Daniel Walker
Daniel Walker is the Founder and Chief Executive Officer of Zegal, the trusted legaltech firm. Prior to founding Zegal, Daniel practised at DLA Piper, Stephenson Harwood and Clyde & Co, in Hong Kong, Singapore, and the UK.
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Table of Contents
You’ve come up with an idea for starting a business? That’s great! Now comes the hard part: Making your vision a reality.
For that, you will need startup capital—that initial infusion of money needed to turn your idea into something tangible.
The numerous financing options for startups seem daunting, but if you take some time to do some due diligence, it starts to get clearer. This introductory guide highlights some common sources of startup fundraising.
Introduction: Types of startup funding
Many entrepreneurs will choose to use a combination of fundraising, which broadly fits into three avenues:
- Personal
- Debt
- Equity
Personal financing, or “bootstrapping,” is when founders use their own money. It’s straightforward and has clear advantages(like Zegal!). However, most entrepreneurs need more than their personal money to start a business.
Debt financing means borrowing money from an outside source (usually a bank or from friends or family) with the promise of paying back the borrowed amount, plus any agreed-upon interest, later.
Equity financing means raising capital by selling shares in your company to investors. Investors who buy equity become partial owners and are entitled to a share of the business’ profits over time.
Stages of early financing
At the start: Seed financing
Seed financing refers to the money used to get the business off the ground. It could be a combination of personal funding or debt and equity from friends and family, a bank, angel investors, or venture capitalists (VC). However, most VCs will invest at a later stage.
When seed funding, a company will generally be at a pre-revenue stage and not offer a product or service. Instead, it will have a clear idea of what they want to build. Therefore, a seed investment agreement aims to help the company develop a product to fit its market niche.
As the business gains traction and demonstrates a proof of concept and the beginnings of a predictable revenue stream, the company may look to raise capital in a series round.
Next steps: Series A and Series B financing
The second financing benchmark, Series A funding, generally refers to more significant equity investments from outside third parties, for example, 10-20% stakes in the business.
Series A financing aims to build a successful, profitable business that can survive independently. The investment amounts in this round are more significant than seed financing and commonly come from VC funds that professionally invest in early-stage companies and other private equity funds.
Family and high-net-worth individuals may also invest individually or jointly, depending on the size of the investment round or how hot the deal looks in the market.
Although it typically won’t be referred to as Series A, which almost always concerns equity investments on a preferred share basis, some businesses may raise capital at this stage through commercial loans and mezzanine debt.
As a company grows and requires additional capital, the subsequent rounds of equity investment through the issue of shares to investors are called Series B, Series C, and so on through to IPO.
In-depth: A closer look at startup funding
Now that you understand the three main types of financing and with the various stages of financing in mind, let’s focus on the familiar sources of funding available to startups.
Bootstrapping
Bootstrapping is self-funding your company by stretching your resources and finances, such as your savings, redundancy money, or selling other assets.
In short, you’re starting your company with the money and assets you (and your co-founders) currently have. Bootstrapping is a great first option and can get you through the initial stages of building your business.
Unfortunately, many entrepreneurs don’t have much assets or money. If your idea is complex and you want to scale your operations significantly and quickly, you will likely need to bring in outside sources of capital reasonably early on.
Friends and family
A common source of financing for startup businesses is friends and family. While it may be challenging to get a loan from a bank or independent investors, those close to you and believing in you are more likely to be willing to take a chance on your fledgling business.
When accepting money from friends and family, ensure they:
- Know all about the risks and rewards.
- Are clear whether the money they provide is an investment in exchange for equity, a loan, or an outright gift.
- Are given fair and favourable terms on their investment, either from equity or terms on the loan (for example, a higher rate of interest than they could achieve in a fixed rate investment like a bond or savings account).
- Have been informed of your expectations for the business.
Breaking down family investments
The money provided by your family or friends could be a gift, a loan or an equity investment in your business. Each has pros and cons, and each should be recorded in writing and, in many cases, a legal document.
Gifts
The great thing about a gift of money is that you don’t have to pay it back! However, you probably won’t raise as much money as you would if you offered a potential return on the money.
Also, gifts can quickly turn into loans in the minds of friends and relatives should your business succeed. A signed document or a letter saying the money was a gift will protect you down the road.
Loans
A loan agreement is an excellent way for friends and family to invest because they have set repayment terms. They will know how long it will take to get their money back (and at what interest, if any).
Debt financing from friends or relatives means that you will pay a lower interest rate than if you borrow the money from a bank or commercial lender (and you might even be able to borrow money interest-free).
As a bonus, you may be able to negotiate more flexible repayment terms than a commercial lender would permit, and it is less likely that your friends and family will insist on default provisions typically attributable to bank lenders, which can force your business into liquidation if you fail to repay.
However, as with the downside of any debt financing, you will be tying up some of your business’s cash flow to make the repayments. No matter how informal you believe your relationship is, entering into an agreement detailing the loan terms is crucial to avoid future disagreements.
Equity
Although you won’t have to pay them until you make a profit or cash out, you are turning a friend or a relative into a business partner by offering equity.
