Planting a Seed: 5 Funding Options to Get Your New Startup Off the Ground

The pros and cons of angel investors, convertible debt, online lenders and more

You have a great idea. You have a dedicated co-founder. You have a product. But you don’t yet have a company.

The first big challenge you’re going to face after building your product is scraping together enough capital to grow your startup. The good news is there are lots of options. The bad news is that they all come with drawbacks and hidden complexities. Here are five popular ways to turn that minimum viable product you and your co-founder built into a growing company.

1. Friends and family

Nearly every business in America, from restaurants to dry cleaners to tech giants, got some of its initial funding from friends or family members. Even Jeff Bezos, looking for money to launch Amazon.com, turned to his parents.

Their capital resources will be more limited than a bank or a VC, but your friends and family members will likely be the most understanding investors you’ll ever have. They want you to succeed, and they’re more understanding than larger investors about your need to build on your schedule.

Pros

• Friends and family investment is easily accessible, and it offers a safe and welcoming environment in which to raise capital.

Cons

• When your friends and family invest in you, you’re exposing them to serious financial risk. If you lose your aunt’s life savings when your startup never takes off, will you be able to stomach sitting next to her at Thanksgiving?
• Unless your friends and family are accredited investors, you’re headed for a tangle with SEC regulations. If you plan on raising VC or selling the company to a strategic acquirer later on, you’ll want to work with a lawyer to make sure any unaccredited investors follow SEC regs to the letter. If you don’t, you’ll have a messy cap table and some unpleasant audits in your future.

2. Angels

Angel investors tend to be wealthy individuals, often entrepreneurs who have exited a business or two and are interested in innovative tech. They invest small amounts (generally less than $100K) to help local entrepreneurs build their startups. In exchange, they get a slice of equity.

Pros

• Angels often have extensive networks of advisors, tech leaders, and fellow investors. A good angel investor can introduce you to the people you need to know in order for your company to succeed.
• Angels are more likely to invest on the strength of an idea alone than other investors. Your brand new startup doesn’t have the metrics to prove its financial viability, so an angel is going to look at your business plan, MVP, and the passion of your team.

Cons

• Equity investment from angels comes with all the downsides of VC: dilution of co-founder equity, a board seat, and giving up a slice of control of the business you started.
• Angel investing is a local phenomenon. If you don’t live in a city with active investors, or if you’re not tapped into their networks, angels can be hard to come by.

3. Convertible debt

Convertible debt is basically a loan that you and your investors (usually angel investors) agree will convert into equity at a specific date, usually after your next round of funding. The principal appeal of convertible debt for early- and seed-stage companies is that it delays the debate over a company’s value. Founders and investors generally have wildly different ideas about what a company is worth, and if a founder can delay the conversation until their company has a strong product and a healthy revenue stream, that works to their benefit.

Pros

• Issuing convertible notes is fast and simple compared to selling equity, and the legal fees are much lower ($1,500 to $2,000 as opposed to the several tens of thousands of dollars in legal fees for issuing preferred stock).
• Convertible debt rarely gives investors control rights.
• Interest rates for convertible debt tend to be lower than other forms of debt accessible to early-stage startups.

Cons

• Convertible debt often comes with a valuation cap, a maximum valuation at which the notes will convert into stock. If you go to raise equity and your company is valued higher than the valuation cap, your convertible noteholders will be able to buy shares in your company as if it were worth less than it actually is.
• It also typically gives investors a discount on buying equity in later rounds — usually 20–30%. This can lead to more dilution at less profit if your company is a hot commodity.
• Multiple liquidation preference can spring a trap on you if your company exceeds the valuation cap.
• Like the name says, convertible debt is debt. If it doesn’t convert to equity, you’ll have to pay it back.

4. Revenue

The cheapest money you’ll ever get is revenue from clients. You don’t have to give up equity to get it and you never have to pay it back, with or without interest. The sooner you can build a minimum viable product and find your first paying customers, the sooner you can start plowing your revenue back into the business. Subscription-based businesses are often able to get full-year payments upfront, too, which is a huge aid.

Salesforce ISVs have even more advantages: the AppExchange is a trusted and established platform that grants you a certain amount of credibility that non-partners don’t have. It opens the doors to qualified customers of all sizes and in all industries.

Pros

• Companies whose growth is primarily driven by customer revenue are very stable businesses. They’ve built a solution people need, and they know how to attract and keep customers.

Cons

• Revenue is not rocket fuel. It can take a lot of work and time to build a good revenue stream. If you’re bootstrapping, scaling up to $10M ARR will take dramatically longer.

5. Online lenders

Outside of special programs like the SBA 7(a) loan program, traditional banks are disinclined to lend to new companies. They’re simply too risky. Online lenders have stepped in to provide working capital when fledgling startups need it most. Companies like Kabbage and OnDeck offer quick and easy loans with simplified online application processes.

Pros

• The application process is very fast — sometimes you can get money the same day.
• It’s possible to borrow small amounts when you need it, rather than a large, one-time influx of cash. These small, fast loans can save your company if an unexpected one-time event reduces your cashflow, threatening your relationships with customers, vendors, or employees.

Cons

• The amount of money you can borrow is quite limited (typically less than $100,000).
• Interest rates are high — sometimes very high — and complicated fee and payback structures make it hard to tell exactly what the true interest rates are. APRs between 50% and 100% aren’t uncommon, and some online merchant cash advances (MCAs) have APRs as high as 350%!
• Because payback begins immediately — often the next business day — these loans carry significant cash risk for small businesses if you don’t understand the implication of their payback structure.
• These loans are designed for unexpected cash crunches instead of long-term growth. Think of them as emergency financing.

A brand new startup is a delicate thing, and your cap table is only clean once. Make sure you understand the advantages and disadvantages of a funding source before you agree to it. If you’re lucky, you’ll soon be generating enough revenue to make yourself attractive to other investors and funding opportunities.

Lighter Capital is a fintech company revolutionizing the business of startup finance by providing tech entrepreneurs with up to $2M in capital to grow their startups, while retaining equity and control.