The reading level for this article is Novice
While staying with my brother at his apartment in Queens last week, I had the opportunity to talk to one of his roommates by the name of Mitch. After finishing a dinner of an authentic New York City mushroom and cheese pizza, Mitch and I started talking about the business he wanted to start. He told me about his idea, the market knowledge he had gained so far, and how he hoped to bring his product to market. He also mentioned that he would need funding for the venture, and asked for some advice on how to obtain it. "I hope to obtain venture capital, but am not positive how it works," Mitch stated. "Do I sell them 49% of the company for their investment? What will be the valuation for the company if there aren’t any sales yet? Should I go to a bank first?"
I explained to Mitch that while I have not personally had a need to raise money for a business venture as of yet, I had taken an MBA class on Venture Capital Deal Structure, participated in the Venture Capital Investment Competition at Kenan-Flagler Business School, read two texts on Entrepreneurship, and talked to quite a few persons who had raised capital.
I provided Mitch with an overview of the different types of capital available to an early-stage venture and how he might go about obtaining each. I also realized at the time that many young entrepreneurs would need similar information, and as such committed to write an article on the subject at my earliest opportunity. The following is essentially what Mitch and I discussed that night.
Debt vs. Equity
First, nearly all types of funding one can raise fall under one of two categories — debt or equity. The basic difference is that debt has to be paid back (it is a loan) whereas equity funding does not. In exchange for equity funding, the funds provider (investor) receives a percentage ownership (shares) in your company that grows proportionally to the overall value of your company. At a liquidity-producing event such as a sale of the company or an Initial Public Offering (IPO) to the stock markets, the equity holder could cash out their stock, ideally receiving a large return for taking the risk early on.
In his article, "Financing Instruments," attorney Michael T. Redmond explains the difference with "Although there are certain exceptions, debt instruments generally represent fixed obligations to repay a specific amount at a specified date in the future, together with interest. In contrast, equity instruments generally represent ownership interests entitled to dividend payments, when declared, but with no specific right to a return on capital."
Standard types of debt include personal loans from family members and friends, bank loans, issued notes, and corporate bonds. These financing loans are provided at an agreed upon interest rate and time period. Some debts, called convertible debts, can be converted to common stock later on, but most are paid back with cash on a set schedule or set date. Whether the receiver of the loan pays only the interest during the term of the loan and the entire principle (the initial amount of the loan) back at the end, or pays part of both the interest and the principle at each payment period, is determined in the terms of the loan. Debt instruments can be secured by assets of the corporation or unsecured (backed by a pledge of credit).
The advantages of providing debt capital to a business include a reduction in risk, as upon bankruptcy debts must be paid back before any assets can be distributed to stockholders, and a near certainty of receiving the initial principle with interest back within a set period of time. Disadvantages for the issuing institution or person include not being able to participate in the value growth of the company.
Equity financing, on the other hand, provides stock to the investor in exchange for funds. This is usually the form of investment that venture capital funds, angel investors, or other private equity funds make. In exchange for the investment, the investor can benefit from the growth of the company and receive either common or preferred stock.
Common stock is the most basic form of equity instrument. It represents an ownership in the corporation and includes an interest in earnings. Holders are also entitled to receive dividends (periodic disbursements to shareholders based on earnings and the decisions of the Board).
Holders of common stock have the best opportunity to share in the company’s growth, but also must take into account the increased risk of coming after holders of debt and preferred stock in the case of company failure and bankruptcy.
In the view of the business owner, there is one important advantage to issuing common stock in exchange for financing. There is no obligation to repay the amount invested. The investor’s prime reward for taking the risk is participating in the value growth of the company and cashing out upon a liquidity event. Another advantage for the investor is the ability to vote for directors.
Preferred stock is a second form of equity instrument. While it is equity, it can have certain features that resemble debt that can make it attractive.
Most important to the investor, it has rights over common stock, reducing the risk of loss of investment. When issued, investors can also negotiate with the company whether it will be voting or non-voting stock and how dividends will be distributed. In short, it offers greater flexibility and reduced risk, and hence is preferred to common stock.
Preferred stock is usually the type of stock issued to venture capital funds upon investment in a company.
Increasing Your Chances of Receiving Debt Funding
While obtaining funding can be a difficult process, there are a few things you can do to increase your chances. Here are some tips.
