Alternative Capital Series: Startup Funding
Welcome to our new series, Alternative Financing for Startups!
The top two reasons for startup failure from 2000-2020 were "ran out of money" (37%) and "no financing or investor interest" (31%). This is the start of a series that looks at alternative capital and financing options for startups and highlights the give and take with each choice.
The challenge of raising capital
One of the biggest challenges for first-time startup founders is raising capital. Lack of capital is also one of the top reasons for startup failure.
According to the Kauffman Foundation, “At least 83% of entrepreneurs do not access bank loans or venture capital at the time of startup. Almost 65% rely on personal net worth and family wealth for startup capital, and close to 10% carry balances on their personal credit cards.”
Why is it hard for entrepreneurs to get funding?
There are a variety of reasons.
Access
Geography: 75% of funding is clustered in New York City, Silicon Valley, Los Angeles, San Francisco, and New England.
The decline of the community bank: The number of community banks and credit unions have declined since 2008, making small business loans harder to come by.
Bias: “In 2020, U.S. companies raised record amounts of venture capital, at just under $150 billion. But of that capital, only $1 billion went to Black or African-American startup founders, which comes out to less than 1 percent of total funding,” per Crunchbase data. Crunchbase also found that “just 2.3% VC funding went to female founders in 2020. The total funding to female-led startups fell in 2020 and the proportion of dollars to female-only founders also declined.”
Readiness and Fit
The “Shark Tank” effect: VCs are just one source of funding. The Kauffman Foundation found “that just 0.6% of businesses actually raise venture capital due to the industry's focus on companies with the potential for "high growth." Companies may put their efforts into venture capital when other forms of funding are a better fit.
Invest-ability: Can you show a clear path to a return on investment? Many pitches lack the following:
-Proof of traction. Do you have any referenceable customers?
- Product Market Fit - most entrepreneurs go with their gut when starting a company and do not do the legwork to determine if their product has actual “have-to-have” traction with their ideal customer.
-Differentiation from existing solutions. How will you compete with existing options? Why are you better?
-A big enough, realistic total addressable market (TAM). Every US adult is not your TAM.
Balancing a valid understanding who is most likely to buy.
-A lack of understanding of the go to market cost to scale the business and grow customers.
What types of funding are available for startups?
So how are early-stage companies staying afloat? There are a variety of ways startups can raise capital. This series will cover:
Bootstrapping (with personal savings or through services that aren’t necessarily core to the product)
Friends & Family
Accelerators / Incubators
Angel Investors
Family Offices
Venture Capital
Grants
Corporate seed funding through companies like Google, FedEx, Amazon
SPACs / ICOs
Bank Loans / Debt
When people think of startup funding, they often think of venture capital as the main source of funding. Many early stage startups don’t yet fit the criteria that VCs are looking for, which is why it’s important to consider other funding options as well.
Before you seek funding
Why do you need to raise money? How do you know you’re ready to raise money?
Funding is a tool for growth. Have a specific reason to raise money. Funding brings expectations; will you be able to grow the business fast enough to meet those expectations?
When should you start looking for seed capital?
You’ve established a strong founding team that reflects a mix of product, technical, business acumen and market knowledge.
You have a working prototype / minimal viable product (MVP)
You have at least 3-5 customers (paid or otherwise) and have a pipeline to acquiring more beyond your family and friends. You’ve started to validate product-market fit and you’re not just a services company.
What do you need to have before you seek funding?
Stay tuned for a future blog post on this topic! Here’s a quick checklist for now.
Consider your options. Equity, debt and convertible notes have different trade-offs and commitments. Understand what you are giving up and who you can raise from.
Have a perspective on what your goals, what you want to build, and how you will get there
Establish yourself as a C-Corporation, preferably in Delaware. Clerky let’s you do this with a few clicks and about $800.
Develop a prototype of your minimal viable product.
Start to validate who your ideal customer is.
Draft a business plan and financial model; this doesn’t have to be fancy. It can be a slide deck and a spreadsheet with some assumptions.
Craft and practice your pitch and company story. Do this with people outside of your network if you can. Lunchclub and Clubhouse are great for this.
Determine what you’re asking for. Set your limits on what you’ll give up.
Build momentum. Don’t wait for funding to show progress. Continue to build your business and prove traction in the market.
Find an experienced startup lawyer.
Identify and protect intellectual property.
Develop milestones (what you’ve accomplished to date and 12-18 months out) that you plan to meet with funding.
Build out an advisory team.
Do the math. Are your assumptions, funding requests, and projections realistic? Can you explain your rationale for the projections and costs to investors?
Be able to answer the question, “raising this funding is going to be me X, Y and Z.”
What does it cost to raise funding?
Wait- it costs money to raise money?! Yes. Like applying to college or buying a house, there’s a cost in time and money to raise capital.
It can take several quarters to a year for founders to close funding. The research, preparation and follow up is a big time commitment. The cash costs can include fees for legal, regulatory, independent auditors (for high limit bank loans). Fundraising is also an emotional marathon; highs and lows over a long time period. Here’s Paul Graham’s take on fundraising.
How do you know how much to ask for?
There’s no universal formula to plug in numbers to magically establish valuation. Look for comparable companies in your market and assess your differences. Find balance in not overvaluing or undervaluing your company. Ultimately it is expected that the amount you’re raising will get you to 18 months of milestones and you’ll either get to profitability (not likely early on) or start fundraising at 12 months so you have a 6 month runway.
Failory found that founders overestimate the value of the intellectual property before product-market fit by 255%. This is where research and validation with your team of trusted advisors comes in.
What’s the best form of investment for my company?
This is a personal decision. Everybody’s check cashes; what happens after funding is what really matters.
This series is designed to help you think through which investment model is best for you. We’ll be adding more content and tools in the coming months!
Getting started
We formed Fractionalist to help startup founders beat the odds. Regardless of what form of funding you’re seeking, we can help you tell your company’s story in a compelling way.
Sources
https://www.sba.gov/business-guide/plan-your-business/fund-your-business
https://www.uschamber.com/co/run/business-financing/business-financing-challenges
https://hbr.org/2021/02/women-led-startups-received-just-2-3-of-vc-funding-in-2020
https://news.crunchbase.com/news/global-vc-funding-to-female-founders/
