How a Start-up Gets Cash
Only three ways exist to get cash into a start-up:
- Revenue. Customers provide cash in return for the company selling them product or service.
- Loans. Somebody provides cash in return for the company promising to pay back that money plus interest.
- Investments. Somebody provides cash in return for a part ownership of the company.
More established companies have a fourth way: they can sell assets. Creating revenue is the primary mission of the start up, so let’s a bit about loans and investments.
If you decide you need outside sources of cash, loans are one of two primary mechanisms. The primary advantage of a loan is that you do not have to give up equity in the company. Primary disadvantages are (1) you have to repay it under the terms of the loan agreement, and (2) for most start-up businesses, you will likely need to co-sign for the loan personally, and that means your personal assets serve as collateral for the note. In other words, if the company cannot pay back the loan, the lender will expect you to pay back the loan; and just because the company is a corporation does not free you from this obligation . . . and that is precisely why the lender will ask you to co-sign the note. In effect, the lender is giving you a personal loan (based on your personal credit history) and is allowing the company to be a co-signer, thus initiating a credit history for the company.
Since start-up businesses are generally too risky for most banks to lend money to, the Small Business Administration (SBA) established the Basic 7(a) Loan Program. Entrepreneurs apply for a loan under this program through their local bank. If approved, the bank lends the start-up between $200K and $300K, the SBA reduces the risk to the bank by underwriting 70-90% of the loan, and the entrepreneur provides collateral to the SBA. The loan can be repaid over 10 to 25 years.
Another kind of loan that start-ups can secure is bridge financing, often available from traditional investors such as angels or VCs. Bridge financing is a loan that is not intended to be paid off, but instead to be converted into equity upon the next round of investment. Its raison d’etre is that a company may need cash now, intends to raise a round of investment later, and some combination of the following two situations are true: does not have time to create all the paperwork now for the investment round, or does not want to establish a valuation for the company now because within a short period of time a major milestone will be met and the company will likely be worth a lot more then. Bridge financing is one example of a convertible debenture, which is any loan instrument that provides the option to be converted into equity instead of being paid off.
The other major source of cash is investment. An investment is very simply a purchase of a part of the company. It is thus an exchange of a percent ownership of the company (usually stock, in the case of a corporation) for cash. Typically, investors in a start-up include entrepreneurs themselves, friends and family, angels, and venture capitalists.
What is an Angel Investor?
Angels are high net worth individuals (often former or current entrepreneurs themselves) who invest their own money in start-ups, and often like to stay involved in the company providing wise counsel on an as-needed basis. Ten years ago, angels were quite difficult to find; today they are much easier to find thanks to the proliferation of angel networks. Lists of angel networks can be found online at Gust (www.gust.com), the Angel Resource Institute (www.angelresourceinstitute.org) and in the back pages of Preston [PRE07]. You can also locate angels through incubators (find a list of incubators through the National Business Incubator Association — www.nbia.org) and accelerators (find a list of accelerators through the Global Accelerator Network — www.gan.co). Cohen and Feld [COH11] have some great tips on what to watch out for when working with angels.
What is a Venture Capitalist?
Venture capitalists invest other people’s and other financial institution’s money in start-ups. Unlike angels, they are professional investors; their careers depend on the success of portfolio companies they have chosen to invest in. Berkery [BER08], Crowley [CRO12], and Feld, et al. [FEL12] contain a wealth of ideas on how to work with venture capital firms.
The above is extracted from my latest book, Will Your New Start Up Make Money? Buy your copy in Kindle at http://www.amazon.com/Will-Your-Start-Make-Money-ebook/dp/B00JOOZQNE or paperback format http://www.amazon.com/Will-Your-Start-Make-Money/dp/0996028307.