There's No Such Thing as Free Lunch: How to Choose the Best Fundraising Option for Your New Business - Entrepreneur

There's No Such Thing as Free Lunch: How to Choose the Best Fundraising Option for Your New Business - Entrepreneur


There's No Such Thing as Free Lunch: How to Choose the Best Fundraising Option for Your New Business - Entrepreneur

Posted: 05 Oct 2020 07:00 AM PDT

10 min read

Opinions expressed by Entrepreneur contributors are their own.

One in four U.S. businesses are not able to obtain the funding they want, according to a survey by the National Small Business Association. Funding can be a maze for even the most experienced of entrepreneurs, who need to choose from multiple paths—each with its own risks. Ideally, you'll seek the solution that's best tailored to your business needs but also to your personal financial status.

Every source of funding comes with its own specific costs. There's cheap money, and then there's expensive money. Each option takes a different amount of time, requires giving away a different amount of equity, and has a varying level of risk involved. Be sure to do your research, assess your runway and money management skills honestly, and look at your competitors for a general sense of how to successfully raise funds in your industry.

Here are the most common funding routes for startups, plus tips and insights from seasoned investors:

RELATED: Sign Up For a Risk-Free Trial of Our On-demand Start Your Own Business Course 

Revenue from customer sales

The least expensive form of funding is customer sales. It's a form of revenue that you don't have to give back to anyone, and you don't lose a portion of control over your business in the process. Naturally, the hard part is generating sufficient revenue from sales on a regular enough basis to keep your operations ticking over. Still, it's a popular choice for many founders who see early positive traction and have sound financial projections. You could even opt to sell your product or service before it's officially launched in order to cover any expenses you incur in the construction phase.

Pros: Don't have to pay money back or give up equity

Cons: Difficult to generate enough money to sustain operations

Difficulty: Medium - leveraged through early profit

Business type: Subscription-based companies, pre-sale models

Personal debt

Business loans, credit cards, and lines of credit account for roughly three-quarters of financing for new businesses. In fact, it's unusual to meet an entrepreneur who hasn't gone into debt starting their company. Most investors want to see that you have skin in the game, meaning that you've personally contributed to your own business - whether that's opening a new credit card, borrowing against your retirement savings or against your home. 

Personal debt is high risk, high reward. The advantages are that you don't have to give up equity and you have total control of the funding as the money you borrow is attached to you personally. That is also the downside. If your business doesn't perform as you expect, you are the person who loses out. Compared to other funding options, where everyone loses out in a poor performance scenario, personal debt is a heavier burden to carry. You also won't be paid back for your personal investment as you can't raise money to cover that debt.

Ramin Behzadi, general partner at 7 Gate Ventures, notes that personal debt is typically used to maintain the status quo in a company and not for immediate short or mid-term growth—that comes from equity rounds.

If personal debt is the right funding path for you, check in advance that your credit score makes you eligible for the amounts you'll be requesting, and speak with a financial advisor before committing to new lines of credit. 

Pros: Don't give up equity and it shows investors you have skin in the game

Cons: Debt is tied to you personally and you can't raise money to cover the debt

Difficulty: Medium- leveraged through financial institutions but dependent on personal credit history

Business type: Various

RELATED: Sign Up For a Risk-Free Trial of Our On-demand Start Your Own Business Course 

Government and bank loans

Getting a government-backed loan is a good funding route but be aware that you'll have to jump through some hoops. These types of loans aren't particularly common and typically only apply to founders who have lots of assets or income. They also vary in amount and conditions, so you have to find information from your local economic agency to suss out if it's right for your startup. The U.S. Small Business Administration is useful for local-level government funding, as is the State and Territory Business Resource.

Gabe Zichermann, chief executive of Failosophy, suggests that if you want to secure funding via a bank loan, identify the bank that you have the closest relationship with and ideally where you have all your accounts, so that they can see your financial position. As well as offering a standard business loan, bank credit processors can also provide financing where you borrow money against your projected revenue streams. This option is preferable for startups that have recurring revenue but can't raise capital, for example, restaurants, retail stores, and wholesalers.

"Bank loans have the same benefits as personal debt in terms of keeping equity and control, but they often aren't viewed favorably by venture capitalists," Zichermann adds. If you have debt on your company books when approaching investors, they'll know that they aren't your primary payback group and may think that the money they give you would only be used to repay the bank.

To listen in to Gabe Zichermann and Ramin Behzadi discuss different options to find funding for your business sign up for a risk-free trial of the Start Your Own Business course and check out our live webinar on 10/07 at 3 pm ET.

Remember, any loan you receive will have interest rates, so you'll eventually pay back more than you took out. If you can't afford the extra amount, consider looking to friends and family for investment.

Pros: Keep equity and control, and can borrow against projected revenue streams

Cons: Hard to obtain, will be off-putting for venture capitalists

Difficulty: Low -leveraged through formal financial institutions but dependent on location and early traction

Business type: Startups with recurring revenue like restaurants, retail stores, and wholesalers

Friends and family

Raising money from people who know you is a relatively safe choice for founders. Most of the time, friends and family don't have to be sold on your business because they are investing in you, and simply want to help your company grow. They are also less likely to request ownership in your business. However, you may feel a stronger obligation to return their capital because of the relationship you share with them. This option is lower risk than others, but can be higher pressure.

