Funding and Financing Arrangements for Growing and Bootstrapped Businesses

Byfractionalfin

According to CNBC, 47% of startup failures in 2022 were due to lack of financing and, closely related, another 44% to running out of cash. Clearly, a central focus of startups and growing businesses should be financing and cash management and, consequently, the development of a strong capital structure (the business’s funding composition).

Although many bootstrapped businesses are able to sustainably grow off of their own cash flows after an initial cash infusion from their founder(s), other businesses need to introduce other sources of capital to reach their short-term and long-term objectives. That will be the topic discussed in this article—a very high-level overview of the following financing options for startups and small growing businesses:

  • Bootstrapping and retained earnings
  • Friends and family investments
  • Seed capital from angel investors
  • Crowdfunding
  • Incubators and accelerators
  • Venture capital
  • Growth equity
  • Commercial asset-based revolving loans
  • Commercial bank loans and secured term loans
  • SBA loans
  • Private placement notes
  • Junior debt and mezzanine debt

A much more granular discussion of the key terms businesses encounter in the above financing structures is provided in this article.

A note of caution: As is true of other discussions we have had on this blog, every business is unique with its own unique set of circumstances. Generalities often do not translate well to your situation.

Bootstrapping and Retained Earnings

Bootstrapping, the process of starting a business without external funding (i.e., relying on existing resources, such as personal savings) is more common than the media stories would lead you to believe. According to the SBA – Office of Advocacy, approximately 80% of small businesses are initially funded through personal savings or other bootstrapping methods.

Bootstrapping can be a great option for entrepreneurs starting a business as a side gig or for businesses that require relatively small upfront capital or technological investment. This allows founders to retain equity in the business while remaining in complete control.

Without the influence of external financers who demand a high level of return on their early-stage investments (and, thus, growth), bootstrapped businesses tend to grow with more control and at the pace of the founding team. There are obvious benefits to this approach of business, just ask Mailchimp’s founder Ben Chestnut.

Pros:

  • Retain equity and control
  • A calmer approach to growth can be taken, often one that avoids the growth at all cost trap
  • Flexibility and agility with no investor constraints

Cons:

  • Often fewer resources available to bootstrapped companies
  • Slower growth potential
  • Sometimes requires increased personal investment

Terms: This is your cash, so it’s your decision what to do with it and how to best invest it. But stay disciplined!

Note: For a related discussion about financial planning and analysis (FP&A) and cash management for startups, check out our article here.

Friends and Family Rounds

There are many scenarios and business models where a founder is unable to bootstrap the early stages of a business. In such cases, he or she may need pre-seed to get to an important pre-offering milestone, such as the development of a prototype for validation purposes, or a seed round after some very early traction to reach the next important milestone, usually with a focus of further demonstrating early signs of product-market fit while setting the stage for aggressive growth.

Although there are several options for pre-seed and seed funding, friends and family and angel rounds are the most common. A friends and family round is exactly as it sounds—a round of financing from friends and family members. These typically range from $10k to $500k. 

A friends and family round can be a great way for founders to reach a particular and attainable milestone that will either bring the business to profitability or to a clear point where additional funds can be raised from more experienced investors. This funding source can help the founder preserve optionality and ownership of the company.

Extreme caution, however, should be taken when taking money from friends or family to fund a risky venture (i.e., every new business). Broken relationships as the result of business failures and lost money are all too common. Because of this, it is often advised to rely on friends and family rounds sparingly and to treat all investments from friends and family with many of the same formalities that are expected from experienced seed and early-stage investors.

These investments can often be best structured formally as loans, convertible debt, or equity. And make sure you are very clear with those investing about the extreme risks of their investments. In my opinion, an investor, including a family member or a friend, should not be given the opportunity to invest in a business without fully understanding the risks involved with the investment, the vision of the business, and the details of the investment structure. This can be a limiting factor if your network has limited exposure to business and entrepreneurship.

