Startups Can Obtain Capital From Unlikely SourcesBy Michael Parduhn
This is the third in a series of articles that deal with issues related to starting a new business.
During the dot com boom, the focus on financing had been venture capitalists (VCs). In the aftermath of the dot coms, entrepreneurs are still using VCs for funding, but not exclusively. Ponder this, what is the most overlooked source of funding?
The initial stage of a start-up is typically funded through “credit card” financing. What is this? Well, when entrepreneurs need to photocopy their business plan, they charge it! When they need to travel to see a potential customer, they charge it! When they need to buy components to build a prototype, they charge it! This gives the founders ten thousand dollars or so to help with ramp up costs. This type of financing can be also take the form of home equity loans for those who own a house. Other related sources of funding include bank loans and government programs.
Another source of early funding comes from friends and family. This source allows the founders to raise some seed money from those people who have the confidence that the money will be wisely used. An added benefit is that friends and family won’t require much in the way of due diligence, which is the process that VCs use to investigate your business before investing. Depending on the family, the founders might be able to raise another ten thousand dollars each. Even more, if someone has a rich uncle.
Using these sources, a start-up can possibly raise between tens of thousands to a hundred thousand dollars. This is a great start for a set of founders who are following their dream. However, we are only half way through alternate sources of funding.
The next step for some start-ups is Angel investing. Angel investors typically put in tens to hundreds of thousands of dollars, and are individuals who have been there, done that, and have a lot of cash as a result. They are looking to stay involved in the excitement that surrounds a start-up, without having to be involved in the nitty-gritty day-to-day operational issues. Angels might give advice and provide contacts, but they also provide cash. Angels are people who are connected in their industry and are trying help folks who are in the same position that they were once in: having a great idea, a lot of enthusiasm, and in need of some cash to get the company off the ground. Angels typically require some amount of due diligence, but they are typically knowledgeable about the industries they are investing in, so they know what will and won’t fly.
So, what is the source of financing that is most over looked? Revenues. That’s right, companies can actually sell a product or service for money to real living, breathing, customers. Go figure! This was a completely foreign concept during the dot com frenzy, when the concept was king and companies with actual revenue where looked down upon and profits were the kiss of death. But this is how a lot of companies have started. So how does this work? Well, a start-up that has a great solution to a problem will go out and find a company that needs their solutions. The start-up then convinces this potential customer that they can solve the problem, and with just a little money up front to cover some costs, build the “customized” solution. The start-up then builds the product, which solves the problem, and receives a nice sized payment on delivery. You might say, “So what? What good does that do?” Well, now the start-up has a working prototype, revenues, and a satisfied customer in the industry. These are three items that every start-up dreams of. Additionally, they have cash on hand since the founders are initially earning sweat equity instead of a salary. In the end, a start-up might end up with tens of thousands of dollars in cash.
But don’t get me wrong, VCs are a good source of funds for a start-up. A good VC will provide more than cash too. They provide the contacts with potential customers and help you build out the management team. Overall, they can bring a new venture to the “next level.” So once a start-up has flushed out the details of its business plan and maybe have some customers, it might be the time to talk with VCs. But keep in mind that the VCs do significant amount of due diligence and are very savvy investors. Gaining funding from VCs takes a lot of time from the management of the company and will take several months to make a decision. VCs do take a significant portion of the company’s equity, and some control of the company. But if a start-up needs millions of dollars, VCs are the way to go.
Parduhn is a graduate student in the Alfred P. Sloan School of Management, and serves as the lead organizer for the MIT $50K entrepreneurship competition.