Reality check: actual capital sources for start-ups and how to better position your firm for funding
Entrepreneurs typically ask us two questions about funding a new business. First, where do start-ups go to get funding to finance growth? And second, what can they do to effectively prepare for the “ask”?
News and industry magazines bombard us with stories about small companies raising money right and left, making funding look like a done deal. However, the reality for many start-ups—particularly non-tech start-ups—is quite different.
Venture capital matters much less than you think
In his great book Illusions of Entrepreneurship, Scott Shane illustrates how low the overall share of VC money actually is as a funding source for start-ups. VCs invest in about 3,000 companies each year, of which only about 500 are start-ups. This means that VC funds financed less than 0.03 percent of all new businesses last year—or about 1 in 4,000. Also, to make the VC-funding fight even more challenging, VC investors typically concentrate in a handful of industries, typically pumping $3M-$5M into companies already generating at least $100K per month in revenue.
The most common source of new business capital? The founder’s own savings
Many entrepreneurs start businesses with their own money, either through savings or personal bank loans. And while you may think family capital plays a big role, it actually doesn’t: family and friends account for less than 10 percent of funding. Taking this at face value, if a founder eventually wants funding, he or she may be wise to focus on developing a sound business—as small as it might be—while optimizing personal finances. This can help ensure the founder has a strong value proposition in spite of limited resources, which helps generate factual evidence of viability. Approaches like Lean Startup and others focus on this critical goal.
Informal investors are more important than either venture capitalists or friends and family.
“Real” informal investors don’t look like the business angels seen in magazines. Less than 15 percent are accredited. They are typically less wealthy and less experienced. They also make smaller investments and expect lower returns. In some cases, people founders meet along the way while building their new business may become investors, either as equity partners or by getting involved in other ways (financial backers via convertible notes, for example). This means that networking and building relationships might be more valuable in the long run in terms of securing financing.
New businesses don’t borrow; founders do.
Many entrepreneurs borrow personally to fund their new businesses. When doing so, excitement, lack of planning, and the difficulty of gauging time or resources required to get off the ground means owners overextend. Companies fail because of poor cash flow management. Sometimes this simple fact materializes too late for founders to take corrective action.
Because they are frequently asked by banks or private investors to personally guarantee company funding, founders benefit from developing strong personal finance and debt management skills before they embark on the task of securing funding. In early stages, the owner’s frugality, budgeting, and good credit/financial management can make the difference, putting the firm in a good position to secure a bank loan, credit card or private investment.
The core of any funding effort? Proof of concept, evidence of growth, strong support and clear messaging.
If you’re looking for funding, ask yourself: What problem am I solving? How will this business make money? How can I build a business with a sustainable competitive advantage? Why am I the best one to do it? What’s my model and go-to-market plan? What have I done to prove this business is real? Who is working with me to make it happen?
These questions are central to any funding decision. Even so, don’t get caught up in the belief that money will solve all problems. Focus on crafting a valuable business. Strong, differentiated and well-articulated businesses find it easier to get funded. By crafting a sound value proposition, building a viable business, and assembling a solid team of advisors, you create the kind of trust and gravitas that increases your chance of success when presenting a case for obtaining financing.