March 22, 2022 by Adam Hoeksema
Raising capital for business needs of any kind can be a complex and sometimes futile process. The sad fact is that most companies fail to do so. The market can be irrational, unfair, and favors only the most persistent and well-prepared.
However, knowing where and how to look puts your startup at a distinct advantage. There are three main ways a company raises capital: From earnings, from lenders, or from investors. As a startup, earnings alone probably aren’t going to cut it, and to expand your company quickly and enter the market, you’re likely going to need one of these funding methods or use a mix of all three.
The ideal way to maintain independence involves holding onto as much equity as possible. Capital from sales and loans allows you to maintain full ownership of your equity. In contrast, investors will be taking their share, so knowing how to raise capital in a way that best suits your business while maintaining the highest equity share possible is key.
Hewlett Packard started with just over $500 of their own money and clawed their way up without venture capital, selling audio oscillators. This goes to show that funding the company yourself, or bootstrapping, is possible - and the benefits of this strategy to your equity share are obvious – but it’s very hard work. In most cases, for rapid growth, you’re going to need money from outside.
In this article, we’re going to look at how to raise capital, define the three methods of doing so, identify useful strategies for each of them, and address their pros and cons.
How to Raise Capital for a Startup -
Option 1: Bootstrapping
According to Seth Godin, author of the Bootstrapper’s Bible, Bootstrapping is more than just using your credit card debt and bank account to start a business, it’s about the right state of mind. Essentially, bootstrapping is going it alone, and this can bring huge personal benefits in terms of independence and maintaining control over the direction and vision of your company.
Simply put, bootstrapping is raising capital for business using only your own finances and operations income. Not all companies are suitable for this form of capital raising; those that are, have little-to-no assets, can be founded and run based primarily on ‘sweat equity’ (elbow grease of the founders), and have a long cash runway (the amount of time before your cash runs out). Companies like this also benefit from the rapid turnover of products.
While other forms of investment lock you into various commitments: either sharing your dream or being financially bound to a bank or lender; funding your startup from your own pocket and the income generated by your business gives you the ultimate freedom of control. There’s only one catch – it’s incredibly hard work.
The good news is that companies using this strategy are not bound to it forever. It’s easy for a bootstrapped company to switch to loans and/or investments after a growth plateau, so in this sense, the risk to the company is low, as long as the cash runway lasts.
As mentioned, bootstrapping starts with a state of mind. Much of the attitudes here apply to any startup, but when self-funding, realizing these philosophies is critical.
Considering your company as an alteration in the engine of commerce is the first step to succeeding, and finding people who want your product more than they want their money is the first step. If your product or service is powerful enough, it will pay for itself, upfront.
Another significant part of the bootstrapping mentality is figuring out how to do things cheap enough that you don’t care if it doesn’t work. But how do these philosophies translate into actionable steps?
First of all, a bootstrapped startup should be a side-gig. Unless you’re starting out with huge amounts of savings and can cover everything, you’ll need to start slow and small. Even if you do think you have enough savings, keeping your day job (or at least a part-time job) extends your cash runway and prolongs the life of the startup.
Getting your hands dirty is crucial to bootstrapping. You’ll want to do a lot of the work yourself at first since that’ll keep staff-related overheads to a minimum. Consider your hours of labor analogous to financial investment at this stage.
Your founding team needs to be adept and competent to cover all the bases required at the initial stages to get from your current position to selling your product. Bootstrapping will be very difficult without a foundational skillset among your founders. With a good team, you will be able to get your product to market simply by putting in the work.
The next step is to acquire customers. Your approach here will need to be tailored to your needs, and following convention, though appealing as a time-saver, might be a mistake. Make use of A/B testing to determine which customer outreach practices will be your strongest.
Persistence in sales really does pay off. Follow-up and customer care are key attributes to early success in a bootstrapped startup. Learn your customer’s pain points and how to demonstrate your solution to them.
