When your startup reaches that pivotal stage when it begins to grow faster than your revenue stream, you’ll need to seek outside capital to keep up the momentum.
First, you need to determine whether equity investment, debt financing, or a combination of the two might be the best route. This article outlines the difference between the two; which to use is an entirely different topic.
The equity of any type of asset, whether intellectual or physical, is the value someone is willing to pay for it minus liabilities. That could mean the value of an entity today measured in time and money invested versus its value in the future measured by comparable growth.
Once the owner and investor determine the valuation of the asset, the owner can then sell parts of the equity in order to raise capital. There are a variety of methods to raise equity capital – seed, angel, and managed venture capital – each with their own pluses and minuses. An equity capitalist is interested in startups that show great potential and could have significant growth due to their involvement (like, tenfold growth within five years).
Without a doubt, first and foremost on any equity capitalist’s due diligence list will be the management team. Great ideas with a lousy team will get nowhere, while pretty good ideas with a great team have a chance to make it big.
Once they invest in your startup, the equity capitalist might have an active role in the decision making of the company, even to the extent of changing the personnel running the operation. Because they have bought in to your company, they are now your partners; how active they become needs to be sorted out up front.
Because of an equity capitalist’s involvement, you need to do your due diligence on anyone you accept investments from. Only deal with professional investors; failure to do so will result in myriad complications and possibility the inability to raise additional capital later.
Commercial Debt Financing
Commercial financing is only available to startup founders who have something of value that the lender can instantly liquidate. The finance company is not interested in becoming a partner in your company; instead, they are in business to make money by lending their money to you.
Like equity financing, there are a variety of methods available to secure debt financing. Traditional banking will always be the least costly source for your financing, but remember bankers are not in business to take on risk. When they ask for multiple years of company tax returns, it is to see a steady and reliable set of profitable growth numbers.
Borrowing from a bank relies on two variables: the actual collateral that secures the loan, and the cash flow showing your ability to repay the loan. You might have enough collateral, but if your business is losing money, the bank can’t expect you to handle the added expense of loan payments.
Many early stage startups turn to private commercial financing, which is better suited for riskier situations. Factoring companies use the loans you make to customers (invoices for finished work) as the collateral for their funding. With this type of financing, the emphasis will be the creditworthiness of your customers rather than the credit of your company. Equipment leasing companies will allow you to purchase new equipment and pay for it over time, usually three to five years.
A final note regarding capital: When seeking any sort of outside capital, whether equity or debt, remember that certain sources of financing are familiar with – and like to work with – startups. Take the time to explore your options, and be sure that the source you are considering is well-acquainted with your startup’s focus.