Upon an individual coming up with a brilliant business idea, the inevitable question that always pops up in their mind is “this is fantastic, but how am I going to fund this?” No matter the quality of the idea, a lack of funds acts as an almost impassable impediment to an entrepreneur successfully implementing their business idea. Hence, having a basic knowledge of how businesses can raise money, as well as their pros and cons are sure to benefit any entrepreneur. This article will explore the two major ways in which a startup can accumulate funds so that it can give itself the best chance of success.
Any startup, or indeed any business, has two fundamental ways in which it can raise money to expand the scope of its operations. These are by either bootstrapping or resorting to external financing. Firstly, bootstrapping is when an investor uses either their capital (equity investments, savings, salary, etc…) and/or the revenue accrued from their startup to fund the expansion of their business (source). This method can have numerous advantages, such as the following:
-
The entrepreneur can maintain full ownership over their business
-
Entrepreneur maintains full control over business operations
-
Entrepreneurs won’t accrue any liabilities (e.g. from taking out a business loan)
However, as with pretty much everything in the business world, advantages are always accompanied by disadvantages. The most prominent of which are:
-
The inevitability of slower business growth (source).
-
The business will have less credibility than a rival using external financing (due to prestige associated with the external financier, for example) (source).
-
The business might experience cash flow issues (source).
Many of the most famous and recognisable companies today were initially bootstrapped, such as Microsoft, eBay and Apple. Although an attractive option for the passionate and resourceful entrepreneur, as a company grows, the need for external financing becomes more acute. Hence, throughout its life, a business is likely to experience numerous and diverse sources of funding. The usual order is for a startup to initially be bootstrapped, then resort to external sources of funding.
Elaborating on the latter, external funding involves raising money from sources outside the startup (source). There are many different types of external financing, with these being primarily divided between equity and debt finance (source). As their respective names suggest, equity finance involves giving away a share of ownership in the startup for funding, meanwhile, debt finance doesn’t involve ownership relinquishment, but is characterised by the charging of interest to the borrower (source).
Types of external equity financing include:
-
Angel investment – involves knowledgeable, wealthy individuals who purchase a stake in the business (source)
-
Venture capital – involve large stake investments in the startup by a venture capitalist (source)
-
Initial public offerings (IPOs) – the issuing of shares of the company in exchange for capital (source)
-
Corporate investors – investment by large corporations (source)
-
Crowdfunding – investment from the public for an ownership stake (source)
Similar to equity financing, the world of debt financing is characterised by obscene levels of jargon.
Common types of debt financing include:
-
Business loans – loans provided by a financial institution (e.g. a bank) (source)
-
Bond issues – involves borrower promising to pay interest and principle upon maturity (source)
-
Peer-to-Peer lending – matches borrowers with individual lenders who believe in startup’s potential (source)
-
Credit Cards – source of credit usually at very high (effective) interest rates (source)
External financing has numerous advantages:
-
Higher levels of business growth (source)
-
Access to expert advice (source)
-
Possibility of tax shield benefits (source)
-
Prestige/reputational benefits that come with financier
Core disadvantages of external financing:
-
Possibility of relinquishing ownership (source)
-
Interest payments (source)
-
Loss of control over business decisions
Hence, when deciding on what form of financing to use, a startup must carefully weigh up the associated benefits and costs of each financing option and choose accordingly. The startup size, access to expert advice, the wealth of the founders, as well as the nature of the startup (virtual or brick and mortar) are all factors that will impact the financing decision.
Disclaimer: The information provided in this blog is strictly for educational purposes, It does not constitute investment, accounting, financial, legal, or tax advice. It has been prepared without taking into account your personal objectives, financial situation or needs. Before acting on any information you should consider the appropriateness of the information having regard to your objectives, financial situation and needs. The views and opinions expressed in this blog are those of the writer and do not necessarily reflect the views or positions of Hatch Quarter Pty Ltd.