Funding for Startups: Pros & Cons of 6 Common Financing Options
As a founder starting or growing a business, you know access to capital is crucial for growth - especially if you can’t fund the business yourself.
You have several options for funding your startup: money from family/friends, bank loans, angel investor or venture capital, crowdfunding, grants from a governmental program or research institution, and now an additional option - a Convertible Income Share Agreement (CISA).
Every entrepreneur’s situation is different, so choosing the right source of funding is just as important as getting money in the door.
The type of funding your startup business can raise depends on many factors: stage of the company, business strategy, track record as an entrepreneur, etc. Each funding method has its own benefits and drawbacks. For example:
- A bank loan could come with a low interest rate, a predictable payment schedule, and allow you to retain equity ownership in your company, but having to make regular interest (or interest + principal) payments could hamper a young company, especially if revenue or profits don’t occur as planned.
- On the flip side, a conventional equity investment wouldn’t require payback on a fixed schedule. Instead, equity investors own part of the business, which reduces the founder’s ownership percentage. Additionally, equity investors will want certain governance and control rights, as well as pushing you towards a certain growth path that hits the investors necessary return targets.
Here, we offer an overview of some of the most common startup funding options for entrepreneurs, along with their pros and cons.
You’ll also learn about a new, innovative startup funding option that doesn’t require early-stage founders to sacrifice excess ownership or bet the proverbial farm: convertible income share agreements.
Pros and Cons of 6 Startup Financing Options
1. Personal Finances
Almost 65% of entrepreneurs start their businesses with personal or family savings, or using income from a primary job or spouse’s job, according to the Kauffman Foundation. While bootstrapping - starting and growing a business with little or no outside cash or other support - is feasible for certain types of businesses with no large upfront costs, some founders progress to the point where they need more capital for growth than they can afford on their own.
Also, funding a business with personal money may detract from quality of life, particularly if the entrepreneur has to cut back in other areas.
Nonetheless, at the earliest stages, this is often the only way to fund a business. Plus, other traditional sources of capital often like to see that the entrepreneur is personally invested before they invest.
Unfortunately, this option assumes a lump sum of cash available to invest in the business - and many don’t. Almost 70% of adult Americans have less than $1,000 in a savings account.
This means two things: 1) Americans need to spend less and save more, and 2) there are likely talented entrepreneurs that are prevented from starting or growing their company due to their personal financial situation..
Pros and Cons of Self-Funding a Startup
- Self funding a business gives the founder complete control. They do not have to answer to outside investors or give up a portion of their business.
- Founders can grow their business at any pace they feel comfortable with.
- Many founders do not have the personal capital available to self fund their own business
- Growing the business could be much slower without the additional capital available to invest in growth initiatives
2. Family & Friends
Another source of funding for startups is friends and family (sometimes referred to as F&F). Often, this is the first outside capital that comes into a startup. These people trust the entrepreneur personally and might provide capital at very favorable terms. The investment is considered debt if the money is to be repaid, or equity if the investors become part-owners of a piece of the business.
For many entrepreneurs, raising money from friends or family isn’t an option. Relatively few people have the privilege of a wealthy network of friends and family.
Other founders have the desire to insulate their business from their personal lives. If things go south, losing your friends and family’s money could hurt relationships.
Lastly, many businesses grow too large for friends and family money to be able to fund, requiring institutional sources of capital.
Pros and Cons of Friends & Family for Funding a Startup
- Typically, F&F financing is made on good terms for the entrepreneur and business.
- F&F are typically supportive and can be flexible if things don’t go as planned.
- Things can get complicated when you add a financial layer to a personal relationship.
- Some entrepreneurs’ friends and family may not have the means to provide F&F funding.
- At some point, F&F funding may not be enough to continue growing the business.
Another common source of funding for startups is a bank loan or debt investment. These come in many flavors. We’ll go into more detail about the specific options, but for now, know that a traditional bank loan can either be a personal loan to the entrepreneur as an individual, or a business loan to the entrepreneur’s business.
