A great business idea? For startups, that is hardly enough to be successful. Securing funding is as crucial as having an innovative idea. Fortunately, there are many options available for every startup stage. What factors should founders consider?
Where do startups get their funding to build a successful business? This question is paramount for entrepreneurs. Early-stage companies are not generating revenue or profits—they start with an idea.
To turn this idea into a thriving business, startups must invest money. There are a multitude of funding options out there, each tailored to different stages and needs of a startup.
How to select the right funding option for your business
Choosing the funding option that matches a startup’s needs is determined by various factors. First and foremost, founders must define their own funding profile.
Define your profile as a founder
Every founder has a different perspective on how to fund their startup. Some seek to bootstrap to stay completely independent. Others chase a VC investment as soon as possible, while some opt for a diverse capital stack, including different types of funding.
Before funding their business, founders should ask themselves about their priorities. It helps to determine what kind of funding is best for their startup:
- Equity or debt?
- Traditional or alternative funding?
- Working with VCs and potential pressure?
- Retaining full control?
- Repaying interest?
- Cash at hand or not?
- Avoiding extensive share dilution?
- Access to network and know-how?
When founders seek funding, understanding priorities, preferences, and what to avoid is essential. It sets a startup’s financial identity.
Assess your financing
What do I want to achieve with my funding? This question is crucial when it comes to financing.
While securing equity might be suitable for some investments, debt might be better for others. For projects with complex or uncertain ROI predictions—like product development—equity works well. Debt capital is different. Since startups must repay debts, the ROI must be more predictable, as is the case with marketing activities for example.
Both options, equity and debt, come with cost of capital, which affects the funding decision. Raising equity through a VC involves direct costs like lawyer’s fees, which are evident instantly. Indirect costs from selling shares become apparent later on, in the event of an exit for example. Debt is a different ballgame. It comes in many cases without dilution of shares. Yet, receiving large sums all at once can lead to high capital costs. After all, idle cash in the bank creates costs when not reinvested.
Align your funding with your business – not the other way around
Whether equity or debt: It is vital to align funding with your business plan and strategy. A different funding instrument is needed for a startup that wants to expand into new markets compared to a startup striving for profitability.
Understanding a startup’s specific use case and its goals must be evaluated upfront. Founders should consider what they want to achieve with the fresh capital. It usually determines the amount of money and the timing.
Which option in which phase is suitable, differs for every startup. Factors determining this include:
- Business model
- Product or service offered
- Market environment and the industry
Nevertheless, in order to give founders an indication of which types of financing may be useful and when it helps to divide them into different phases. Those are stealth mode, pre-seed and seed stage, growth stage, and later stage.
Before a startup is officially founded, it’s in stealth mode. Founders secretly work on their ideas, conducting market research, crafting business plans, and preparing for the company’s birth.
Funding during this phase usually comes from the founder’s personal funds or money from family and friends. External investors are rare.
Pre-Seed and Seed-Phase
In the pre-seed and seed phases, a startup’s inception, market-entry, initial sales efforts, and team building are on the agenda. This period can extend up to three years. As these phases demand substantial capital, they involve funding from external investors like incubators, accelerators, business angels, and venture capital.
Incubator: Nurturing and guiding
Incubators assist startups in finding business ideas, crafting business models, offering infrastructure, networks, expertise, and funding. In return, they receive company shares and a say in decisions.
These programs emphasize long-term collaboration, often spanning five years, making them suitable for early-stage companies refining initial concepts in an experienced ecosystem. Completing an incubator program should enable a startup to stand on its own.
Accelerator: Boost your growth
An accelerator is a program supporting startups in their early stages with funding, infrastructure, networking, know-how, and coaching. Usually organized by companies, accelerators live up to their name by speeding up a startup’s progress.
To participate, a startup’s idea should be solidified, and the company established. Unlike an incubator, these programs only run for three to six months, offering financing in exchange for shares, up to €100,000.
Business Angel: Funding, network, and know-how
Business angels, often experienced managers, founders, or entrepreneurs, provide more than just funding. They bring their operational expertise to the table, offering insights and advice. They typically invest up to €500,000 in return for shares.
Another crucial benefit is the business angel’s network. It serves as a bridge to other investors, which might become relevant in different funding stages.
Venture Capital: The most prominent way of funding
Venture capital (VC) ranks among the most common ways for startups to fund their business and can come into play early on. VC firms collect money, set up a fund, and invest in startups.
VC funding amounts vary widely, from several hundred thousand euros in pre-seed and seed stages to several hundred million euros in the growth phase.
VC funding is a core component in startup funding and has its place in many different stages—from pre-seed to later stages like Series D or E. In exchange for their investment, VCs receive shares in the company, as well as co-determination, information, and control rights.
Besides legal and consultation costs, the cost of capital with venture capital is noticeable not until a later stage when founders sell their company. The more shares are sold, the greater the dilution. That’s why founders should carefully consider the long-term financial consequences of giving up shares.
With stealth, pre-seed, and seed stages behind, the focus of a startup shifts to market penetration and scaling during the growth stage. The startup should transform into a scaleup, necessitating product expansion, team investment, and organizational structure building.
This phase is capital-intensive and can span several years.
Beyond equity through VC rounds, debt financing can enter the room during this phase. Opting for debt demonstrates the startup’s financial maturity and diversifies its funding mix. This diverse capital stack includes instruments like venture debt, bank loans, or alternative debt funding.
Venture Debt: Large capital, high costs
Venture debt is used during or shortly after an equity financing round. It involves receiving debt capital, mainly for growth. This approach maintains liquidity between VC rounds and minimizes share dilution. Startups that have already completed a VC round are eligible for venture debt. Stable revenues are also necessary to service interest payments. Funding can reach up to €50 million.
Nevertheless, venture debt comes with significant costs. Upfront payments and interest (between 10% and 20%) are direct expenses, accompanied by indirect costs such as warrants or equity kickers. As startups with venture debt undertake repayable debts, they should weigh this financing form meticulously beforehand.
Alternative Debt Financing: Tailor-made funding as re:cap offers it
Recent years have seen the emergence of several alternative debt financing instruments for startups. Fintechs, in particular, specialize in this area, one example is re:cap. They provide debt capital based on data-driven risk assessments, automated disbursements, and reporting.
This financing instrument centers on a startup’s capital needs, aiming to fulfill them at the most convenient time on a quarterly, monthly, or even daily basis.
Such alternative debt fundings are well-suited for startups already showcasing resilient, growing revenues. Ideally, these revenues are recurring, enhancing investor willingness to make the decision to fund your business.
Alternative debt financing offers various benefits:
- Startups secure needed liquidity aligned with their business
- No dilution of company shares
- Startups can arrange flexible repayment terms
- Financing excludes warrants or equity kickers
- Funding can be tailored to specific timings, allowing startups to avoid unnecessary capital costs of overfunding
Such alternative debt financing options can reach up to €8 million, which usually can be flexibly repaid within five years. Besides the interest rate, there are no additional costs such as warrants, covenants, or other securities.
Considering the long-term implications of startup funding
Founders have a variety of instruments at their disposal for financing their startups. Ultimately, which form is the most suitable depends on the business model, market environment, and the ambitions and goals of the founders.
Yet, one constant remains: thoughtful consideration of the chosen path is paramount. Whether opting for debt or equity, traditional or alternative instruments, funding decisions reverberate in the long run. That’s why founders should approach these choices with careful evaluations.
Want to take control of your funding? re:cap offers alternative debt funding. You get optimal funding amounts, timing, and usage – tailored to your needs. So you avoid overfunding, as every cent comes with costs that impact your cash balance.