Sunday, December 11, 2011

Funding (My favorite topic…) – Part 1

90% of startups don’t make it because they are underfunded.  And 75% of businesses are funded just from the entrepreneur’s own savings, retirement funds or borrowing capacity. Most startups don’t have a great understanding of all the funding options that are available to them, so that's why I think it's actually one of the most important topics to become well informed about. There are two (or really three) main types of funding:

(1)    equity – selling a portion of your company
a.       common stock – all shareholders are treated the same
b.      preferred stock – shareholders get special treatment (potentially more voting power) and get an additional interest rate paid to them
(2)    debt
(3)    hybrid of debt and equity – convertible debt

It’s important to understand the advantages and disadvantages of your funding options before you choose one over the other.
For equity, the main advantage is that you share the risk with your shareholders. However, the disadvantage is that you will also be sharing your profits. You will also have other owners (who might be a pain to deal with or very helpful) and they will have their own opinions and need to be informed about your business. The other thing to keep in mind is that it is 5x easier to raise money from your current investors/shareholders, so be sure to treat them as well as you treat your customers.

There are also several types of debt: personal debt, home equity line, credit cards, etc. Entrepreneurs can choose to borrow money based on their own credit worthiness, but it’s often better if you can get a commercial loan on the business itself. If you choose to take a loan on your personal guarantee, the bank can come after you and everything you own. For commercial loans, most banks will generally give you the loan for your business if you have collateral or assets that can act as a guarantee.
Many banks will choose to loan to startups and small businesses because 2/3 of America is actually employed by small businesses, so the Small Business Association will often write a check to the bank for 75% of the loan if you’re unable to pay the bank back. These loans often tend to have reasonable interest rates as well.

The main thing to remember about funding is to get the money long before you actually need it. If you wait until you really need it, then most people can smell and see the desperation, so the rates and terms won’t be nearly as good.
Convertible debt has become very popular with investors, but it’s often the entrepreneurs last choice for funding, since it’s usually tipped in favor of the investor. The investors are able to get the benefits of both debt and equity since creditors are higher on the food chain and they get paid first. They also get steady interest and if your company makes it big, then they can convert to equity and you will have to share the profits with them as well. If convertible debt is the only way you can get money from your investors, then you will most likely take it either way. The conversion price of the debt will often be the valuation of your business, so you will need to decide how much your business is worth and you will want that conversion price to be as high as possible. Be sure to keep a look out for the post that is coming up on how to determine the value your business.

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