A standard bank loan typically looks like this:
- Lender loans entrepreneur/business money at a fixed interest rate.
- Regular payments are made to the lender, either just interest payments or interest plus part of the principal (an amortizing loan).
- At the end of the loan’s term, the principle plus interest is required to be fully repaid.
- The lender often assigns certain business property as collateral that can be seized and sold to recover lost proceeds in case of default. Examples of collateral include a building or machinery owned by a business.
- Some loans require personal guarantees, meaning that if the business can’t pay back the loan, someone else (in many cases, the entrepreneur) will owe the lender personally. Personal guarantees can also limit future fundraising efforts, such as equity crowdfunding through Regulation CF.
Bank loans typically take the form of an SBA (Small Business Administration) loan, or a loan to finance a specific purchase or transaction. Here’s a quick overview:
- US Small Business Administration-guaranteed loans: The Federal Government doesn’t loan money to small businesses directly, but it does set guidelines for partner lenders. It also partially guarantees these loans. This makes it easier for lenders to extend loans to small businesses, which makes it easier for small businesses to obtain loans. SBA loans typically have low rates (5.5%-8%) and can be for as much as $5 million. However, they typically have tight lending standards, and are not accessible to all businesses. They also require an unconditional personal guarantee from any business where an owner holds at least 20% of the business, meaning that if the business defaults, the owner is on the hook. NerdWallet has a good overview of SBA loans.
- Other types of small business loans: Businesses can also take out debt to finance equipment, a mortgage, or an acquisition of another business. You can get a line of credit, a business credit card, borrow from your clients or your suppliers, or borrow against unpaid invoices. Similar to SBA partners, many of these lenders require cash flow or assets against which the loan is made. If a business doesn’t yet have the traction or assets to qualify for a loan, the entrepreneur may need to provide a personal guarantee for the loan. Lendio has a good round-up of the various kinds of small business loans.
Pros and Cons of Bank Loans for Startup Funding
- Predictability of the loan repayment schedule and of the amount owed
- Low cost of capital: small business loans for qualifying businesses with proven operational history can have interest rates as low as 5.5%.
- Pre-revenue companies that don’t yet have a predictable cash flow stream may not be able to repay the loan, which typically requires repayment on a regular, inflexible schedule.
- Most early stage companies will not qualify for traditional debt financing unless they can offer up hard assets as collateral.
For a small portion of startups, equity financing is an option. Equity financing means the entrepreneur sells a portion of their business to an investor partner. This is the classic Venture Capital and angel investor model for financing early stage startups.
Venture capital (VC) firms write various check sizes, typically starting at $100k and going up from there. However, VC funding accounts for less than 1% of all new business funding. Furthermore, the chances of receiving a venture capital investment drop substantially if you are located outside of the 10 largest U.S. cities or if you are not a white male. studies show that 79% of venture capital funding goes to all male teams and 77% of venture capital investments are in companies located in the top 10 U.S. cities.
VCs look for a very specific growth profile of a company. asking, “How can this business get to $100 million in revenue in 5-10 years?” If your business doesn’t fit that high growth profile, then venture capital is likely not a fit.
Angel investors are another form of equity investment. Angels can write much smaller checks, sometimes as small as $5k. Angels often look for similar types of high growth, but are much more flexible in what they will invest in.
Other types of equity investors include Private Equity, Family Offices, and High Net Worth Individuals.
With venture capital firms, angels and other types of equity investors, startups can only get funding if they’re able to 1) match their investment criteria and 2) get in contact with them to pitch the idea.
Pros and Cons of Equity Funding for Startups
- Equity financing generally does not come with any fixed repayment requirements. There is an embedded expectation of an investment return, but the return is expected 5-10 years in the future.
