Equity Funding Sources: Pros and Cons for Startups

When it comes to funding sources for small business startups, there are two main categories: equity and debt. We discussed debt funding in a previous post on qualifying for a business loan; in this post, we will focus on equity funding, in which a business gives up a percentage of its ownership to an investor or investors in exchange for capital. Please be advised that this post is for informational purposes only and should not be taken as advice or direction.

Sources of equity funding include self-funding, friends and family, investors, crowdfunding, and grants. Each of these sources requires some type of investment from the business owner, and each comes with advantages and disadvantages, as described below.

Self-Funding

Most new startups are initially funded by the owners themselves. Self-funding (also known as “bootstrapping”) means that you will need to supply sufficient capital to operate your business in the short- and long-term. Because it is unlikely that your business will break even in the first few months after startup, it’s important to ensure that you have the funds to cover any shortfall.

An advantage of bootstrapping is that you don’t need to ask for money or search for a funding source. In addition, completely financing your business yourself means you don’t have to give any ownership to partners or outside shareholders. However, a major disadvantage of self-funding is the potential impact on your personal wealth if your business fails. In addition, self-funding leaves you with limited reserves for the future.

Friends and Family

Another common source of equity funding is friends and family. Funding your business this way requires having enough friends and family to reach your monetary goal. You’ll also need proof of concept and a friendly pitch to convince them to contribute.

In this case, personal relationships help sell the idea to individuals who already know you and want to help. Advantages of this funding source including giving you more time to build your business and the likelihood of more forgiving terms for payback.

However, keep in mind that family and friends may not possess useful knowledge to advise or guide you in your business venture. In addition, a limited amount of funding may be available, and they may be a one-time source of capital. It’s also important to consider the impact that the failure of your business could have on your family and friends and/or your relationships with them.

Investors

Investors may include venture capitalists, private equity firms, and angel groups. Unlike friends and family, who may not have much business knowledge, investors can be partners in your business and may connect you with consultants, mentors, and other sources of support. In addition, they usually provide enough funding to launch and may be able to provide additional funds if needed.

Not surprisingly, securing investor funding requires a harder sell, with specific, financially based proof that your business idea is a good one. Investors will also expect your heavy investment first, and they will take an equity position, not just a payback of interest. In addition, they may not be willing to provide guidance or advice. It’s also important to keep in mind that investors generally won’t sign a nondisclosure agreement, so you’ll want to be sure you can trust their discretion.

Crowdfunding

Crowdfunding has become increasingly common as a source of startup funding with the advent of online platforms like Kickstarter and Indiegogo, among others. (Investopedia reviewed and ranked the top six platforms for business here.) While many people are familiar with rewards-based crowdfunding, in which donors receive incentives for their financial contributions, equity crowdfunding provides you with working capital in exchange for a piece of your company.

Equity crowdfunding enables you to obtain financing even if you lack personal savings and access to other funding options. It also allows you to leverage an existing online platform with an existing database of investor users, and it can be a good way to test the public’s reaction to your product and build a following.

On the other hand, crowdfunding requires a significant investment of money and/or time to generate interest in your project before it launches. Prospective investors will expect transparency in the form of financials and business plans. In addition, you risk giving away too much of the business to investors if you get the rewards or returns wrong.

Grants

Grant funding is reserved for businesses operating with a not-for-profit business model. Grantmaking organizations exist to provide funds to nonprofits, and they do not require repayment. Grants can come from public or private sources, and there are many websites that assist grantseekers in locating them.

Applying for grants can be a very time-consuming process involving lots of paperwork, and there are often strict eligibility requirements and tough competition; for government grants especially, there may be many strings attached. Because of this, when applying for grants, it’s important to ensure that the nonprofit’s mission matches the grantor’s interest; otherwise, applying will be a waste of time.

For more information about this and other topics, consider registering for the NaperLaunch Academy workshop series or scheduling a one-on-one appointment with a business librarian or NaperLaunch coach.

Posted: 
Wednesday, October 20, 2021 - 09:00