Remember, shareholders have the right to participate in certain business decisions. If you offer equity in exchange for raising money, you will need various documents, such as a shareholder’s agreement, to record the relationship.
Bank loans
Another option for funding your startup is a bank loan. Unlike investors, however, banks want an assurance of repayment and generally look for companies with some track record and credit.
This will naturally take a lot of work for a startup to demonstrate. In addition, banks will usually ask for collateral to secure the loan.
You should think carefully about how much risk you’re willing to take on before you get a loan or give any personal guarantees.
Government funding
Many governments recognise that inadequate funding is often startups’ most common stumbling block.
Those who want to be recognised as startup-friendly have crafted a pro-business and support environment to help entrepreneurs get on their feet.
Hong Kong and Singapore offer government-supported initiatives that provide equity financing schemes, cash grants, and loans. Of course, various conditions need to be met depending on the type of funding you desire.
Nevertheless, checking whether you are eligible for any of these is helpful when considering your options.
Private investors
A popular way to obtain funding for many startups is through private investors. Two standard options are:
- Angel investors
- Venture capitalists
Angel investors
Angel investors are high-net-worth individuals who invest in very early-stage companies like startups.
If you convince an angel investor that your business model is the next unicorn, they will provide you with the necessary capital. In return, you offer equity in your business immediately or at some time in the future (if you choose to use a convertible note agreement rather than the immediate issuing of shares).
Angel investors expect to receive dividends when the company starts to make money but, more importantly, to get a significant return on their investment, typically 6 – 10 times the amount they have invested.
Previously, entrepreneurs had to rely on a wealthy relative to be their angel. Today, angel investors are organised in groups that share their knowledge, collaborate and actively seek great startups to back. Some are even serial investors and invest in many startups a year.
Angel investors will typically fund a startup at the seed stage of a company. The amount they invest is flexible, and they are also very likely to make further investments in future rounds since they know that not all plans go as expected and your business might need additional funding.
It’s important to note that while angel investors can provide insight and advice about your business, their job isn’t ordinarily to build up your company daily.
Venture capitalists (VCs)
A VC is a professional firm that looks specifically for early-stage companies to fund. While angel investors usually invest their own money, venture capital is invested by firms or companies that most often use pooled capital.
The job of VCs is to find businesses with high growth potential. VCs almost exclusively take equity stakes (so you may need to issue new shares) and will often demand a say in how your company is run (for example, by way of a seat on the board), and in exchange for their involvement, expect a high return on investment.
The fact that business angels are using their own money and VCs are using other people’s will naturally affect their capacity for risk. Therefore, VCs are generally more unwilling to invest in nascent startups unless the startup shows some compelling promise or growth potential.
That’s not to say that VCs are not interested in startups at all; in fact, more and more are playing the seed financing game and investing early in the hope of landing the next Facebook!
Agreeing to venture capital investment means bringing more people into your business who have a say in how it’s run and whose job it is to help your business reach its potential.
If you’re not interested in this level of compromise, this might not be the right option for you.
How are private investments structured?
There are several common ways in which an angel investor or VCs may invest in your company:
Ordinary shares
With an ordinary share investment agreement, the startup and the investor will agree to a fixed cash investment, and the investor will receive shares in return. As a holder of ordinary shares, the investor will be entitled to dividends and to vote on company matters.
Preferred shares
More preferable to the investor and commonly seen in later series financing rounds, these are equity shares with special additional rights.
For example, unlike holders of ordinary shares, investors with a preferred shares agreement may be entitled to a fixed dividend regardless of profit levels. Most importantly, in the event of a company liquidation, investors holding these shares receive their investment back before the holders of ordinary shares (who are often likely to receive nothing).
Convertible note
A convertible note is a short-term loan that converts into equity. Investors loan money to a startup, and rather than receiving their money back with interest, the investors receive shares in the startup’s next round of funding, generally at a discount to the price paid by other investors in that round (typically around 15-20% less), based on the terms of the deal.
In short, they are debt instruments backed by the company’s equity.
Simple Agreement for Future Equity (SAFE)
A private investor can invest in your company using a SAFE Agreement. It is a relatively new concept and very similar to a convertible note, intended to replace convertible notes in some situations.
Essentially, it is an agreement whereby the investor provides capital to the startup. In return, the startup offers a warrant to issue shares to the investor at a later time and upon a specific event, such as at the next round of funding.
Crowdfunding
Crowdfunding is a relatively new method of raising capital, and its popularity is rapidly increasing. Crowdfunding takes its name from the fact that members of the public fund your project.
Most crowdfunding websites either use a reward-based model, where people who invest in a new business venture are given some form of reward, such as the product that will be produced, or an equity-based model, where those who invest are given equity in the business.
Which source of funding is best for you?
Fortunately, you have numerous funding options to make your startup dreams a reality.
Many entrepreneurs use a combination of funding sources to get the money they need to develop their business, so don’t be afraid to mix things up and stay in the game.
Which option you select depends on your risk tolerance, how much control of your company you’re willing to relinquish and your financial projections.