- Bringing on new investors who are excited about your business can also mean bringing in valuable, well-connected investors who can advise you on how to build and grow your business, make crucial introductions, help you hire well, etc.
- An early investor’s good reputation can also go a long way with prospects and customers, as well as with potential future investors.
- Equity financing can require a valuation of your company, which can be very difficult early in a company’s life-- especially before it has steady revenue streams or assets. Entrepreneurs may not want to paint themselves into a corner by valuing their company too little or too much, and similarly may want to defer that valuation negotiation until the business is a bit more developed. There are plenty of “equity-like” instruments that can defer any valuation conversations (convertible notes, SAFEs)
- Bringing on additional shareholders, i.e., other owners of the business, also means changing company governance, since the entrepreneur is no longer the sole owner. VCs will seek to have the company managed in order to maximize shareholders’ potential returns, which may not always align with the entrepreneur’s vision for their business.
- If a company follows the storied high-growth VC model, entrepreneurs may end up owning a pretty small percentage of their business after a few rounds of fundraising. This means that the entrepreneur’s position and livelihood are predicated on good relations with and confidence of their investors. In some cases, investors choose to replace the founders as company leaders, which can be a hard pill to swallow for an entrepreneur who’s put a lot into building the company. As a rule of thumb, each round of equity financing will dilute the company 10-20%.
- Access to this kind of capital is very limited.
5. “Alternative” Financing
Less discussed are a few other ways for entrepreneurs to access capital for their business. These options are often less dilutive than traditional venture capital investment and may leverage company assets like blue-chip customers, unpaid invoices, equipment, or other intangibles. These options can be a great fit for some entrepreneurs or some business models. Companies with large amounts of inventory or extremely predictable recurring revenue streams are good candidates for certain types of alternative financing.
Indie.vc has put together a list of alternatives to equity financing, including factoring, venture debt, mezzanine debt, inventory financing, among others. We’ll go over Revenue-based financing and Factoring, then introduce a new financing option for entrepreneurs: the Chisos Convertible Income Share Agreement, which takes a hybrid approach to early-stage funding.
Pros and Cons of Revenue-Based Financing
Companies with high recurring revenues and hefty margins can take advantage of revenue-based financing, which typically claims a fixed percentage of revenues up to a certain multiple (or cap). This means the loan is repaid faster when revenues are larger and more slowly when revenues weaken, therefore fluctuating with the state of the business.
- No minimum payment requirements. No dilution or change in ownership.
- If revenue is reduced, your payments are reduced, unlike a fixed payment loan. This feature can help companies survive periods of reduced revenue.
- This kind of loan can get really expensive if the company’s revenues are growing rapidly.
- You also generally need to start repaying the loan immediately; often there is no ‘grace’ or ‘interest repayment only’ period.
- Revenue-based financing will typically only be available to companies with at least $10,000 in monthly recurring revenue (MRR.)
- Lenders will charge a fee for this kind of loan, typically 1-2% upfront.
Pros and Cons of Factoring
Factoring is similar to revenue-based financing, except that the loan is backed by the company’s accounts receivable. This kind of financing can be a good fit for customers with well-known, large, reliable customers (e.g. blue chip companies) who pay invoices slowly. Factoring is typically structured as a line of credit, so the business only borrows what it needs when it needs it.
- The business can access capital even if revenue hasn’t come in yet.
- The line of credit structure should be both economical and flexible.
- Lenders often require an audit of the accounts receivable against which the loan is being extended; a third-party needs to be hired for this service and will charge the business a fee.
- Lenders may not be willing to extend credit based on any account receivable; for example, payments owed by overseas clients or payments that are very overdue may not be acceptable backing for a lender to offer this kind of financing.
6. The Chisos Option: Convertible Income Share Agreement (“CISA”)
Chisos designed the CISA to provide flexibility without hamstringing the business or the entrepreneur. It combines the best elements of equity and institutional investing, while being responsive to the unique challenges of idea- and early-stage businesses. The CISA is an excellent fit for idea-stage and side-hustle founders, or founders looking to avoid the governance and growth obligations that come with other institutional capital.
