Navigating the complex landscape of funding and finance can be a daunting but crucial challenge for startups and entrepreneurs. Understanding the common sources of capital available is a great first step in getting a handle on venture finance.
Early-stage businesses tend to have a more limited set of options with respect to financing sources as compared to larger and more established companies. In particular, debt capital is often unavailable for startups, at least in their first few rounds of financing (the common exception being convertible debt). The lack of debt availability is primarily a result of the risk profile of startups – investors don't have a lot of downside protection (a startup's liquidation value is typically quite low) but a ton of upside exposure (if a startup ends up growing exponentially). Debt, compared to equity, provides enhanced downside protection (by being senior to equity claims and, at times, secured against assets of the borrower) but limited upside participation. Beyond convertible debt and venture debt (which itself typically only becomes available a few financing rounds in), debt is therefore often inaccessible to startups without severely onerous terms, such as personal guarantees from the founders, as lenders just aren't compelled by the risk-reward trade-off.
So instead, startups typically finance themselves using equity. The investor market for startup equity is comprised of a few main groups of players, and most startups raise capital from each group along their development path. For the purposes of this post, we will take a look at angel investors, venture capitalists, and crowdfunding. Knowing what capital sources are mostly likely to invest in your business based on your industry and stage of growth is essential to optimizing your fundraising efforts.
1) Angel Investors
Angel investors are typically high-net-worth individuals (or groups of them) who provide financial backing for early-stage startups. They are investing their own money for their own gain and are therefore typically able to move faster than institutional investors and may be less demanding about investor rights. In many cases, angel investors also act as strategic partners, bringing experience, networks, or both to the companies they support. Angel investment is often crucial in helping a startup adequately scale to a point where institutional equity investment is available.
However, angels typically have a cheque size much smaller than that of their institutional investor peers who are managing deep funds of pooled capital. Startups are therefore often required to raise from many angels (or a syndicated group), as well as seek supplementary capital from the founders' friends and family.
With a potential exception for investors that will also play a key strategic role, startups should attempt to minimize the administrative and governance impact of angel-stage investments by using simple equity or convertible financing structures and avoiding enhanced information or board-related investor rights.
2) Venture Capitalists
Venture capital is an area of private equity in which professional venture capitalists (VCs) manage the investment of funds of investor money into startups with the intention of generating a return for the fund's investors. For most startups to reach explosive growth, the large checks that VCs can write are a must.
While VCs can write large high-impact checks, as stewards of the capital of their own set of investors VCs are more adamant on securing preferential investment, including priority claims to proceeds when the startup sells, board participation, and other governance rights. The investment process is accordingly longer and diligence into the target startup tends to be more extensive. VCs often prefer to invest alongside other VCs to spread risk and validate their investment thesis, as well as iteratively across multiple rounds to ensure their portfolio startups are achieving appropriate growth milestones before overcommitting capital.
Venture capital firms typically have funds dedicated to specific market segments, stratified by industry, stage of growth, or both. And like angels, a well-aligned VC firm can offer not only capital but also strategic assistance, industry connections, and mentorship. VCs will very likely play a large part in the governance and strategic management of the startups they invest in and will leverage their experience and expertise to help professionalize the startup in preparation for its next set of growth milestones.
3) Crowdfunding
While the prevailing orthodoxy of startups has long been to use friends, family, and angels to scale to the stage of attracting VC capital, and then to raise iterative rounds of VC capital until a successful exit could be reached, crowdfunding has emerged as a relative new method of raising capital that can provide an early-stage alternative or supplement to angel investment.
Crowdfunding rounds take advantage of established investor networks that connect the startup with many, many small investors who each on their own likely couldn't write a check that would compete with the size of an angel check, but who together can meet or exceed that threshold.
While crowdfunding can be an exciting source of capital, it can have drawbacks. For one, accessing the investor network typically requires working through a third-party platform that may have steep fees. Beyond the immediate transaction costs, crowdfunding may also limit future financing options or result in other administrative challenges because of the large number of resulting shareholders.
Navigating Funding Sources as You Scale
Raising iterative capital requires a forward-looking approach – it is essential to ensure that previous investment rounds don't impair your future rounds, and that you are effectively managing dilution and growth expectations at each step. While many parts of your business should stand out to investors, your company's capitalization shouldn't. At MT❯Ventures, our goal is to help you navigate your financing needs and anticipate your growth trajectory, allowing you to spend less time wondering about through the ramifications of different capital sources and structures, and more time focused on what you do best – growing your business.
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