If you are only looking for a few hundred or a few thousand dollars, you should first look to friends and family and then to the banks. If you have assets to back it up (such as cash in your bank account, a house, or a car) you should be able to obtain a loan with relative ease. If you are under 18, you will generally have to have a parent or guardian co-sign the loan. And if you do not have adequate assets to back up the loan, the bank may ask for you to find someone (such as a parent or friend who does have adequate assets) to co-sign the loan. Remember, the less risk the bank feels it has, the greater chance you have of being approved.
If you have an existing account, a good credit history, and relationship at a local bank the process may not be any more complicated than meeting with a loan officer, discussing your plans, filling out a short form, and waiting a week for approval. However, if you have not established these relationships and history, now is a good time to start.
If your are serious about raising funding, you’ll need at least some form of business plan. The more funding you are trying to raise, the most professional and complete this plan will need to be. At its core, you’ll need to explain what you will be providing, what need/gap it fills in the marketplace, who you will be working with and who is on your team, your plan for making sales and marketing, and your financial projections including the time to break even. You may want to read some of the articles on developing a business plan on www.zeromillion.com for additional guidance or obtain a book on how to craft your plan.
In general, you will be more successful obtaining financing if you have formed an entity (LLC or corporation) for your business. While it may still be possible to obtain a loan for your sole proprietorship, you will be taken more seriously and have many more avenues open to you as a corporation or other type of limited-liability company.
If you are under 18, (and therefore unable to form a corporation), you should still be able to obtain a personal loan provided you have a well thought out plan, an established relationship, and assets to back it up, or parents, relatives, or friends who are willing to cosign and secure the loan with assets of their own. It can surely be difficult to obtain the financing you need. If you can learn the language, talk in terms on the bank’s interest, reduce risk where possible, and show you have a grasp of accounting and general business knowledge, you very well may be able to obtain the loan you need.
In the United States, another way to increase your chances of having your loan approved is to go to the Small Business Administration (SBA). If you can have your loan backed by the SBA, and hence by the Federal Government, you will have a much easier time.
When applying for a loan, especially those for larger amounts or to finance large investments or expansions, be prepared to meet with the loan officers and underwriters for your bank. In short, expect to be drilled from every angle by these persons and have your answers ready. It is the underwriter’s jobs to reduce risk, so expect hard questions.
In general if you are looking for US$1000-$50,000 in debt funding, a bank should be able to help you. With the right relationships and assurances you may be able to raise more and at better terms. If you are looking to raise more than US$25,000, however, you may wish to look into equity financing.
Increasing Your Chances of Receiving Equity Funding
Equity funding tends to be a totally different ballgame than debt financing, and generally requires a greater level of sophistication to make it work. If you are looking for between US$25,000 and US$1,000,000 of equity funding, you should start by looking at individual angel investors or networks of angel investors. Angel investors are high net worth individuals and accredited investors (as defined by the Securities and Exchange Commission) who are able to risk relatively large amounts of money in risky ventures with a potential for a high return.
To attract these types of investors, you will need to have the right advisors (lawyers and accountants with the proper experience and contacts) and truly have an idea or business which has a potential for a high-return (US$5M and up, depending on the amount of funding needed).
To increase your chances of being funded, be sure you have a solid business plan, experienced advisors, and a team with market knowledge that has proven they can execute.
If you are looking to raise US$500,000 and up and you have a business with a potential return greater than $50M over five years, you may want to look into venture capital firms. At the seed stage (very early stage funding), you may be able to raise between US$500,000 and $10M (or potentially more if it is the right plan with the right people) in a Series A offering of your company’s stock. To raise this amount of money and still maintain a good portion of ownership in your company, you’ll need to have a high valuation before your accept the funding (your pre-money value).
For example, if based on your intellectual property, first mover advantage, unique idea, and experienced management team your business was given a pre-money valuation of US$5 million and provided with US$5 million in Series A venture funding, you will have given away 50% of your company (providing there is no higher than a 1x participating preferred feature).
To increase your chances of being funded, have a very good business plan and be sure to have it introduced to the venture capital firm by the right person. Most VC firms receive thousands of business plans per year and can only give a cursory (five minute) look at most. If you can have a lawyer who works closely with the firm or successful CEO who worked with the firm in the past hand-deliver the plan you’ll have a much better chance of getting in the door.
In summary, it can be difficult to obtain funding for your business as a young entrepreneur. Hopefully through this article you have learned the basics and now have a better idea of what type of funding you need, where to go, and how to increase your chances of receiving what you need. I wish you well and thank you for reading.