The point here is to work on things that do not scale. Focusing on scalability is inefficient at this stage and your major focus should be to get your first customer. Then your third, then your fifth, and making them loyal to your brand. This involves doing things that you will not be able to keep up in the long run. This may seem counter-intuitive at first, but it’s one of the most important parts of bootstrapping.
Finally, revise and improve quickly. From bending over backward for your customers at the beginning, you will be learning how to improve your product and strategies. Version 1.0 will always be inferior, so drop the ego and make necessary improvements based on customer feedback.
- Ultimate liberty over the direction of your company; preservation of equity
- No ties or responsibilities to external funders
- Forces you to learn the intricacies of your company to a deeper level than you would necessarily have to if you were outsourcing tasks to staff
- Teaches you to use your own funding – a skill that will become useful if you want to branch off your startup to begin another project using the resources
- Extremely hard work
- The financial risk is all yours
- Growth will be slower, and you may spend longer in plateaus
Bootstrapping is the cheapest way to raise capital for your startup, but It’s also the slowest. It will be a lot harder for companies relying on high startup costs. But if your project can be run by a small and skilled founding team, this strategy will allow you to maintain full independence and vision for the company without losing any equity or tying yourself down to external funders.
Option 2: Loans
If you’re looking for a way of quickly getting a hefty capital injection but would rather pay for it in interest than in shared equity, it might be worth checking out loans. Grants may sometimes be available, but these are often subject to specific requirements, and unless you’re a non-profit they can be rare. Further, through grants, it’s much harder raising capital for a business than it is for an NGO.
A business loan is borrowed capital used to cover expenses until a company can cover them itself. There are many types of loans for businesses, but they will generally charge a certain amount of interest and be tied to a certain payback period. Established businesses will be more eligible for this type of funding than startups. Therefore, any startup taking business loans will likely incur higher rates of interest to match the increased risk to the lender.
High-interest loans become bad financial decisions the longer they are in play. Therefore, it’s good to take one out only if it can be paid back quickly. However, there are some non-bank lending options that can be safer and more reasonable in rates than an “online” lender.
The first thing you’ll need to do to get a loan is to improve your chances of being approved. Know your credit score and exactly which type of loan you need. Banks and credit unions are the most common lenders used by founders, but a little research goes a long way, and you may be able to find a better deal by other means.
Bank loans are usually a lump sum, paid back over an agreed-upon period at an annual interest level. However, some lenders offer credit lines, where a company is given access to funds to be taken as needed. This allows borrowers to only pay interest on the money that they use.
Microfinance is another option, available as collateral-free loans from certain providers. These are usually high-interest loans with strict repayment criteria. You may also consider looking for a Community Development Financial Institution (CDFI), local municipal revolving loan fund, SBA microloan program (in the U.S.), or borrowing from a friend or family member.
Once you’ve established the loan you want, check your credit score to ensure you’re in with a chance of approval and begin the application process. You’ll probably need tax returns and financial records, and different lenders will ask for different records on top of these. Having a strong business plan drawn up will vastly improve your approval chances. You will likely require a set of financial projections that demonstrate your realistic financial expectations on how you predict your business will perform. Most lenders want to see 3 to 5 years of projections including an income statement, balance sheet, and potentially cash flow statement but they will want to understand when you expect to break even and how your funds will be used. Luckily, our 57 different CPA-prepared financial projection templates help you generate lender-ready projections using your unique numbers.
Compare fees and interest rates between lenders, and make sure you factor in the reputation of the lender you choose. Follow customer feedback to see what you’re getting yourself into.
The actual application process may be possible online or over the phone, or you may have to show up in person.
- Loans will usually be attached to your personal guarantee. This means you won’t be giving out any equity and can maintain control over the direction of your company
- Long payback schedules mean you can spread the cost over many years
- You’re flexible to use the money however you wish
- Can get an immediate boost in capital for your company
- You’ll have to pay back the loan even if your company fails
- There are strict eligibility criteria; as a startup, you might incur high interest rates
- The application can take a long time and be very complicated
- There is a risk to your credit score
Loans can be a useful middle-ground between the sacrifice of equity in investment and the hard work and slow progress of bootstrapping. However, they come with their risks and difficulties, not least the complicated nature of the application process.