Often even businesses with strong potential aren’t candidates for either VC or a traditional small business loan. Here are a few common reasons:
- The nature of their business (small total addressable market or slower growth projections).
- Lack of operating history.
- Lack of tangible assets for collateral.
- Lack of provable customer or revenue traction.
- Desire to maintain independence and avoid bringing on outside investors.
Unlike other providers of funding for startups, Chisos will fund businesses with any of these characteristics if the founder is impressive.
The CISA also solves the problem of access to capital.
What happens when an entrepreneur outside of CA or NY has 10 years of experience in her field and wants to start a company to solve a problem she deals with on a daily basis? Where will she get the funding if she has not been able to save enough money and doesn’t have a wealthy friends and family network? What if she needs $25K to build a prototype or MVP? What if the problem she is solving is “only” a $100 million problem? Any one of these hurdles could prevent this company from becoming a reality; collectively, they all but guarantee that this first-time founder will be excluded from entrepreneurship.
At Chisos, this is the core problem we’re looking to solve.
So how does a CISA work?
After a founder has completed our background and diligence process, we sign a Convertible Income Share Agreement, which consists of an equity component from the company (usually a SAFE) and an income share agreement with the founder. The investment is then distributed to the company for use in the business. The investment amounts usually range from $15K-50K.
As the founder works on building the business their repayment on the income share agreement will depend on their personal income. If the founder is not taking a salary from the business, then they owe $0 for that period of time. When the founder begins earning over $40K / year from any income source, they will start making payments on the income share agreement.
We view the CISA as a founder friendly hybrid instrument that sits somewhere between traditional venture capital and traditional debt. While we do require a certain amount of repayment via the income share agreement, the payments are flexible and scale with the founders income. Unlike traditional debt, the payments will never be overly burdensome if the founder should lose their income. Furthermore, there is no compounding interest that could cause the amount due to balloons to unmanageable levels. On the equity side, the CISA allows the founder to claw back up to 2/3rds of their equity, meaning the founder keeps more of their own company.
For more in-depth detail about the CISA’s structure, read Chisos Investment Terms Explained (Part 1).
Pros and Cons of CISA Funding
- The CISA doesn’t require collateral or business revenue since the investment is backed by the entrepreneur’s potential in the form of an income share agreement.
- Repayment is flexible, and Chisos doesn’t expect repayment if the entrepreneur’s earnings are below a certain income threshold.
- The term of the CISA is inherently flexible, giving the business more breathing room without being hampered by a fixed debt repayment.
- The CISA doesn’t require turning over a lot of equity in exchange for capital. It does include the option to convert to a small equity portion in the case of a larger fundraising event, though the equity % to which the CISA converts can be paid down if the entrepreneur so chooses.
- Chisos connects its entrepreneurs with a community of entrepreneurs, advisors, partners, and other resources to support business growth.
- The CISA can be a good fit for a much broader set of business models than straight debt or equity financing: it’s not just for SaaS companies or established high-margin service companies. It can be just the capital you need to buy that piece of equipment and get your business off the ground.
- A CISA requires the founder to accept a liability. If the business fails, the income share agreement still remains.
- Chisos isn’t currently offering financing larger than $50,000, though we expect our check size to grow as we prove out the model over the next year.
If you are starting a company or thinking about starting a company, Chisos wants to get you started. You can apply here.
What to keep in mind when considering funding options:
- Cost of Capital – what do you have to give up to obtain this investment?
- Flexibility – will your business be able to make consistent, scheduled payments?
- Control – does this investment affect your ability to run your business?
- Collateral/Guarantees – can investors seize assets, or do you have to pay them back personally if the company can’t repay them?
- Dilution - How much of your company will you have to give up for the investment?