Startup Financing 101: The Basic Alternatives

Entrepreneurs spend a lot of time and effort sifting through the seemingly endless array of potential financing buzzwords and fads. In this blog, I cut through the cluttered terminology and identify the four basic avenues available to startup,s which are:

Use Your Own Funds

Entrepreneurs often use their own savings, 401(k) contributions and credit cards to fund the initial stages of their business, and even for key purchases in later stages. While self-funding is a necessary evil, remember that a successful business pays its own bills. You should focus self-funding on long-term investments, like equipment or a marketing campaign, but avoid using it for ordinary expenses, like rent and utilities. Using your own money can blur the lines between entrepreneur and company and weaken the legal protections inherent to a corporate shell. Before making any contributions, open a bank account in the name of your company, track the flow of money into and out of the company, and be able to document whether each transfer of funds is a loan to the company or a capital contribution.

Sell Shares in Your Company

Selling shares is great for your company’s balance sheet: it increases net worth and creates no liability. The twin downsides are paperwork and loss of control. Shares are a type of security and thus their offering and sale are subject to federal and state securities laws. These laws require the issuer (i.e., your company) to register with the federal Securities and Exchange Commission, as well as equivalent state agencies: a massive undertaking. Registration requirements are subject to numerous exemptions, but even these require careful documentation. Selling shares also means surrendering some control over your company, although, depending on the terms of the shareholder agreement, you keep control over major decisions so long as you retain more than 50% of voting shares. But even if you do, minority shareholders usually have certain rights, such as the right to request financial information relating to the performance of the company. In addition to friends, family and angel investors, another potential source of equity investment are “seed round” programs such as TEDCO’s Builder Fund and ETC’s Accelerate Baltimore.

Take Out A Loan

Loans take many forms: credit cards, personal loans (perhaps from a friend or family member) and bank loans being the most common. Loans provide cash for startup costs, growth or just to bridge the gap between revenues and expenses for a while. Of course, loans also create pressure to make the business perform well enough to repay the loan on-time. This pressure can be constructive or harmful, depending on whether the amount and term of the loan are calibrated to actual company needs and ability to repay. Loans also create paperwork. They must be accounted for properly, as they create both an asset (cash) and a liability (repayment).

Credit cards can be tricky when you use your personal card. Since it is not the company’s card, you will need to record each and every purchase you make on behalf of the company, and treat it as short-term loan or expense which the company must repay to you. Bank loans often require a great deal of personal information, liens on any equipment owned or used by the company, and a personal guarantee from you of the company’s repayment. Government programs, such as the federal Small Business Administration, offer loans on generous terms to startups that meet their criteria.

Win A Grant

Grants are a great source of funding because they provide cash and increase net worth but do not dilute your ownership or control of the company or create a repayment liability. Grants may involve “strings” however: the granting entity may designate the purposes for which the grant money may be spent. This may require special accounting to track the grant money from receipt through expenditure. Winning a grant requires substantial effort. Government grant programs require extensive applications, documentation and interviews. Private foundations may rely more on pitch competitions, in which the entrepreneur (in addition to submitting a written application), appears before a panel of seasoned veterans of the entrepreneurial process and competes with other entrepreneurs for prizes in the form of a grant.

Entrepreneurs should keep an open mind and be alert to opportunities that present themselves. Self-funding, selling shares, taking out a loan and winning a grant can all be important means of financing a successful startup.

The Van de Verg Law Office offers legal services in the area of startup Entity Formation & Governance and Financing. Contact us today to set up a free consultation.