Pros:

  • Early access to capital needed for a proper launch
  • Can include flexible terms and provide quick funding

Cons:

  • High potential for strained relationships
  • Limited investor pool and limited funding capacity

Terms: It’s best to not get lazy with how investments by friends and family are structured. Fully disclose risks and have parties sign formal agreements. Common structures include gifts, loans (with repayment plans), cash for equity, and convertible equity.

Seed Rounds: Angel Investors and Seed Venture

If a friends and family round doesn’t make sense to an early-stage founder who needs capital or those relationships have already been exhausted, angel investors or seed venture capitalists are often the next best option. These rounds can vary in structure depending on the specific circumstances and the preferences of the investors and founders involved.

As previously mentioned, whereas pre-seed rounds are often meant to bring a startup’s idea to life, seed rounds typically fund a product’s market entrance (and transformation) beyond its beta users. These rounds commonly range between $1-$5 million, resulting in 10%-20% dilution. Common structures include convertible notes and equity deals, with board seat provisions, conversion discounts, and anti-dilution protection.

Angel investors and seed venture capitalists will both expect very large returns on their risky investments—and because these investors can often exhibit a relatively high level of control on the startups they fund, going this route is certainly not for the faint of heart, and is best suited for founders with some prior startup experience or founders who have a go for broke mentality. 

For those who raise a seed round, ample time should be spent: 

  • Getting to know their prospective investors to find a good match
  • Understanding early-stage investment structures and key terms
  • Finding an experienced lawyer who can represent their interests
  • Forming and executing a roadmap for the startup’s future, including a funding strategy; although raising a seed round will take a lot of resources to pitch and build relationships, the team must not lose sight of its operating goals

Pros:

  • Necessary capital to access the next stage
  • Access to investor expertise and networks
  • Accelerated growth and maturation
  • Investor validation and investor follow-on potential

Cons:

  • Early dilution of ownership
  • Release of control and large investor expectations
  • Pitching time and effort
  • Potential investor-founder conflicts

Terms: Typical structures include convertible notes and equity deals, with board seat provisions, conversion discounts, and anti-dilution protection being common.

Crowdfunding

Over the past ten-plus years, crowdfunding has become an increasingly popular form of pre-seed and seed funding for startups. Some rewards-based crowdfunding websites like Kickstarter provide a valuable platform for startups and indie makers to receive non-dilutive funds from thousands of “backers” who are interested in providing small amounts of money to back pre-revenue concepts in return for a small reward, often early access an early-stage version of the product or some branded swag. Kickstarter is great for trendy consumer products.

There are other platforms, such as SeedInvest, that provide digital access to strong networks of professional and retail investors seeking equity investments. Equity-based crowdfunding platforms allow startups to solicit a diverse group of investors, while final terms often look similar to traditional pre-seed and seed rounds. 

While crowdfunding can come with many benefits, including acting as an early feedback channel, there are downsides to consider. Some of these include high preparation costs, high fees, and missing out on an investor who is committed to the startup and is willing to provide consistent guidance (as some angels and seed venture capitalists do).

Pros:

  • Product exposure and market validation
  • Often non-dilutive financing

Cons:

  • Low likelihood of funding goal failure
  • High fees and preparation costs
  • Increased execution and intellectual property risks
  • Less committed and involved investors (can be a pro and con)

Terms: Some crowdfunding platforms like Kickstarter offer nondilutive financing options (providing startups with gifts in exchange for rewards), while equity crowdfunding platforms will often structure deals similar to how a typical angel or seed investor would. Equity investment, convertible notes, SAFE (Simple Agreement for Future Equity), and preferred equity are all used. Some crowdfunding platforms also offer more creative forms of repayment to funders, such as revenue sharing and equity tokens.

Incubators and Accelerators

Incubators help incubate startup ideas. They are usually close-knit startup communities (often providing intimate shared workspaces and coaching) that provide support for entrepreneurs to transform their ideas to early stage businesses.

