Choosing the Right Option to Fund Your Startup Business

Starting and growing a business is a challenging process that demands much more than just a brilliant idea. In the world of business, it is a well-known adage that you have to spend money to make money. 

While this saying has been true years, rising interest rates and inflation makes funding your business properly more important than ever in 2023.

Whether you are leading a brand new business venture or expanding an existing one, it is likely that you’ll need startup funding in order to earn returns in the long run. The capital required to launch and grow a business can vary widely and might include everything from administrative and legal fees, buying or leasing equipment, renting a location, marketing, and inventory.

Although there are various ways for entrepreneurs to finance their businesses, the following is an overview of the most popular approaches. It is important to note that businesses do not have to rely on a single method of funding. Many successful startups leverage a combination of funding types based on factors such as the required amount, timing, and strategic goals.

Bootstrapping

Bootstrapping, or self-funding, is the most common method of business funding. In fact, according to the U.S. Chamber of Commerce, 78% of founders use their own money to launch their business. 

Even if you don’t plan to fully fund your business on your own, other funding types, like bank loans and equity investments, require business owners to have “skin in the game,” in part because putting your own money on the line shows that you’re driven and motivated to succeed. 

Self-funded business owners often use credit cards, small personal loans, and even loans from friends and family to add to their own money. While a great way to get short-term funding, short-term borrowing can result in high-interest rates and damage your credit score. 

Self-funding gives you full control, but may lead to a longer launch phase and more gradual growth. 

Business Loans

Financial institutions such as banks and credit unions offer a variety of financing options for businesses, including startup business loans, lines of credit, and hard money loans. Among these, term loans, a form of debt financing, are the most prevalent type of commercial loan. In this financing option, a startup borrows a certain amount of money and repays it along with interest over a predetermined period.

Term loans can come with a fixed interest rate, a variable interest rate, or a mix of both, enabling the entrepreneur to manage their business credit effectively. For instance, a startup business loan might have a 25-year term, with a fixed rate for the first decade and a variable rate at Prime + 2.25% thereafter. In a high-interest-rate environment, such as that of 2023, this could be a strategic way to fund a startup business, hedging against the possibility of future rate decreases.

The approval of such loans often depends on the credit score of the business or the entrepreneur. A good credit score can increase the chances of securing a bank loan and provide more options for how to fund a startup business.

In order to facilitate easier access to capital for small businesses, the Small Business Administration (SBA) offers a specialized form of term loan known as an SBA loan. Because the government backs a portion of an SBA loan, they are a good option for startups that can’t afford a traditional term loan, which requires personal collateral or a higher equity position.

There are several types of SBA loans, but the two most common are its flagship 7(a) loan program and the community development 504 loan program. Each of these programs has its own set of uses and requirements (for example 504 loans are used for large assets purchases like property, where as 7(a) loans can be used for business operating expenses, and even working capital). Check out our article on these programs to determine if an SBA loan is the best way to fund your business.

And if you really want to dig deep on the SBA loans, we have developed an SBA 7(a) loan interactive infographic where you can get loan data by state, industry, and funding amounts.

A second type of business loan is a line of credit (LOC), also known as a business line, which functions similarly to a credit card. The company is given a credit limit that it can use as needed while only paying interest on the amount borrowed until it is repaid. The commonly used inventory LOC allows a business to purchase the inventory it needs while the inventory itself acts as collateral.

The final type of business loan, known as invoice financing or merchant advance loans, is a hard money loan that provides cash up front against unpaid business. The interest rates on these loans are extremely high.

Approximately 20% of businesses rely on bank financing in some capacity. In 2022, the SBA provided 47,678 7(a) loans totaling nearly $25.7 billion, or an average loan amount of nearly $540,000. For the 504/CDC loan program, the SBA approved nearly 10,000 loans for a total of $9.2 billion, or an average of $995,000.

Over 60% of the Masterplans for business plans developed in 2022 were for loans from banks or other institutions. This was up from 54% in 2021.

An important consideration for businesses seeking bank funding is interest rates. Most commercial loans are tied to the Federal Reserve’s funds rate. As a means of fighting inflation, the federal funds interest rate increased from 0.25% in January 2022 to 5.25% in May 2023, with one or two more interest rate hikes anticipated later this year. Consequently, it is critical to develop a detailed financial pro forma to be sure the loan can be serviced by the company’s revenue.

Angel Investors

Angel investors are high-net-worth individuals (HWNIs) who provide capital to early-stage or startup companies in exchange for an ownership stake, also called equity. Unlike institutional investors, angel investors invest their own money; often providing seed capital to entrepreneurs when traditional lending sources are unavailable. Angel investors are willing to take on more risk than a bank would, but they also seek high return on their investments. On the other hand, angel investors can also offer mentoring, expertise, and access to networks to help startups grow. 

Angel investors are increasingly turning to convertible notes or SAFE notes as a funding option. These notes are a form of debt funding that can be converted into equity at a later date at a discounted rate. Convertible notes offer several advantages for both the investor and the business owner. For investors, it mitigates risk by allowing the option of debt repayment with interest. It gives businesses access to capital without diluting ownership, especially in the beginning when it's hard to figure out how much the business is worth.

According to Pitchbook/NVCA’s Venture Monitor, angel and seed funding has tripled over the last six years. In 2022, seed and angel investments brought in a total of $21 billion, with an average size of $2.9 million.

Venture capital firms (VCs) and angel investors play a pivotal role in the startup ecosystem, providing equity financing to businesses with high growth potential. These investors, often institutional entities, pool funds from various sources like pension funds, endowments, and business groups. They target startups and early-stage businesses, particularly those that have demonstrated their potential and are poised for expansion. As the success of these venture capitalists is tied to their investments, they actively participate in shaping the strategic direction of the companies they invest in.

