.
The entrepreneurs ought to have clarity about the purpose of the fund utilization as once exhausted they may not get the remaining funds until the next due date. Thus, a capital-lacking business wouldn’t be able to meet its target goals. That’s why it’s imperative to the founders to have a detailed business plan, go to Market strategy, Cap table, etc. The funds are used for the following purposes in its seed stage:
- Prototype creation
- Product Development
- Hiring People
- Working Capital
- Licenses & Certification
- Raw materials & equipment
- Legal & Consulting Services
- Office Spaces & Admin
- Marketing & Sales
Why opt for funding?
As per a recent study, around 94% of new businesses choose to exit out of the market during their first year of operation. Lack of funding arises out to be one of the most usual reasons. Money is the fuel of any business. Without it, the business can’t survive for long. The long, harder yet enthralling journey from the small idea to a huge revenue-generating business model requires a fuel named capital. That’s why, at almost every stage of the business, entrepreneurs find themselves asking – How do I finance my startup? In the pre-seed stage, founders can rely on bootstrapping or such as donations, subsidies, and grants that have no direct requirement for return of investment are described as “soft funding” or “crowdfunding“.
Yet the problem that arises now is that these funds are provided with limited sources of funds. Which once exhausted will create a burnout situation crumbling the business with being left with no working capital to carry on further operations. Thus when a business gets funding from say, Venture Capital, Angel Investor, and other various options. They get access to the resources as well as the guidance and supervision of professionals. Moreover, when a startup starts getting traction & expands, huge funds are required for such purposes which cannot be fulfilled by relying on bootstrapping, etc. Eventually, they need more funding in order to achieve their expansion. There are some downsides to this but we’re not gonna discuss that here.
Equity Raising VS Debt Raising
Before we talk about the various types of fundraising strategies. Let’s clear a very small concern which many people don’t know about, Which is that there are two ways of raising finances for the company. One can either choose Equity or Debt raising as per their needs & viability of the business.
Now one must be thinking what is the difference between these two, as there will be cash inflow in both the option, But that’s not it is
Equity financing is when a business decides to raise funds by selling company stocks. It can be in the form of common equity shares or preferred shares. By doing so, you’re essentially selling off little pieces of your company to investors to raise capital.
Equity financing is often used by startups to kickstart their business, or by small businesses looking to expand. Several forms of equity financing exist; which we will discuss below. Though it has its benefits it sure does come with some conditions as the investors get voting rights along with a board seat & can influence business decisions etc.
Debt financing is any type of loan that a company uses to fund its business as part of the capital-raising process. Especially, when a business chooses to fund their working capital with a loan, it means they get their money from an outside source.
This incurs a debt to the lender of those funds, which needs to be repaid along with the interest over a specified due date. Now the loans can be short-term or long-term, business chooses either of the two as per their needs. A short-term loan is suitable for day-to-day operations, inventory management, wages, raw material, etc. on the other hand long-term loans can be used for capital expenditure such as buying machinery, lands, new office spaces, etc.
Types of funding?
At the end of 2018, there were over 1.4 million outstanding small business loans held by community banks, worth over $94 billion. But while community banks are a critical source of capital for small businesses, they have been declining. Luckily, there are more ways to fund your business.
Bootstrapping, also known as self-funding or raising, is one of the best ways to raise capital when you’re kicking it as a startup. The founders can invest their own money or ask friends & family to contribute. It is considered the best approach to use your own money, as you’re tied to the business and most of the time it is quite hard to convince investors to fund the business without any traction and a potentially successful plan. Thus, Self-funding or bootstrapping should be considered as a first funding option because of its advantages.
It is one of the easiest processes as there are no formalities involved, no compliances of any kind, and the advantage of no cost of raising. Of course, funding the business yourself carries some risk. However, the fact that you have enough confidence in your business to invest in it can make investors or lenders more likely to commit funding to it too. But this option is as much suitable only if you have low working capital, and the burn rate is low. However, some businesses require heavy cash consumption from the first day onwards then it may not be a perfect option.
Crowdfunding is one of the many new methods of raising capital, thanks to technological advancement. What happens in this option of funding is that you take money in the form of a loan or investments from more than 1 person at the same time.
Crowdfunding is the most recent capital raising strategy to make it onto the scene. Thanks to the internet, startups like Elevation Lab (makers of the iPhone dock) and Oculus (later acquired by Facebook) have become household names.
