As a startup owner, you may find it difficult to raise capital until your business has proven its business case or product. While some startup founders bring on investors, others may use their capital and savings to try and grow their business if they can. This article will explain the differences between bootstrapping and raising external capital and which may be better for your business.
What is Bootstrapping?
Bootstrapping is when a startup founder uses their own capital to fund their business. This may stem from their savings or inheritance. Business founders may also leverage their homes when supporting their startups. This means they take a loan from the bank using their home’s equity, and their home is also used as security for the loan. Although this may be risky, this business model is relatively common in New Zealand.
External Capital
External capital is a common alternative for startups looking to raise money. It can come from various sources, each with benefits and drawbacks.
Continue reading this article below the formFriends and Family
In the very early stages of a business, asking friends or family for capital may be the easiest way for a business to obtain funding. This stage is commonly known as pre-seed investment, whereby a business is in its initial stages and looking to secure funding for a prototype or idea rather than an established product.
At this stage, a founder may partner with other co-founders or other businesses that may offer money or the provision of key services in exchange for shares in the company. A common pitfall for early-stage businesses in this process is founders giving away too much equity in exchange for early investment, and it is recommended that businesses seek legal advice before entering into these arrangements.
Angel Investors
In the early stages of a business, angel investors may also be interested in investing. However, typically, this would be done once the business is slightly further along its journey and has developed its product but needs additional capital to start expanding its operations. Angel investors may wish to conduct some due diligence into the company before investing to ensure they make sound financial decisions and are comfortable that they will likely receive a return on their investment.
Venture Capital
Venture capital firms also invest in startups. They manage funds used to invest in these companies and have investors who invest in those funds. At this stage, businesses receiving funding from venture capital firms have typically established their core product and will use their funds for greater expansion in the market.
Private Equity
Private equity firms also invest in other businesses. While these firms typically invest in more established companies, they can also invest in promising, well-performing startups.
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Debt
Alternatively, your business can raise money via debt funding. While raising funds through debt funding will usually incur interest payable on top of debt repayments, the main advantage of debt funding is that you do not give away any equity (or ownership) in your business.
Convertible notes are another relatively common tool startups use to “bridge” funding rounds. This is a hybrid debt/equity instrument that acts as debt. That is to say, when your investor transfers funds to the company, this incurs interest until a “trigger event” occurs. Thereafter, the funds and interest incurred convert into equity.
The main advantage of convertible notes is that they defer the valuation needs. At a high level, a convertible note will require you to ‘pay back’ the loan amount plus interest in the form of shares.
Key Takeaways
As a startup founder, you must manage your business’ finances. This can be difficult at the start of your business’ growth. Some business owners may use their savings to fund their businesses, including leveraging their homes. Alternatively, business owners may look to external investment.
If you need help with raising capital for your business, our experienced startup lawyers can assist as part of our LegalVision membership. You will have unlimited access to lawyers to answer your questions and draft and review your documents for a low monthly fee. Call us today on 0800 005 570 or visit our membership page.
Frequently Asked Questions
Yes, venture capital firms typically want to exit your business eventually. This can be done via an exit event, usually a sale of all or most of the company’s critical assets or shares, or via an IPO.
Yes, you will likely have to pay interest on any debt funding obtained. However, if a friend or family member provides a loan, they could do so on an interest-free basis.
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