Companies have four possible sources of funds:
- Equity financing
- Debt financing
- Internal financing
- Public-sector financing
Each source has its pros and cons. Companies will often combine several of these sources together, and the mix will change over the company’s lifetime.
In equity financing the entrepreneur raises money by selling shares in the business to investors, thereby making them partners. This is the typical form of investment for angel investors and venture capitalists. Angel investors are usually individuals investing their own money, while venture capitalists are professionals investing a fund of other’s money. (This situation is somewhat confused by the fact that some angels have organized into angel funds and some VCs do put some of their own money into their funds.) The benefits of equity financing are: relatively large amounts are available; it can be used to grow the business rapidly; the equity investor does not have the same rights as debt lenders to the assets of the company in a liquidation. Equity investors earn their returns when the company is sold, so their incentives are to some degree aligned with the entrepreneur’s incentives – they both want the business to succeed. The main drawbacks of equity investment are that it tends to be expensive, and that it entails a reduction in the entrepreneur’s control of the company.
Here is a diagram of a typical multi-stage equity fund-raising process:
A few points to note about the process. The first source of equity capital for your new business will be your own money (
The next step in equity fund-raising is F,F&F or friends, family and fools. The logic here is that if you cant even convince your friends and family to invest in you, there must be something wrong with your business idea. On the other side of this one, people who are not your friends and family but who invest in your business anyway at this stage are the “fools” because the assumption is that your F&F are maingly investing in you because they love you.
After founder’s capital, the company will go through a series of equity financing rounds, which will likely include different investors at each stage, until the company reaches a successful IPO (or trade sale). If all goes well in this process, everyone involved will make a very good return on their equity investment.
Debt financing typically comes from banks. The company borrows money from a bank and promises to repay the principal plus interest on an agreed schedule. The benefits of debt financing are that it is less expensive than equity financing and does not usually entail a reduction in control of the company by the entrepreneur. The downsides of debt financing are: it is often unavailable for companies without a history of operating results; if available it can be more expensive than other forms of debt; if the company defaults on the loan the lender may seize the company’s assets, including any valuable IP; too heavy debt obligations may deter equity investors who do not want to see their investment used to service or pay off debt.
Internal financing means that the company reinvests its earnings to grow the business. This is sometimes referred to as organic growth. The benefits of internal financing are that it is less expensive than either debt or equity, it entails no reduction in control of the company by the entrepreneur, and it does not create a liability for the company that can result in insolvency or loss of assets. The main drawback of internal financing is that it is usually relatively slow to acquire and may not allow the company to grow as quickly as competitors who are using alternative funding methods. This can be a significant drawback in hot and contested markets.
Public funding comes from government sources. It generally takes several different forms:
Direct equity investment – looks just like private equity investment, but relatively rare.
Matching equity investment – requires a matching private investor. Usually the public equity will be priced the same as the private equity and will be issued on the same terms. Most public-sector equity programs are done on this basis.
Grants – generally these are non-dilutive, meaning that no equity is given in exchange for the grant. Some grants may be done a reimbursement basis for expenses. Reimbursement grants may be disbursed only after the funds are spent or may include some portion disbursed up-front. Some grants may be conditionally repayable; meaning that they must be repaid upon certain pre-agreed conditions being met. The non-dilutive aspects of grants make them very valuable.
Loan guarantees – the government guarantees some or all of a bank loan that the company is taking. This encourages the bank to make riskier loans than they would otherwise make.
Fund-of-fund investments – the government invests in venture funds, which then invest in companies.
The pros and cons of public funding include the same pros and cons of the underlying funding class listed above. The additional benefits of public-sector funding are: the government is a credible investor and therefore the company’s credibility can increase after a public-sector investment; public-sector programs may invest for developmental purposes or a mixture of developmental and financial purposes, which makes their funding available to a wider range of companies than private sector funds; acquiring government funds can increase the company’s likelihood of raising private sector funding. The additional cons of public-sector funding are: some programs may incur significant administrative overhead; investments may take longer than in the private sector; some programs may be mutually exclusive (“double-dipping”) so you need to carefully consider which program or programs best meet your needs and which ones are mutually exclusive.
As you can see, each source of funding has its own special benefits and challenges. As an entrepreneur, you will need to navigate the financial markets as well as navigating your customer market if you want to successfully scale your company.