Funding a Startup: The Three Types of Equity Funding
A high-level guide for early stage founders who are considering getting funding for their startup in exchange for equity.
Phewf… are you ready for this ride? The world of finance can be really complex for some, particularly when you are trying to raise capital for your own startup for the first time (eep!). Plus, it’s really not that easy and every startup will do it differently. However, I will focus mostly on the type of funding that you will hear the most about on the news: equity funding.
What is Equity Funding?
Funding, in the context of startups, is when a person or an organisation provides you with finance in order to grow or develop your product. Equity investors require a longterm ownership stake in a venture in exchange for capital.
There are three main types of investors that require equity in return: angel investors, venture capitalists and strategic partners, but let me start off with the most basic way of funding your startup… yourself.
Bootstrapping — Funding Your Startup Yourself
This is the stage where the founder(s) invest their own money to the startup. Bootstrapping (self-funding your startup) is often underrated and sometimes, founders may decide to skip this step and go straight to funding with just an idea. But imagine how that might sound to a potential investor? If you are not willing to put your own money and time into your idea, how could someone else?
In fact, there are some companies that never received any external funding and are incredibly successful. You may have heard of companies like AppSumo and Australian-founded company, Envato.
When you first start out, it is often difficult to get funding from venture capitalists because of multiple reasons. Venture capitalists are looking for startup ventures that will grow quickly, giving them tenfold returns for their investment. When you first launch a startup, getting this funding can be difficult as there are a lot of risks associated with an underdeveloped product or idea. That’s why, it’s common for founders to turn to angel investors to get investment.
Angel investors can either be an individual or group of individuals who use their own personal money to finance startups, rather than professionally managed funds. Most of the time, angel investors are friends and family of the founders. Other times, founders would reach out to their community to get investment. Angel investors are often ex-entrepreneurs, business leaders or wealthy individuals.
Recently, there has been a surge of angel investors! Online sites like AngelList have made it a lot easier for entrepreneurs to reach out and pitch to potential investors. For investors, it’s also a much more efficient way to meet promising startups and learn about the ventures. If you’ve watched Shark Tank, you will notice that the judges/investors on the show are “angel investors”!
- Easier to obtain if you have already established a high level of trust with your friends and family.
- If your angel investors are ex-entrepreneurs, they will be able to offer assistance beyond capital, providing expertise and networks.
- Angel investors usually invest without a structured timetable or control over the company’s decisions.
- Handling your friend’s and family’s money can cause tension with your relationships with them.
- Less capital is usually offered, compared to venture capital.
- Angel investors can be really powerful people to have on your side. However, if entrepreneurs do not perform due diligence with an angel investor, they may find themselves stuck with someone that lacks the expertise to help them or be difficult to manage.
Venture capital firms invest in new ventures using funds raised from limited partners such as pension funds, endowments, and wealthy individuals. These firms are run by professional investors, often referred to as venture capitalists. Venture capitalists focus on investing in startups that are believed to have long-term growth potential, so that they can hopefully tenfold their returns on investment.
The two main differences between angel investment and venture capital is the magnitude of investment and control rights that VCs will have in their portfolio firms. Angel investors often invest sub $1mil, while VC rounds often raise above that. These control rights include having seats on the startup’s board. Worst case scenario… they will have the capacity to replace an entrepreneur as the CEO if they do not believe the entrepreneur is fit to lead the company. Best case scenario, a good venture capitalist will do everything they can to help the startup and can be extremely powerful comrades to have on your side.
- One of the only ways to access over 1mil in funding.
- Connections: venture capitalists are very well connected! If you have them on your side, they will find the right people to help you, if they are unable to.
- Business expertise: many venture capitalists are ex-founders, so they are able to contribute to startups beyond finance.
- Loss of control: receiving a large amount of capital usually means a loss in ownership stake. That’s why it’s incredibly important to do your own due diligence, as venture capitalists have the power to make decisions in your company.
Strategic investors are extremely similar to venture capital firms, and are sometimes referred to as corporate venture capital. Like the name suggests, the investments made by strategic investors are often strategic in nature (such as getting access to technology important to the firm’s initiatives), as well as financial.
Unlike venture capital firms, the investment size that strategic investors will fund will vary. For example, they could invest a smaller amount of money (~20k) into something more experimental or the investment could be massive. As you can imagine, firms with “deep pockets” are likely to start their own venture capital arm. That’s why, a lot of banks, particularly in Australia, are emerging sources of capital for startups.
Notable strategic investors include: NAB Ventures, Reinventure and BCG Digital Ventures.
Which Type of Funding Do You Need?
Before I jump ahead to answer this question… it is important to note that I did not cover government grants, personal credit and bank loans in this article.
Okay, so you’re a startup and you feel like you finally need a bit of cash in your pocket to progress. If you refer to the Entrepreneurs Finance Framework above, you will be able to see which quadrant your venture lies.
- Bottom left: If you’re small business (i.e. low-risk, tested business), bank loans and personal credit will be sufficient. Example: cafe.
- Top left: If you are a using proven technologies to create something (i.e. less risky, almost guaranteed return), utilising commercial banks, project finance and strategic investors are usually your options. Example: creating a new smartphone.
- Bottom right: If you are using new technologies i.e. a startup, it often means that the only ways to get investment is through angel investment and venture capital. Example: Airbnb.
- Top right: If you are using new technologies and the product is extremely capital intensive, it is really difficult to get funding except through government support, due to the risky nature of it all. Example: new drug for curing a certain disease.
With all of that being said, bootstrapping, particularly for students like you and I, is probably the best way to go until you really need the money.
Are you a student-run startup and have questions about funding?
Feel free to e-mail me at email@example.com and let’s see if we can help you!
P.S. I am learning all of this as I go! I am not an investment-guru at all, so it’d be great if anyone will be able to correct or add anything to this article.