Depending on the location of the startup and the type of product, joining an incubator can be relatively easy for founders who have a strong pitch put together. Incubators are typically local and community-oriented, running on local or state grants.

Although incubators are not commonly a source of funding for startups (in fact, in rare cases an incubator with charge startups a small monthly fee), they provide support for founders, including access to angel investors and venture capital scouts who have connections with the incubator program. Startups can often stay at an incubator for 12-26 months.

Accelerators help accelerate startup development and growth. These are typically competitive cohort-based programs that last 3-12 months that engulf startups with resources, such as mentors, education, networking programs, and follow-on support.

The application process to join top accelerators, such as Y Combinator or Techstars, is very competitive and often involves a small equity investment. Joining an accelerator can be an important source of seed capital for some startups, but the real value comes from the resources provided by the program. Most accelerators today are focused on preparing startups to raise their pre-series A or series A rounds.

Pros of Accelerators:

  • Can provide extremely valuable startup resources to expedite growth
  • Validation and credibility
  • Fundraising guidance

Cons of Accelerators:

  • Focused on extreme growth and fundraising (a pro and a con)
  • Often takes equity with options for future equity investment (a pro and a con)
  • Can be very competitive and high-pressure environments (a pro and a con)
  • Some programs have less credibility than others; some programs even have a negative stigma in certain startup networks

Terms: Incubators often take a small equity investment (1%-10%) in the startups they support in return for their support. Accelerators often take a more meaningful equity position and structure their investments similar to how other seed investors would. Y Combinator popularized the SAFE (Simple Agreement for Future Equity), a structure somewhat similar to a convertible note but much simpler.

Venture Capital

Venture capital is a form of equity financing that provides funding to high-potential startups and early-stage companies with significant growth potential. Venture capital firms, also known as VC firms, invest in these companies in exchange for equity ownership, aiming to achieve substantial returns on their investments.

VC firms evaluate startups based on their innovative business models, market potential, competitive advantage, and the capabilities of the founding team.

Most venture capital funds have well-defined focus areas (e.g., consumer healthcare, B2B SaaS) and specialize in a certain stage of startup development (e.g., seed, series A, series B). In addition to capital, many venture capital firms offer value-added support to their portfolio companies. This support often includes mentorship, strategic guidance, industry connections, and access to their network of experts and potential customers. 

Venture capital funding can be a significant catalyst for startups, as it provides not only financial resources but also validation, credibility, and access to a wide network of resources and opportunities. However, it’s important for entrepreneurs to consider the potential trade-offs, such as dilution of ownership and the pressure to deliver on growth expectations.

Taking venture money is a major decision for founders and will frequently change the trajectory of the business—there will be increased scrutiny of major operating decisions and startup performance as VCs pressure startups to provide outsized returns for their funds. Consequently, it is very important for founders to understand the terms of the financings and to have patience (if possible) in finding venture investors who are a good fit for their visions. 

Venture capital transactions come in a variety of different structures depending on the stage of the startup being funded. Early-stage rounds tend to rely on convertible notes and SAFEs, while middle and later-stage rounds are often structured as syndicate equity and preferred stock financing, as well as mezzanine financing.

Pros:

  • Capital to scale
  • Strategic guidance and resources
  • Increased future liquidity opportunities

Cons:

  • Equity dilution and loss of control
  • Pressure for explosive growth and execution
  • Time-consuming pitching and due diligence process
  • Potential misalignment with controlling investors

Terms: Venture capital transactions come in a variety of different structures depending on the stage of the startup being funded. Early-stage rounds tend to rely on convertible notes and SAFEs, while middle and later-stage rounds are often structured as syndicate equity and preferred equity financings, as well as mezzanine financing, which often includes a high interest rate as well as a generous bucket of equity kickers (e.g., warrants). Venture capitalists typically request liquidation preferences and anti-dilution provisions that can put founders in difficult situations.

