So, you have a great idea for a startup. The concept, design, and plan are intact and ready to go. This all means nothing, however, without properly deciding how you will finance your company.
The three most common options for funding a startup are bootstrapping, angel investment and venture capital. You can also go the friends and family route. How do you know which form of investment, if any of these, is the right one for your startup?
The main attraction of bootstrapping is that there is no need for external investors. In other words, you do not have to rely on the financial resources of others. Also, the amount of outside debt and equity financing from banks and investors is minimal. The problem is that it puts a great strain on your personal savings account. But even that can be avoided by pooling together money from multiple founders.
When bootstrapping a startup, the financial burden rests completely on the founders. And when you’re not receiving a paycheck, watching your bank account slowly drain can be terrifying and risky. There’s always the very real possibility that your company will fail, and you’ll be left broke and without a company. When weighing the pros and cons of bootstrapping, consider how much your startup will cost, a plan to monetize, and how much of a hit your savings account can afford to take.
On the flipside, bootstrapping gives founders complete freedom because they are not bound to external investors. Not only can founders make financial decisions, they can also creatively, conceptually and managerially develop the company. Before, only “mom and pop” stores and well-established entrepreneurs used the bootstrap approach. Now, companies like Finisair, which went from a bootstrap investment to a $5 billion public valuation, have proven that personally financing a company carries much larger potential than it ever did before. At the end of the day, bootstrapping allows the founder to maintain 100 percent ownership of the company.
Angel investing involves an external investor who provides advantages such as experienced help, connections to the right people, and most of all, a generous supply of money and capital. The price to pay for all these advantages, however, is convertible debt and ownership equity. The angel investor generally seeks annualized returns of 20 to 30 percent or, eventually, a post-dilution return on investment of at least 200 percent.
In addition, the angel investor usually has a great deal of decision-making power regarding the direction of the company. Since the angel investor is typically investing his or her own personal funds, a personal (and sometimes in-your-face) relationship with the founders is what you should expect, which can be tricky, complicated and aggravating. Maintaining a smooth and fruitful relationship -- with a clear understanding of respective roles -- is key to this type of investment.
The angel invested startup usually has a higher user rate than a bootstrapped company thanks to the angel’s connections and an increased supply of money to throw behind marketing the product. In addition, the angel investment tends to lead to greater infusions of capital, mergers or acquisitions, with the goal of reaching a bigger market in approximately three to five years. If bootstrapping has low short-term risk and high long-term risk, then angel investing has medium short-term risk and medium long-term risk.
Venture capitalist funding is the most ambitious form of investment. Both the short-term risk and long-term risk are large -- but the potential for growth, as well as the speed at which it occurs, are unmatched. Venture capitalists manage the pooled money of others in a professionally-managed fund, and the startups who receive part of this fund must, in return, give up ownership equity and a high amount of control of the company. Startups who are interested in venture capital financing are not your typical small business, but are part of high technology industries such as biotechnology and IT.
Venture capitalism investment usually occurs in stages, starting with seed funding then moving on to rounds of growth funding, with mergers, acquisitions and IPO’s as part of the process. Most small businesses don’t really have venture capitalist financing as an option, but it’s something to keep in mind if you think your enterprise has the potential to explode in the future.
A combination of these different types of investments is also possible. Your small business may not be ready for venture capital or angel investments now, but after an initial bootstrapped launch, other forms of investment may become feasible or even necessary avenues later on.
Furthermore, in the current web revolution, options other than the traditional bootstrapping, angel investment or venture capital are gaining popularity. Friends and family provide an alternative to personal credit card debt. Super angels make hundreds of small investments in short periods of time, and angel groups or angel networks share research and capital. Peer-to-peer lending, through organizations such as Lending Club or Prosper.com, typically provides up to $25,000 with a three or five year fixed rate. And some NGO’s, such as Kiva and Microplace, have expanded their microfinance programs to US entrepreneurs, giving out small business loans.
Each entrepreneur needs to weigh the pros and cons of each scenario, as well as their personal financial situation. Also take a good, hard look at your business plan. Try to determine how long it will be until your company starts making money. If it’s going to be a while, bootstrapping probably isn’t for you. If you’ve had other successful ventures or a pile of cash stashed away, keep control for yourself and away from outside investors.