Venture capital funding is segmented into several stages, each representing a different level of business maturity and associated risk. The initial stage, seed funding, is often sourced from individual investors or angels, although an increasing number of VC firms are establishing early-stage seed funds within their portfolios. The investment amount in a seed round varies, but it's typically less than $2 million.

Subsequent funding rounds, known as series rounds, are denoted by letters. Series A funding typically takes place once a startup has gained some traction and is ready to scale. The amount raised in Series A rounds can vary significantly but generally falls between $2 and $15 million. In 2022, early-stage businesses attracted $68.4 billion in investments, with an average deal size of $12.2 million.

After Series A, a business progresses to Series B, Series C, Series D, and so forth, with the deal size typically increasing substantially with each round. Venture capital deals can range anywhere from $10 million to over $1 billion. When deals reach this magnitude, multiple institutional investing groups are often involved. According to the NVCA/Pitchbook Venture Monitor, there were approximately 4,200 late-stage deals in 2022, totaling nearly $94 billion, with an average deal size of close to $22 million.

Pitching to a VC requires thorough preparation. Forbes reports that VCs finance only 1–2% of the business plans they receive. To enhance your chances of success, it's essential to target VC firms that specialize in your industry. Resources like PitchBook and Foundersuite can provide valuable insights into VC funding and assist in building your investor funnel.

In 2022, 31% of the business plans created by Masterplans were for angel or venture capital investment, an increase from 26% in 2021. This trend underscores the growing importance of venture capital and angel investment as key financing options for startups, contributing to the overall startup funding landscape.

Incubators & Accelerators

Incubators and accelerators are specialized programs that provide support to startups and early-stage companies, aiding in their growth and development. These programs offer a variety of resources, including office space, mentorship,and access to a network of industry professionals. They often focus on specific industries or types of businesses, such as technology or biotechnology, to provide tailored assistance.

An incubator program is designed to nurture startups over an extended period, offering resources and mentorship to help them grow. On the other hand, an accelerator program provides intensive, short-term support, typically culminating in a demo day where startups present their business to potential investors. This can be a crucial step in securing venture capital funding, a key funding option for many startups.

While most incubators and accelerators do not provide direct financial investment, they play a significant role in the startup funding landscape. They equip startups with the guidance and tools necessary to succeed, helping them refine their business plans, improve their cash flow management, and prepare for funding rounds. This support can be invaluable for startup founders, helping them navigate the challenges of launching a new business and securing the capital they need to grow.

Crowdfunding

Crowdfunding has surged in popularity with the emergence of platforms like Kickstarter and Indiegogo, particularly for launching new consumer goods. In crowdfunding, entrepreneurs set goals for campaigns and offer perks or early access as incentives for donations. Although less common, equity crowdfunding, which involves individual investors contributing to the business in exchange for equity and future dividends from profits, is also becoming more prevalent on marketplaces like AngelList, SeedInvest, and StartEngine. 

However, it's important to note that some of these platforms operate on an "all-or-nothing" basis. This means that even if you're close to your funding target, you might walk away with nothing. If you're an entrepreneur with a dedicated customer base or an innovative consumer product, crowdfunding could be a viable startup funding option for you. Beyond the financial aspect, crowdfunding also offers promotional advantages, especially for direct-to-consumer (D2C) business models. It can help raise awareness about your startup business, attract potential venture capitalists or other investors, and even validate your business plan. By effectively leveraging crowdfunding, startup founders can secure the necessary capital and equity financing to turn their business ideas into reality.

Grants

Grants are a form of financial assistance that are typically offered by government agencies, non-profit organizations, private foundations, and industry-specific groups. They offer startups and small businesses a unique funding option that doesn't require taking on debt. While these grants are often awarded to established companies that meet certain eligibility criteria, such as being minority- or veteran-owned, or supporting a government contract, startups may also qualify for specific grant programs.

Grants are usually tied to specific objectives, such as research and development, employee hiring and training, market expansion, or environmental sustainability initiatives. As a result, businesses that receive grants are often required to meet certain benchmarks and report their progress to the grant provider.

Working with a professional grant writer can increase your chances of securing a grant. They can help identify suitable grant opportunities, prepare applications that meet the eligibility criteria of the funding organization, and maximize the chances of being awarded. This can be a valuable resource for entrepreneurs and small business owners looking to fund their startup business without resorting to traditional financing methods.

GrantWatch is a valuable resource for businesses seeking basic information about the grants that are currently available. 

Conclusion

Starting and growing a business is an exciting journey, but it is also a challenge that requires a lot of hard work, dedication, and financial resources. Fortunately, today's startup founders and small business owners have a broader range of funding options than ever before. These options range from securing grants, small business loans from lenders, VC funding from venture capital firms, to equity funding from private equity firms. The key to unlocking these funding opportunities lies in crafting a comprehensive business plan, complete with credible market research and detailed financial projections.

To help you get started on your entrepreneurial journey, we offer a wealth of resources on business planning, including frequently asked questions, business plan samples, and financial calculators. If you're seeking professional assistance to create a compelling business plan or pitch deck, schedule a meeting with one of our experts. They can guide you in understanding what startup funding options are right for your venture and equip you with the tools you need to prepare for funding your new business.

Disclaimer: The information in this article is intended to be general information; it is not legal or financial advice. Specific legal or financial advice can only be given by a licensed professional with full knowledge of all the facts and circumstances of your situation. Consult with legal and financial experts before making financial investments.