Times may be tough now for startups, but despite the troubling broader market, venture investments and exits posted an uptick in the second quarter, bringing new hope to fundraising in a challenging environment.
The number of deals funded from April to July increased slightly to 1,374 from 1,336 in the prior quarter, while the overall dollar investment held steady at $27 billion, according to PricewaterhouseCooper and CB Insights.
A widely-claimed figure in Silicon Valley is that nine out of 10 startups fail—and nearly half flame out after the first four years. Some of these failures stem from the lack of management, but many others are related to the lack of capital.
The road to startup capital is a steep and winding path but not impossible, even in today’s climate. The best practice for raising capital is to work backward from the end. Knowing how you want to exit the company down the road can help determine how best to think about getting funding today.
Consider the following four funding options for a new startup.
1. Raising Funds with Friends and Family
Bootstrapping is the first step and can be the most advantageous way to muscle through the early days of a startup if you, or your friends and family, have money to invest. At the seminal stage of a company, banks may not want to invest in an unproven idea with no assets and no predictable revenue behind it. Angel investors want to see skin in the game from you or your immediate circle; their funding is an implicit endorsement of the founder and concept.
The upside of such a friends-and-family arrangement is that it’s usually informal and doesn’t require lawyers and legal fees, which are no small expense for cash-strapped startups.
Friends and family loans can come in the form of a gift, a long-term low-interest loan, or small equity stake that doesn’t dilute your ownership. Structured personal loans, however, may be the best when bringing relatives into a startup, since equity stakes likely make these family members voting shareholders of your company. Financial gifts come with intangible and psychological strings that can snap under bad outcomes.
The downside of friends and family money is the awkwardness of not being able to return the capital to them. Money has the ability to turn friends into investors, and investors’ financial relationships with founders are typically not familial.
2. Moving On to Seed and Angel Capital
Angel investors are the next step for startups after family and friends. Angel investors usually take equity stakes or convertible debt in amounts of $25,000 to $100,000.
Angels can be individual qualified investors or angel networks composed of individuals who may organize around specific themes in which they have interest or expertise. Angels tend to be hands-on investors who recognize the potential of a startup and take a stake in it if they think they can add value beyond their investment of money. Their goal is typically to help the company get to the next level of venture capital, when their positions may be bought out at a premium and made more valuable over time.
The good news is that angel investment often comes at a crucial time in a startup’s evolution—during a grow-or-die cash-intensive expansion phase. The right angel investors know how to help combine cash and connections for the best outcomes to see their investment through to the next level.
According to a study by William Kerr and Josh Lerner of Harvard, and Antoinette Schoar of MIT, startups that received funding were 20% to 25% more likely to survive after four years and 16% to 19% more likely to have grown to 75 employees.
While there are many advantages to angel capital, founders need to think several steps ahead. More rounds of fundraising add up to less ownership and control for founders.
3. Aiming for the Next Level with Venture Capital
Venture funds come at later stages in a startup’s lifecycle, typically when a company is ready to commercialize its innovation and is deemed to be five to eight years out from going public or being acquired.
Venture capital firms are looking for a large market opportunity, an experienced management team that can deliver a clear path to monetize their investment and returns of 25% annually. The median venture capital investment in 2019 was $8 million to $10.3, according to Statista.
Like angel funding, venture capital levels were lower in the first half of 2020, but surprisingly not that much. Global venture capital investments retreated just 10% in the first half of 2020 versus the comparable period in 2019. Given the uncertainty and stock market volatility, that drop could have easily measured double that value.
Because of the current market conditions, venture capital investors are now looking at how companies can weather the market downturns as much as they have coveted upside management in the past.
Founders courting venture capital should weigh the loss of control versus the pace of scaling and exiting. Typically, founders see decreasing ownership and control due to subsequent rounds of investment. The quickened pace of development, commercializing and scaling may hasten a public offering or acquisition.
Founders should also recognize that the same qualities that led the company’s creation may not be the ideal qualities for scaling the company. In fact, only a quarter of founders make it to a public offering, and only 40% of them are still leading their companies by the time the startup is five years old.
4. Raising Capital with Debt Financing
Debt financing makes sense for startups that already have revenue streams that will satisfy underwriters’ standards for loan repayment. It also appeals to founders who don’t want to dilute their ownership or give up management control. Banks typically do not take an equity position, take a seat on the board or demand double-digit earnings growth. For startups that structurally won’t grow at rates greater than 20% per year, bank loans are often a better fit.
Unlike angel and venture funds that invest in the potential of an idea, many banks take a more conservative approach and require collateral in the form of founder assets or company hard assets. The average small business bank loan in 2019 was $633,000 and the average SBA loan was $107,000, according to Fundera.
For founders who are committed to their mission and have the potential to grow the company over time (but not overnight), debt financing may be the best option for raising capital. Further, timely repayment of loans creates a stronger credit profile, and that in turn can lead to lower costs of capital and more funding options over time.
In the end, it’s important for founders to think several steps ahead when weighing their options for raising capital. While scoring venture funding might seem like a big step in the right direction, it isn’t the right move for every founder. Conversely, when fundraising also opens doors for new opportunities and expertise, it may pave the way for better returns and more sustainable growth down the road.