July 20, 2020

Fundraising for founders: What options are available?

Every founder faces the question “Where do I get the money to scale-up my business?”. This extremely difficult question can arise after the startup has created an MVP, first sales or even before there is any product.

Founders should not take this decision lightly since there are various options with different advantages and disadvantages. Important considerations are the required funding amount, the relationship with the investor/lender and the regulatory framework around the funding option. The following shows several options founders can explore to raise capital for their businesses. Some options are better suited for the very beginning of the startup while others are options which can be explored after the business is already running.

The first option that founders explore is the funding through friends, family and fools. Founders can ask close friends or relatives for smaller amounts of money and collect the capital they need to start their business. The close relationship with the individuals which provide the money gives the founder more freedom. Usually, there are no heavy contracts involved regarding equity stake negotiations or repayment schedules of the collected funds. The money that a founder needs can vary heavily depending on the industry. A founder of an ecommerce company requires less capital to build his first product than a founder who needs to build medical equipment. In the second example, the founder will most likely run into the problem that the circle of friends and family cannot provide the required funding to start the business. One more problem is that friends and family might not have experience in building and scaling a company and therefore do not function as an advisor to the startup. If a founder is also looking for an investor that acts as a mentor, friends and family might not be able to provide this skill.

Founders who are looking for money and guidance can apply to a startup accelerator program. Once a startup is selected, it will get a budget, mentoring and office space (if the accelerator is not fully online) for a fixed term (often 6 months). Since this is a cohort-based program, it can increase the network of the founders and offer opportunities to learn from peers who face the same challenges for their businesses. The accelerator supports with pitching and networking events to boost the startup as well. Founders must be willing to give up equity for the services they receive from the accelerator company.

Traditional ways to get funding are through business angels, family offices or VC firms. Business angels are individual investors who are supporting startups at a very early stage with capital and knowledge about specific industries. They invest smaller amounts than a VC firm and can often be the bridge between the pre-seed and seed stage of the startup. A VC firm is investing a certain amount of money and gets part of the startup in exchange. Let us consider a theoretical startup called “New Opportunity” and a VC firm called “Take My Money”. Both parties agree that New Opportunity is worth EUR 4.0m and that it will receive an additional EUR 1.0m funding from Take My Money. The startup gets the EUR 1.0m for their business, and the VC firm receives 20% of the startup in exchange. The 20% represent the EUR 1.0m of funding as part of the “new” total value (EUR 5.0m) of the startup which is the EUR 4.0m (value without the new money which is called pre-money value) plus the EUR 1.0m (funding from Take My Money). This option has more benefits than just the possibility to raise big amounts of capital. An additional advantage is the knowledge and network of the VC firm. If the startup founders have no experience in scaling a business (it could be their first experience in leading a company), the VC can advise them along the way to take certain steps.

Grants from government agencies, foundations or commercial entities can be an attractive option if the founders already have the necessary documents and requirements (e.g. industry and development stage) to apply for a grant. Startups get selected by a jury after pitching their business ideas. The winning startup receives the price and has no obligation to pay the money back.

Applying for a bank loan is another option a founder can take. The advantage of such an option is that the founder does not have to give away parts of the company. The relationship with the bank is over after the loan is paid back. The bank will require a type of collateral to provide the loan. A founder must bring in some type of deposit which will be transferred to the bank if the loan cannot be repaid.

Founders who are looking for alternatives to funding from VC firms can explore the option of crowdfunding. The principle is that a bigger group of individuals contributes with smaller funding amounts to finance a project or business. This is usually done via internet platforms. A founder must present the business idea, information regarding the current development stage and the required funding amount on the platform. Platform users can decide to provide funding and will receive something in exchange. The structuring of a crowdfunding depends on various factors like development stage, performance to date and growth plans. There are several types of crowdfunding structures which differ in the type of rewards for the money providers. The next section explains a few of the most popular types of crowdfunding:

Equity crowdfunding is like funding through a VC firm. The startup is giving up equity as a reward for the received funds. The benefit of an equity crowdfunding platform is the big reach. Founders do not have to go to several VCs to present, but rather have one platform which helps them to reach several individuals who can invest small amounts.

Donation-based crowdfunding requires the startup to not pay back the received funds or give something in exchange. This is an attractive option, but these types of platforms are usually tied to specific criteria that must be met (often a charitable cause). One criterion could be that the project is improving the use of energy, fighting poverty or social injustice.

Reward-based crowdfunding enables the startup to raise funds in exchange for a non-financial reward. One example could be a fashion startup that produces sustainable clothing. Each person that gave money to the startup via the crowdfunding platform will receive one of their clothes as a reward. This solution is attractive for startups where the production costs are equal to the funds by an individual backer from the crowdfunding platform.

Revenue-shared crowdfunding allows the startup to raise funds and pay them back over time with parts of their revenues. This structure is an attractive option for businesses with variable sales. If sales are high, the repayments will be high as well. If the sales are low, the repayments will be low. This flexibility is one of the advantages. In addition, the underwriting process is faster and requires no collateral as it would be from a traditional bank loan. The investors (backers from the crowdfunding platform) have an incentive to promote and support the business since a faster payback of the money they invested yields a higher return. The overall costs of capital might be higher than the ones of a traditional bank loan since the startup does not provide collateral and has a flexible payment scheme.

In conclusion, Founders face a variety of options to choose from and should carefully consider the advantages and disadvantages of each. There is no best or worst way to raise funds since it always depends on the startup’s industry, development stage, knowledge and willingness to give away parts of the company.

BV4 supports early-stage startups throughout the process of fundraising by preparing the pitch deck, financial model, market sizing and valuation tools for the startup.