It is not a secret that funding is the key point in startups development. For technological innovations funding often determines the launch of a project and, consequently a company creation. (Exception may be IT sector, where technology can be created without involvement of additional funds, but then anyway startups will need funding to commercialize it). In energy, bioengineering, healthcare, etc., even the first prototype already requires fundraising. So, 9 out of 10 young technological companies generally look for funding to implement their ideas and develop their businesses.
There are different forms of funding that can be used to build a startup based on a new technology.
These funding methods have been extensively described on the Internet and other Medias, so today young companies can easily find all necessary information about funding. In order to avoid repetition of the already existing material, in this article, I won’t be writing about funding methods, but I’ll try to focus on investor’s point of view on startup funding. Better understanding of investor’s motivation and expectations can be helpful for young companies looking for funding.
Funding methods can be divided into 3 groups: debt financing (a loan), equity (shares sale) and cash flow (revenues).
Business-angels are independent investors (executives, retired executives, entrepreneurs), generally coming out from spheres where they have a certain experience or they are passion about, who invest their own money in early-age startups.
Business angels can invest in startups that at the present moment have only a theoretical concept of technology or business model. The investment range typical to business-angels is $10K – $1M.
In case where investment exceeds $1M, it is usually a joint capital of several business angels, having a common interest in a particular sphere.
The terms of agreement typical to business angels are equity, part in future revenue, or convertible notes. (Convertible note is an agreement which gives the investor who loaned money to a startup the right to receive shares of the company in the future rather than money he (or she) invested with interest).
Venture capital (VC)
Ventures capitalists are professional investors who, unlike business-angels, don’t invest their own money. It could be money of trusts, pension’s funds, etc. Sometimes big corporations create their own venture capital funds in order to invest in startups that are developing something innovative in their sphere.
Almost all venture funds have the following common features:
- VCs typically invest in already proven concepts (prototype, experimental data), backed up by detailed business plan.
- Unlike business-angels, VCs are interested in something with a really high potential: a technology that will bring them minimum 10x more than they have invested. So, when dealing with a venture capitalist, startups have to show not just that their idea could pay off in the future. They must convince the investor that their technology will be largely efficient, cheaper or that the market is highly promising. VC’s motivation to fund only high-potential start-ups is mainly due to the fact that he (or she) invests in several start-ups. Statistically, most of them will fail, several will return the invested money but bring no profit, and only one of them will become a real breakthrough.
- For venture capitalists the notion of time plays a very important role. Venture funds do not invest their own money, and they have to return it in a specific period of time. For almost all venture investments this time is limited to 10 years.
- A venture investor doesn’t think about having a part in future startup’s income. His principle goal is to bring a startup to IPO or to sell his (or her) shares to a bigger venture fund.
The typical range of venture capital investment is $100K – $10M.
Growth Venture Capital (GVC)
The difference between growth venture capital and classic venture capital is that GVCs invest bigger money ($10M-$100M) with minimal risk and faster return. Generally it takes 2-5 years between investment and IPO. GVCs invest only in mature and well executed companies.
GVCs usually have a big expert’s office that makes deep studies of investee, market and all possible influential parameters. Generally, GVCs implement more complex and sophisticated agreements that will protect them even if something goes wrong in the future. (For example, preference participation is a typically used term).
In the recent years crowdfunding has seen rapid growth. Crowdfunding can be briefly described as funding of a company by selling small amounts of equity to many investors through specialized Internet platforms (Kickstarter, Indiegogo, RocketHub, Crowdfunder).On these platforms startups present their ideas to a wide audience of people who want to invest their personal savings in innovative projects. Just in the last few years, the number of crowdfunding platforms has grown exponentially and the funds raised on the largest of them have reached several hundreds of millions of dollars (for example, to August 2013 Kickstarter has raised $750 M).
Why do people participate in crowdfunding investment — what motivate them? Some studies show that the majority of people are motivated by a potential financial return in the future. Inspired by the success of Facebook and other well-known start-ups, people are willing to invest in risky projects the amount of money, which they can easily loose. However, unlike professional investors, people rely more on their intuition and personal beliefs whether it is right to invest or not. People tend to choose those startups, whose idea corresponds to their personal interests. Often crowdfunding investors are families and friends of startups founders.
The range of crowdfunding investment varies between 10,000 and 200,000. Some studies refer to 100,000 as the average of a single investment campaign. However, today it is quite difficult to talk about fixed average value. Just a few years ago this value was about $10K. Today we can find more and more investments exceeding $1M.
