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.
This age-old saying has been true years, but with rising interest rates and inflation, funding your business properly is 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 to invest in your business 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, 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 and more gradual growth.
Pros of Bootstrapping:
- Full control
- Less risky
- Lower cost
- No delay for capital
Cons of Bootstrapping:
- Limited funding
- Slower growth (due to lower capitalization)
- Personal risk
- No access to mentorship and advice
Banks, credit unions, and other financial institutions provide a range of business loans, including term loans, lines of credit, and hard money loans. Term loans are the most common type of commercial loan. In this type of loan, a business borrows a sum of money and pays it back with interest and principal over a set amount of time. Term loans can have a fixed interest-rate, a variable interest rate, or even a combination of the two so the entrepreneur can hedge their bets – for example, a 25-year term, fixed for the first 10 years, and variable at Prime + 2.25% thereafter. In a higher interest rate environment like that of 2023, you might hedge your bets that rates will vary downward in the future.
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; 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 loan is a line of credit (LOC), 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 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 4.75% in February 2023, with more interest rate hikes anticipated. Consequently, it is critical to develop a detailed financial pro forma to be sure the loan can be serviced by the company’s revenue.
Pros of Bank Loans:
- Maintain ownership
- Consistent repayment schedule
- Establish credit history
Cons of Bank Loans:
- Strict qualifications (credit score, etc.)
- High interest (especially on hard money loans)
- Long-term commitment
- Requires down payment (aka equity position or equity injection)
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.
Pros of Angel Investors:
- Typically passive investors
- Less focused on exit
- Mentorship and networking
Cons of Angel Investors:
- Seek high returns
- Can be difficult to find
- Dilutes ownership equity
- Legal & regulatory requirements
Venture capital firms (VCs) invest money in exchange for equity in a company, much like angel investors. However, VCs are usually institutional investors who gather funds from sources such as pension funds, endowments, and business groups. They seek out startups and early-stage businesses with high growth potential, especially those that have already proven themselves and are ready to scale. Since VC firms profit from the success of their investments, they are heavily involved in shaping the strategic direction of the companies they invest in.
Venture capital funding is divided into several stages, with each stage representing a different level of maturity and therefore risk.
The earliest stage is seed investing, which, as we touched on earlier, is often found from individual investors (angels) rather than VC firms, though more and more VC firms are creating early stage seed funds as part of their managed portfolio. The amount invested in a seed round varies depending on the amount needed, but it’s typically less than $2 million.
The subsequent rounds of investing move into the series rounds and are designated by a letter. Series A funding usually occurs after a company has some traction and is ready to scale. Again, Series A rounds vary wildly but are typically between $2 and $15 million. In 2022, there was $68.4 billion invested in early-stage businesses, with an average deal size of $12.2 million.
After Series A, a business moves into Series B, C, D, and so on, and the deal size jumps considerably. A deal at this stage can range from $10 million to $1 billion or more. Often, when a deal gets to this size, there are several institutional investing groups involved. According to the NVCA/Pitchbook Venture Monitor, there were about 4,200 late-stage deals in 2022, totaling almost $94 billion, for an average of nearly $22 million.
Pitching a VC requires extensive preparation. Forbes reports that VCs only finance 1–2% of the business plans they receive. To improve your odds of success, it’s crucial to target VC firms that specialize in your industry. PitchBook and Foundersuite are excellent resources for gaining insights into VC firms and building your investor funnel.
In 2022, 31% of the business plans Masterplans created were for angel or venture capital investment, up from 26% in 2021.
Pros of Venture Capital:
- Large investments (typically in the millions)
- Mentorship & expertise
- Path to IPO
Cons of Venture Capital:
- High expectations
- Loss of control
- Strict target reporting
- Legal and regulatory requirements
Incubators & Accelerators
An incubator is a specialized program designed to support startups and early-stage companies in their growth and development by offering various resources, including office space, mentorship, and access to a network of industry professionals. Incubators often focus on specific industries or types of businesses, such as technology or biotechnology, to provide tailored assistance to their clients.
On the other hand, an accelerator program provides mentorship and support to startups over a specified period, usually culminating in a demo day where members of the cohort present their companies to potential investors. Accelerators can be industry-specific, providing tailored guidance to startups operating in a particular industry, or they can be more generalized, assisting companies from various industries.
While most accelerators and incubators do not offer direct financial investment (as in cash), they help startups by providing them with guidance and tools to help them succeed.
Pros Of Incubators & Accelerators:
- Product validation and refinement
Cons of Incubators & Accelerators:
- Competitive application process
- Loss of control
- High expectations
- Usually require fees
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, some of these platforms have an “all-or-nothing” basis, meaning that even if you come close to your target, you may still come up empty-handed. If you have a dedicated customer base or a novel consumer product, crowdfunding could be the right move for you. Crowdfunding also has promotional advantages, particularly for direct to consumer (D2C) business models.
Pros of Crowdfunding:
- No equity dilution
- Product or service validation
- Connect with early adopters
- Generate pre-launch awareness
Cons of Crowdfunding:
- No funding guarantee
- Platform fees
- Expensive rewards
- Legal and regulatory requirements
Grants are a form of financial assistance that are typically offered by government agencies, non-profit organizations, private foundations, and industry-specific groups. Grants provide businesses with the opportunity to start or expand their operations without having to take on debt. While they are more commonly awarded to established companies that meet certain eligibility criteria, such as being minority- or veteran-owned businesses or supportive of an awarded government contract, startups may also qualify for certain grant programs.
Typically, grants are tied to specific purposes such as research and development, hiring and training employees, expanding into new markets, and supporting environmental sustainability initiatives. As a result, grant recipients are often required to meet specific benchmarks and report on their progress to the grant provider.
To increase your chances of success in securing a grant, working with a professional grant writer can be beneficial. A grant writer can help businesses identify suitable grant opportunities, prepare grant applications that meet the eligibility criteria and requirements of the funding organization, and maximize the chances of being awarded.
GrantWatch is a valuable resource for businesses seeking basic information about the grants that are currently available.
Pros of Grants:
- No repayment (free money!)
- Targeted funding
- Validation of business
Cons of Grants:
- Strict eligibility requirements
- Complex applications
- Limited use of funding
- Usually not for startups
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 entrepreneurs have more options than ever before when it comes to funding their ventures. Whether you're looking to secure grants, bank loans, or equity funding, the key to success lies in developing a comprehensive business plan that includes 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. And if you're looking for professional assistance in creating a compelling business plan or pitch deck, schedule a meeting with one of our experts to guide you through the process and help you prepare for funding success.
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.