As an early-stage venture capital investor, I see hundreds of business ideas a month, and it never ceases to amaze me how many entrepreneurs building a new company come to me for capital as their first option, when in reality I should be their last.
Following is a review of some of the funding options out there, and the pros and cons of each. Ultimately though, the first, and in most cases best, place to raise funds to fuel your company’s growth is . . . your customers. Here's why.
Venture capital investment is really expensive.
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A venture capital investment in almost every scenario is the most expensive capital an entrepreneur can secure. When you raise capital from VCs, they will insist on taking a large equity or ownership position in your company (generally 15 to 30 percent), in exchange for their funding. Additionally, their investment is going to come attached with strict conditions or terms, including but not limited to: voting rights, one-to-two board seats, the right to maintain ownership (aka "pro-rata rights"), claw-backs and more.
All of that may sound scary (and it should). But sometimes, an investment from a VC is the “best” capital you can receive because of the knowledge and resources he or she can bring to the table. Venture capitalists are in the business of overcoming challenges; they invest capital in businesses that are revolutionizing industries and shooting for the moon, in terms of their growth potential.
So, if your business fits that description, hasn’t been successful at securing debt funding and still requires R&D before it’s ready to start sellilng to customers, venture capital may in fact be your best pathway to raising capital.
The unfortunate news, however, is that securing venture capital funding is incredibly hard, and this path is becoming even more difficult given the current industry landscape trends. As a result of the market tightening after several years of growth, VC financing has been down in 2016. With nearly 30 percent fewer companies being funded in Q1 and Q2 of 2016, venture capital will likely be even more inaccessible for most fund-raising businesses.
Debt is cheaper than equity.
The oldest and surest way to secure money for your business is to go to the bank and get a loan, right? Not so fast. Debt financing may be one of the most traditional forms of funding, but in today’s post-2008 sub prime mortgage crisis and Dodd-Frank era of reform -- banks have tightened their lending practices.
If you’re a small business owner, there are generally two options to explore for debt financing: SBA loans and traditional bank loans. In both cases, you’re going to need assets or cash up-front and a solid foundation to lend against. You can’t just show up at the bank with an idea written down on a napkin and expect to get a loan.
SBA loans are provided through the government and allow small business owners to borrow up to $5 million. These loans can be a great option for entrepreneurs who are unable to secure funding from a traditional bank and have nowhere else to go. SBA loans, however, come with additional bureaucracy; and generally the borrower is required to personally guarantee the loan. This means that if you default on your payments, you may lose your car, or worse, your house.
Traditional bank loans will work only if your business fits within a very narrow box that banks are comfortable working within. There’s a phrase often used within the loan department of banks: “people, credit, business.” A good banker looks for trustworthy people, with good credit, who have a business that they understand and can measure.
So, let’s assume you’re trustworthy and have good credit: Your business still may not qualify, because bankers typically have limited imagination and flexibility when it comes to working with businesses outside of their experience and track record.
The best source of funding you’re ever going to find is: your customers.
As an investor, I love businesses that make money and are profitable. As an entrepreneur who starts businesses for a living, my goal is to find product market fit and sell to my customers as quickly as possible.
Aspiring to be an “entrepreneur” and start a company is an exceptionally popular path these days, but too often I’m pitched businesses that don’t have customers, because they don’t have a product or service that anyone actually wants.
At the end of the day, “business” can be simplified into one primary equation. Create a product or service that your “customer” is willing to pay you for (ideally more than what the product would cost to make or the service to perform). Voila! You have a business.
This is often easier said than done, of course, but the key takeaway is that every good business in history begins and ends with the customer.
Bringing this back to funding, the best, cheapest and most efficient money you’re ever going to find is the revenue and profit generated from selling a product or service. The best part about selling a product and receiving money for that product from customers is that you don’t have to give up any equity in your business, and you don’t have to pay down a loan.
Additionally, you'll be building a loyal customer base that will reward you only as your business grows, something I’ve seen first-hand with startups and small businesses using FlashFunders.
Related: 10 Ways to Fund Your Small Business
While I often hear excuses for why founders need money to do this or do that, the reality is that most good ideas can and should generate revenue and profits. And, in the end, it’s this cash flow that should primarily be used to grow the business, before you seek outside capital for now or for down the road.