Business Capital Basics: Fundraising Options for Startups and Small Businesses
May 14, 2014
By Jeff Wolfe
I recently had the pleasure of appearing with our friend Lea Strickland on WCOM-FM’s Focus on Business radio show, and she invited me to discuss the basics of funding and raising capital for business.
While many subscribe to the belief that bootstrapping a business with one’s own organic income is the best way to fund a business, other business executives would tell you that a failure to integrate some type of external capital will cause the business to miss critical business opportunities that can be instrumental in growth or even survival. As a business attorney passionate about seeing entrepreneurs and executives achieve success, I’m here to advise from legal and risk management perspectives as to some of the pros and cons of fundraising opportunities.
In the first installment of this series meant to educate leaders of small businesses and startups about the world of raising capital, let’s talk about types of capital typically at their disposal.
The concept of equity financing is familiar to many people, and it’s more commonly known as issuing shares of stock representing a percentage of ownership in the business. As companies issue shares, investors purchase the shares, fueling the business with money in exchange for an equity stake.
Equity financing can be a powerful way to raise money, but it comes with a high price, as investors in small businesses and startups can take large stakes in the company, thereby diminishing the ownership percentages, and possibly controlling positions of, the original owners and founders. Many startups find themselves in the position of seeking equity financing, since the nature of buying stock in a young business is a high risk/high reward proposition for the investor and often young businesses are unable to secure debt financing due to cash flow or revenue projections.
After young and small businesses begin to make money, they often look to debt financing as a source of capital to take their businesses to next-level revenue potential. Debt financing involves individual or institutional investors loaning money to a business. In exchange for this capital, businesses can expect to make payments to include a portion of the principal amount borrowed, as well as a percentage of interest (where the investors make their profits).
As with equity financing, debt financing can provide a much needed shot in the arm to businesses. Entrepreneurs and executives must be careful, however, not to load their businesses with an amount of debt that ultimately hampers the business’s ability to meet its other obligations (payroll, operating expenses, cost of goods sold). They must be careful, with regard to engaging in debt financing, that projected growth resulting from new capital expenditures must be realistic and achievable, even during significant shifts in the marketplace.
Finally, let’s take a look at a third potential avenue of raising capital for many types of businesses, rewards-based crowdfunding. An internet phenomenon popularized in recent years by sites like Kickstarter and Indiegogo, rewards-based crowdfunding allows a company to obtain financial backing from a large number of individuals in exchange for perks, gifts, products, and or services (or as a pure donation). While rewards-based crowdfunding can be a great way to win money from fans of the company, it can also lead to obligations that the owners can underestimate their own ability to meet, such as generating 1000 new art pieces in exchange for the same number of fan investments.
We will revisit the subject of raising capital for small businesses and startups in the coming weeks and months, including developments in the ability to use crowdfunding platforms for debt and equity financings. In our next installment, we’ll look at the types of investors that executives and entrepreneurs typically engage with along the path to funding their companies.