Growth Equity

Growth equity and pre-IPO financing are private equity funding sources that cater to startups and growing businesses in later stages of development with strong revenue trends. These funding options provide capital to support expansion, scale operations, and prepare for an eventual initial public offering (IPO) or exit. 

Growth equity in particular aims to fuel further expansion and market dominance through large funding amounts (large relative to early-stage venture capital), focusing on later-stage companies seeking capital to accelerate growth, enter new markets, or invest in acquisitions.

Because growth equity and pre-IPO financing are typically regarded as less risky investments than earlier venture capital investments, these types of financings are generally less disruptive to businesses. However, adding these investors to the cap table will still cause additional external pressures for management. 

These transactions are often structured as preferred stock deals with investors wanting board representation.

 Pros:

  • Access to very large amounts of capital for further growth or a nearing liquidity event
  • Strategic support and moderate operational flexibility

Cons:

  • Further dilution and loss of control
  • Increased exit expectations
  • Time-consuming pitching and due diligence process
  • Potential misalignment with controlling investors

Terms: Often structured as preferred stock deals with investors wanting board representation. It is not uncommon for these investors to request warrants, conversion options, and/or liquidation preferences.

Commercial Asset–Based Revolving Loans

Asset-based loans, including revolving lines of credit, offer financing options for startups and small businesses based on the value of their assets. These loans, most offered by commercial banks, are secured by the company’s tangible assets, such as accounts receivable, inventory, equipment, or real estate. Here’s a brief overview of asset-based loans for startups and small businesses:

  • Collateral-Based Financing: Asset-based loans focus on the value of a company’s assets rather than its creditworthiness or profitability. Lenders assess the quality and liquidity of the collateral to determine the loan amount and often lend a certain portion of the value of the collateral, such as up to 80% of receivables.
  • Revolving Lines of Credit: One common type of asset-based loan is a revolving line of credit. It provides businesses with access to a pre-approved credit limit that they can borrow against as needed. The borrower can draw and repay funds within the credit limit, similar to a credit card.
  • Flexible Working Capital: Asset-based loans, especially revolving lines of credit, are typically used to finance working capital needs, including inventory purchases, accounts receivable management, and operational expenses. They provide businesses with the flexibility to access capital when needed to support day-to-day operations. While many asset-based revolving loans will have restrictions on what the borrowings can be used for, some provide flexibility for businesses to use the borrowings for capital expenditures (e.g., equipment).
  • Cost and Interest Rates: Asset-based loans may have lower interest rates compared to unsecured loans because they are secured by assets. However, they often come with additional fees, such as appraisals, due diligence, collateral monitoring costs, and unused revolver fees. Lenders of asset-based loans typically require regular reporting and monitoring of the collateral. This ensures that the value of the assets remains sufficient to support the loan. Lenders may conduct periodic audits or appraisals to assess the collateral’s value.
  • Usage and Repayment Flexibility: Asset-based loans provide businesses with the flexibility to borrow and repay funds based on their working capital needs. The revolving nature of lines of credit allows businesses to borrow, repay, and borrow again as their cash flow fluctuates.
  • Suitable for Seasonal or Cyclical Businesses: Asset-based loans can be particularly useful for businesses with seasonal or cyclical revenue patterns (e.g., landscaping businesses). They provide a financing option that aligns with the ebbs and flows of the business’s cash flow needs.
  • Availability for Startups and Small Businesses: Asset-based loans are accessible to startups and small businesses, especially those with tangible assets or strong receivables, even if they may have limited credit history or profitability. The focus on collateral value makes these loans viable options for many companies in early stages.

It’s important for businesses to carefully assess their specific needs, collateral availability, and repayment capabilities before considering asset-based loans. Engaging with reputable lenders and seeking professional advice can help businesses navigate the complexities and choose the right financing option for their unique circumstances.