Generally, a company gets profit when it is selling something or providing a service to its customers. Financing startup development from its own profit can be considered as the ideal way of fundraising. At the same time in real life self-funding is almost impossible, especially in case of early-age technological startups. It is obvious, that in order to sell a new product and get profit from it, you need first to finance its production.
However, exceptions are possible, especially in case of intangible assets businesses. For example, start-ups that are developing informational or consulting services that don’t require raw materials and equipment could theoretically be self-financed.
Government grants could be also considered as an ideal way of funding. Grants are “free money” in the sense that they do not have to be returned, and you don’t give any equity for it.
At the same time, government grants have a large number of restrictions and generally, it is quite hard to get them. All grants have some kind of eligibility requirements. Typically, the government provides grants only to startups whose research may be useful for the society and conforms to public policy. Cleantech technologies, green energy, environment, healthcare are some of the main directions of state funding. The government does not provide grants for starting a business or redemption of existing debt. State funding is usually destined to research projects with high innovation potential and potential to create new jobs, which are too early for private-sector investment.
Almost all startups that have applied for grants note a high bureaucratization of the process and extremely long wait for final decision. It can take a couple of months to gather data, fill out the forms, and get the necessary certifications to submit a credible grant application. However, even if you have completed all the requirements and have done all the paper work, it will take about one year to get the answer from a specific government agency. (In today’s fast moving competitive world, technological startups need money today and not in one year). Moreover, after a year of waiting, the answer in most cases will be “no”, because the struggle for “free government money” is extremely competitive.
So, if you are planning to create a web shop or develop an advertising service, you shouldn’t rely a lot on grants. At the same time, if you are developing a new cancer treatment, or a green energy technology, you should not completely refuse to apply for government grants. The most effective way could be a parallel search of funding both from government and venture capital.
Non-Recurring Engineering (NRE)
A startup gets fees from corporations for making something for them based on its technology. It could be a one-time cost for research, product development, or development of technical solution for a specific problem that corporation faces. Hiring a startup, a corporation is trying to solve this problem faster and cheaper.
For a young company, this form of funding can be very helpful, both from the point of view of fundraising and experience in technology implementation. However, a young company has to carefully analyze whether or not this cooperation would create barriers to its future development. Such barriers could be a loss of technology exclusivity and intellectual property rights. A corporation can use the terms under which it gets the intellectual property rights on research results or a product. It is obvious that a startup shouldn’t accept such terms. However, the intellectual property rights may be limited only to one year, or to a specific geographical zone, which is not a target area of startup’s interest and, consequently, will not prevent the future development.
So, if a corporation offers the terms, which don’t conflict with the startup’s business development strategy, and could bring funding that doesn’t require any equity sales, there is no reason not to accept such a proposal. At the same time if cooperation brings some money, but distracts startup from direct technology development for a long time, or will limit its intellectual propriety right, the startup should be more cautious about accepting it.
Debt funding is generally related to credits. The major creditors are banks. The main goal of a bank is to make more money with minimal risk.
We are used to the idea that banks increase their profits by raising interest rates. Actually, in the same country banks have practically the same interest rates for similar type of services (otherwise, customers would go to competitors). Banks increase their profits by managing the risk of failure. Consequently, the most important thing for a bank is the guarantee that even if a startup fails, the bank will be able to get back its investments (for example, getting startup’s assets).
There are different types of credits. Let’s consider two most commonly used in early startup funding.
A young startup doesn’t have any assets and equipment to mortgage. Generally, a startup doesn’t even have a purchase order to proof that soon it will surely gain a profit. So, a startup can’t provide reliable guarantees to the bank. In such case a venture loan can be used.
Particularity of venture loans is that banks lend only to those startups that are “covered” by public organisms or institutional investors. If these organisms allow a startup to fail, they will have to repay the loan to the bank. Providing a venture loan, banks often include in agreement the term of warrant coverage. If a startup fails, the bank gets back its money with interest. But if this startup becomes successful, the bank will also get a small part of company’s stock. And unlike venture capitalists that paid for it, the bank will get it for free. That’s why you can often meet an opinion that banks are the last places where a startup should go for fundraising.
Working Capital Line of Credit
A startup can get an order that it can technically implement, but it will perform it and get profit only in a few months’ time. Therefore, it will be illogical for a startup to sell a part of its shares to investors in order to finance production and delivery of the goods, which have been already ordered.
In this case, a startup can open a line of credit, which is a mechanism that allows to get short-term loans that will provide a temporary working capital. With this type of credit the startup has an agreed limit and may borrow up to that amount at any given time. The main condition for the credit line opening is a reliably purchase order.