Option 3: Investors
Investors are probably the most common way a startup finds capital quickly. Ultimately the amount of capital and other business experience available is unlimited with this method, but it does require a substantial loss of independence and equity share.
Outside investment can benefit a company at any stage. It is the exchange of capital and experience, for shares or equity stake in the business and it comes in several forms. Startups may need financing to begin the project, or they may be looking for venture capital to expand after proof-of-concept has been established.
Depending on the stage of the startup, the investment will likely come from different sources and with different levels of cost to the founders.
If personal funds aren’t enough, founders will often look for outside investment in the form of seed capital financing from private investors to get the project off the ground. Again, this is usually in exchange for some shares or equity stake in the company and can come from personal acquaintances or family.
Banks and investors are unlikely to take the risk of investment at this stage, so capital usually comes from someone with a personal connection to the founder.
Seed capital is usually a small investment designed to cover registration expenses and other costs to get the company off the ground.
For seed funding, you’re going to need to justify your plan. Most investors won’t be interested in taking the risk of investing simply in an idea, so plan your approach and choose your investors wisely. The more professional you look at this stage, the higher your chances of success.
Have a business plan; show adequate legal protection and customer discovery, and focus on presenting the feasibility of your project and your qualification for carrying it through the seed stage. Ensure you know the difference between scout and pre-seed stages: If you are still working on a hunch, you’re not ready for seed capital.
Planning for seed funding is a personal investment in your startup skills. In researching your market for this stage, you will have to answer questions that will give you valuable information to succeed later in your business. Who is your customer? What is your unit cost and profit? How much can you shift? These questions will need to be answered in order to pitch your idea to investors.
Market research: surveys, interviews, and focus groups will be the starting point at this stage and don’t have to be expensive. Calculating your revenue potential, or Total Available Market means understanding who will buy your product and who won’t. There are many resources available online to help with this, and it is a necessary requirement before reaching out for seed capital.
For finding VC investors, you will need to pitch your startup. A lot. The first step to doing this is to figure out the story of your project. What makes you relevant to the future of your industry? Find the story about your startup that a venture capitalist will find inspiring.
Note: Successful founders can handle rejection. You’re going to hear “No” a lot in your journey at this stage, and you’re going to have to be tough to succeed.
The next step is to find the right investors. Research at this stage can save you a lot of wasted time and mental energy and dodge some of the avoidable rejections that will inevitably occur. Talk to other founders. This is one of the ways organizations like Y Combinator can be very useful. They have a strong alumni ethos of helping other founders.
Improve your story as you go. You will pitch repeatedly, and as you do, you will get better at it. Eventually, you will find the right investors. Whether this is the first person willing to give you money or the person you think is best suited for your startup is up to you.
- Allows rapid growth to a company at any stage
- Investors can contribute their experience as well as capital. Your success is their success, so they are incentivized to bring as much experience to the company as possible
- Not a loan – Money doesn’t have to be returned if the business fails, and you don’t need a proven credit history
- You will have to give up equity. This means you will lose independence and will have to find a comfortable balance with the investors
- Investors may have higher expectations than a bank. Their goals may not be aligned with yours
The right investor will be able to inject capital quickly and effectively and bring with it the experience to make the money work for your company. If their expectations for your startup are in line with your own, this can be a very valuable partnership. On the other hand, if their requirements are too high and they take away too much of your independence, you may find the direction of your project diverging from your initial plan, and you will be obligated to work with that.
Figuring out how to raise capital for a startup requires knowing exactly what you can and can’t accomplish yourself, and how much energy, savings, or equity you’re willing to expend.
Investors will take the largest cut of your independence, but bring with them a wealth of experience and immediate capital gain. Loans can be high-risk, even if the business fails, but aren’t usually tied to your equity, and bootstrapping allows you to maintain full control over your direction but is a slow and grueling process.
Ultimately, the strategy you choose will depend on your ability, your needs, and your motivations.