Pros:

  • Quick access to cash that can be used for multiple operating purposes
  • Typically provide flexible repayment terms

Cons:

  • Collateral requirements 
  • Monitoring and reporting costs
  • Cumulative fees can get expensive

Terms: Provided by commercial banks, these loans often come with ~5-year terms, straight-line amortization for term loans and bullet repayments for revolvers, strict covenants that address fixed charge coverage ratios (FCC), maximum capital expenditures, and minimum working capital. Interest rates are typically based on a floating benchmark rate (e.g., SOFR) plus a spread. Revolvers come with commitment and undrawn fees.

Commercial Bank Loans and Secured Term Loans

When it comes to financing options for startups and small businesses, commercial bank term loans remain a popular choice. These loans provide a reliable source of capital to fuel growth, fund operations, or embark on new ventures. Depending on the circumstances and creditworthiness of the borrowing business, commercial bank loans may be secured by tangible assets or unsecured, in which case the lender must find comfort that the business is able to generate enough cash flows to repay the loan.

Commercial bank loans are typically offered by traditional banks and come with their own set of benefits. Firstly, they offer competitive interest rates, making them an attractive option for businesses seeking affordable financing. 

Secondly, commercial bank loans often have flexible repayment terms, allowing businesses to tailor the loan to their specific needs and cash flow capabilities. Moreover, these loans can be used for various purposes, from purchasing equipment to expanding premises or hiring additional staff. 

However, it’s important to note that some commercial bank loans will require a personal guarantee from the business owner (if the business is small or lacks a history of strong financial performance), which can pose additional risk to the guarantor in case of default. Additionally, the loan application process can be more stringent and time-consuming, requiring detailed financial documentation and business plans. 

Nonetheless, for startups and small businesses in need of substantial funds, commercial bank loans provide a viable and established financing option to fuel growth and achieve their entrepreneurial aspirations.

Note: When to use a commercial bank loan vs. an asset-based revolver? Following the general rule of thumb of matching your loan term with the life of the assets being financed, revolvers are great to finance daily operations and fluctuations in working capital that result from growth, seasonality, or cyclicality. Term loans are less flexible—the business receives the entire loan upfront and is then required to pay back the borrowed money over the term of the loan, typically 5-7 years. Term loans can be used to finance general growth initiatives.

Pros:

  • Access to large amounts of debt capital
  • Overall borrowing costs can be relatively attractive
  • Structured repayment can be helpful for planning purposes

Cons:

  • Depending on the credit environment, there can be difficult qualification criteria
  • Often comes with stringent covenants
  • Limited flexibility to modify once establishing

Terms: Depending on the circumstances, these 5-10 year loans can be secured or unsecured by the company’s assets. Backend amortization is common with common covenants being based on FCC and leverage ratios (e.g., debt to LTM EBITDA). Both fixed and floating interest rates may be available. 

SBA Loans

SBA loans, short for Small Business Administration loans, are a popular financing option designed to support small businesses in the United States. The SBA itself doesn’t directly lend money but rather guarantees a portion of the loan made by approved lenders, such as banks and credit unions. This guarantee mitigates some of the lender’s risks, making it more attractive for them to provide loans to small businesses that may not qualify for traditional financing.

The SBA offers various loan programs, including the 7(a) Loan Program, CDC/504 Loan Program, Microloan Program, and others, each catering to different business needs and purposes. Some of these programs are great to manage short-term cash needs, like those from fluctuations in working capital, while other SBA programs are designed to support long-term growth initiatives.

As previously mentioned, the SBA typically guarantees a portion of the loan, ranging from 50% to 85% depending on the loan program and loan amount. These loans also require a personal guarantee from anyone who owns at least 20% of the business and will still involve a relatively rigorous application process similar to that which is required for traditional financing.

Pros:

  • Although most SBA loans require a healthy credit history and have financial reporting requirements, there are many scenarios where a business’s cheapest option for capital is an SBA loan, especially in instances when traditional financing options are not available
  • Long repayment terms (10-25 years) at a relatively low cost
  • No covenants and limited collateral requirements

Cons:

  • Generally capped at $5 million
  • Personal guarantee required
  • Can be a slow application

Terms: Depending on the program, SBA loans often range from 10-25 years in length. The longer loans will typically fully amortize. SBA loans can be both fixed rate and variable rate but are usually fixed for those with longer terms. The SBA sets maximum rates that can be viewed here. Like other loans, SBA loans may come with significant fees. They require a personal guarantee from business owners and are often collateral-backed.