The way it works is that- A business founder will put a detailed description of his business idea, product details, hit revenue goals, the reason for funding, and how much he needs on a crowdfunding platform. And if the people like the ring of it, they will invest in the business and make certain pledges to be the first customer or pre-buy and buy the product or service when it first comes out.
One thing which should be kept in mind, that the business ought to be rock solid, as you’re expecting the average consumer to believe in you and fund your idea just through mere images & a description online.
3. Angel Investment
Angel investors are wealthy individuals with a surplus of cash and usually fund business at its startup stage. They mostly invest alone but sometimes collectively involve other angel investors to screen proposal viability before investing.
Many of the prominent companies of the world such as Facebook, yahoo, google have been funded by an angel investor at some point. The downside to angel investment is that they usually tend to take more equity in return for fewer funds than venture capital. They prefer to take high risks in hope of higher returns. Ever seen a shark tank episode? If yes, that’s what presenting your idea to an angel investor looks like.
4. Venture Capitalist
Venture capitalists tend to invest in more mature companies than angel investors and operate out of a firm, rather than working alone. They usually invest in a business against its equity and exit when there’s an IPO or acquisition. Compared with angel investors, venture capital firms invest in a lower ratio of businesses that apply for funding – but when they do, they generally invest more money.
VC also provides mentorship and values the business from the sustainability and scalability point of view. However, there are some downside to it VC tends to invest more in a matured business which is beyond its startup stage, they also take active participation in business decisions and take control of the business (so if you’re not interested in too much mentorship or compromise, this might not be your best option.) VC usually has a short investment window and constantly tries to recover their investments within 3 to 5 years.
5. Incubators & accelerators
Incubators act like a parent to an early-stage startup and help them nurture their idea with training, effective guidance, support, and network to a business. Found in every major city it is considered one of the best ways of funding in the seed stage of a business.
Accelerators do the same thing. However, they help startups take giant leaps.
These programs usually are for four to eight months, in some cases over a year. It helps an early business to make connections with mentors, investors, and other fellow startups, etc.
6. Bank Loans
Term loans are what most people would naturally think of when discussing business loans. They work on the basis of the traditional loan structure – that being, a business borrowing money (a certain amount for a particular purpose) and proceeding to pay this debt back over a fixed period of time at a fixed interest payment rate.
Small business loans are still a major stepping stone on the road to success for many entrepreneurs launching a new business. However, loan approval is not guaranteed. You will need to meet specific requirements, like having an excellent credit score and being in business for a certain period of time. Funding from the bank would involve the usual process of sharing the business plan and the valuation details, along with the project report, based on which the loan is sanctioned.
However there are some downsides to this too If you can’t pay back the loan, your business assets are at risk as loan providers often ask for collateral to back the loan. Depending on the terms of your loan, you may struggle to grow your businesses while making repayments. You will be in debt for a period of time and are personally responsible for paying back the loan.
7. NBFCs or Micro-finance providers
Nowadays, many startup businesses fail to qualify to meet the requirement of the banks to get a loan, That’s where NBFCs come in, these are Non-Banking Financial Corporation that provides the same services as the banking organization but without any legal requirements. The main function of an NBFC is of providing loans & Advances. These are the last resort of borrowing.
Microfinance is a category of financial services targeting individuals and small businesses who lack access to conventional banking and related services. Most microfinance institutions focus on offering credit in the form of small working capital loans, sometimes called microloans or microcredit. These can be one of the great ways to raise capital in the seed stage without comprising equity dilution.
8. Some other quick ways
Most of the startups in the present item are taking advantage of direct marketing and by doing so they get to engage with the end consumer by giving them a sneak peek of their product before their official rollout in the market. And get a pre-order of the product from the market in this way. Every major brand is following this strategy.
For example: When a new car is introduced in the market, companies start taking their preorders before they are even available to the market. Hence, this creates viability for the product, and funds are raised in the process too as Pre-orders are taken by a company when the customer pays a booking fee.
As a founder, one really needs to understand the growing spaces, trends in the market, changes in technology. as a business cannot survive on the basis of bootstrapping for a long period of time if it wants to expand its operations it’ll need to raise capital from external sources one day or another.
There are plenty of options available for you to choose, funding for your startup, as a young founder one must ask themselves how much monetary assistance they require plus the cost of raising too. In our next blog post we’ll be talking more about the stages of funding, and several challenges it involves. so, make sure to check it out.
For any query, Feel free to contact us.