Note About Use of Funds: The SBA has a “no duplication of benefits” rule, which states that SBA loans cannot be used to refinance existing debt if the lender believes the business can obtain the necessary credit elsewhere without undue hardship.

Private Placement Notes

Private placement notes are a financing option that can meet the needs of small and medium-sized businesses (SMBs) seeking to raise capital without going through traditional public markets. These notes are a form of debt securities issued to a select group of accredited investors, such as institutions or high-net-worth individuals. The funds raised through private placement notes can be used for various purposes, including business expansion, working capital, equipment purchases, or debt refinancing.

Unlike public offerings, private placement notes offer several advantages for SMBs. They involve lower regulatory compliance costs and reduced disclosure requirements, making them a more cost-effective and time-efficient option in certain instances. Additionally, private placements often provide more flexibility in negotiating the terms of the offering, such as interest rates, maturity dates, and covenants, allowing businesses to tailor the terms to their specific financial situation and risk profile.

However, private placement notes come with their own set of risks and considerations. Since they are not publicly traded, liquidity can be limited, and investors may have to hold the notes until maturity. Also, due to the exclusive nature of private placements, raising funds through this method might be more challenging than with public offerings, as it requires building relationships with potential investors.

Pros:

  • Flexible terms to fit unique financing needs
  • Access to potentially large amounts of capital with minimal regulatory burden

Cons:

  • Exclusive (and, at times, demanding) investor base
  • Relatively high interest rates and placement costs depending on the business situation

Terms: Private placement notes may come with many of the same terms and covenants as other term loans but may be a bit more flexible to accommodate the needs of the borrower. Private placement notes that are subordinated to other senior debt tranches will require higher interest rates. 

Junior Debt and Mezzanine Debt

Junior debt and mezzanine debt sit below a business’s senior debt and are typically used by businesses seeking relatively high leverage (e.g., a buyout sponsor). Consequently, these types of financings often come with high placement costs and interest rates.

Although junior debt (also known as subordinated debt) can come in many different forms, including public bonds, bank loans, and private placements, mezzanine debt is typically provided by private equity firms that specialize in providing highly subordinated financing solutions. Mezzanine debt, which occupies a position in the capital structure somewhere between traditional debt and equity, comes with high costs (and often options, rights, or warrants) but often minimal covenants.

Pros:

  • Often comes with flexible terms, high leverage, and limited covenants (i.e., covenant light)
  • Can be an attractive option for financial buyers pursuing higher returns and companies in turnaround scenarios 

Cons:

  • Structures can get very complex with increased risks for businesses in the case of default
  • Mezzanine debt often includes an “equity kicker” in the form of options or warrants.

Note on Unitranche Debt: Unitranche debt provides businesses seeking leverage multiple “tranches” of debt (e.g., a revolver, senior loan, and a subordinated loan) bundled into a single loan. This financing solution can be an attractive way for reputable financial sponsors to keep their capital structures clean.

Terms: These forms of debt typically come with minimal covenants. However, lenders often require board of director observation (or seats), prepayment fees, and return enhancements like warrants or options to bring their returns closer to equity holders.

Conclusion

Securing funding is vital for growing and bootstrapped businesses. Various financing options are available, such as bootstrapping, friends and family investments, crowdfunding, venture capital, commercial bank loans, SBA loans, and mezzanine debt. Each option has its pros and cons, and entrepreneurs must carefully consider their unique business needs before choosing the best financing strategy. Selecting the right funding source is critical for success, and understanding the implications of each option is essential.

Keep an eye on FinancialFin as we periodically update this article and add posts taking a deeper dive into each one of these financing sources.