To get started with investment from friends and family, make a list of the people who have money, would be most interested in your idea, and organize a time to pitch them your business. 

Pros: People invest in you personally, they don't have to be sold on your business

Cons: Greater obligation to pay people back

Difficulty: High - leveraged through personal network

Business type: Various

RELATED: Sign Up For a Risk-Free Trial of Our On-demand Start Your Own Business Course 

Angel investors

For startups, angel investors are often the ideal pathway to funding due to their more "human" touch and hands-off involvement in businesses. Angels tend to work on a case-by-case basis, so they can be more generous with their investments, plus more flexible about returns and equity. The catch is that angel investment is often the result of a serendipitous meeting, meaning it can take anything from days to years to find.

Nonetheless, there are ways you can boost your exposure to angels through networks like AngelList, as well as browse investor groups by location, university, and cultural representation. Zichermann recommends finding angels that have experience in your industry and overlap in your circles of interest. He also notes that if you need to continue developing your business while you search for investors, accelerator programs can expose you to lots of angels. But keep in mind that some programs will ask for equity in exchange, meaning you'll give up some control for the privilege of being seen. 

Pros: More flexible about returns and equity, less risky than business loans

Cons: Hard to find suitable angel investors

Difficulty: Medium - leveraged through personal and professional networks

Business type: Various

Crowdfunding

One of the newer options for fundraising, crowdfunding is best-suited to companies that have a physical product. Crowdfunding means you don't have to give up equity or accumulate debt, you can earn social proof as you collect investments, and you can build a pool of loyal advocates for your product from the get go.

The downside is that crowdfunding requires a lot of time and effort to launch the campaign itself, and once it's live, you have to continuously market it. You also have to deal with a number of investors at once, which can be taxing when you're busy running the company. For these reasons, crowdfunding is a longer route to funding and not one that high-growth startups typically use, but it has proven to be very effective for early-stage companies.

Pros: Don't have to give up equity or accumulate debt, earn social proof as you fundraise

Cons: Requires time and effort to launch campaign, have to work with multiple investors

Difficulty: High - leveraged through crowdfunding websites

Business type: Industries with physical products

Venture capitalists

The last and most expensive fundraising choice is to turn to venture capitalists (VCs). This is far more exclusive than the other options listed, and primarily applies to startups in technology, biotechnology, and clean technology spaces.

For perspective, 1,500 startups get funded by venture capitalists in the U.S. every year, compared to the 50,000 that get funded by angel investors. VCs can offer significant investment amounts and years of expertise—which is what makes them so appealing—but they also expect a lot more control over your business. Some VCs will even appoint their own board of directors within your company.

Related: Sign Up For a Risk-Free Trial of Our On-demand Start Your Own Business Course

Similar to angel investors, if you want to move forward with VC funding, you have to target firms that invest in your stage, industry, and ideally, have a shared connection with someone in your current network. Warm introductions are the best stepping stone for VC funding, and pitch competitions are valuable too. Behzadi suggests that a "warm introduction can be initiated from a person within your immediate connections/relationships or it could be cultivated or made with some proper efforts."

Likewise, Kevin Lavelle, senior vice president at Stand Together, says "you should look for a healthy balance of intellectual humility about the challenges of growth consumer investments, and intellectual curiosity about the space." 

Keep in mind that obtaining investment from VCs firms takes a long time, normally around one year in total.

Pros: Higher investment amounts, expert knowledge and connections

Cons: Expect greater control in your company, takes a long time to organize

Difficulty: Low - leveraged through events and network but dependent on industry and profit

Business type: Technology, biotechnology, and clean technology spaces

Before charging ahead with fundraising, think carefully about how different pathways can accelerate your company's vision, and what you might have to sacrifice in the process. Don't feel pressured to accept the first funding offer that comes your way when there could be a smarter route for you. The investment you accept will ultimately be a reflection of what you expect and want for your company.

The Paycheck Protection Program failed many Black-owned businesses - Vox.com

Posted: 05 Oct 2020 04:00 AM PDT

Danielle Parker, the CEO of Detroit Maid, says her business almost didn't make it this past spring.

Parker's company — which provides on-demand cleaning services — is among those that have been forced to completely alter their business model as a result of social distancing and public health guidelines during the pandemic. While Detroit Maid had previously focused 80 percent of its work on residential clients, the company has now shifted to operating predominantly with commercial ones.

Because of how much business slowed, Parker's staff was cut roughly in half earlier this year, and at one point, she didn't know if they'd stay open. "Businesses like mine, we had severe loss in staff, and we weren't sure if we were going to be able to make it through May," she told Vox.

There have been some sources of help, though. Roughly $35,000 in local grants from regional groups like TechTown and Invest Detroit have been major lifelines as Parker's business has adapted. "We went from not knowing if we were going to survive ... to pivoting pretty quickly," Parker says.

Federal support, however, was more challenging to access.

Parker is one of millions of business owners who applied to the Paycheck Protection Program (PPP) — a federal effort to boost small businesses established by the CARES Act — and she's also among those who was denied support with little explanation why.

"They said we didn't meet the criteria, and they didn't specify," she said, adding that PayPal — the company she applied through — was very responsive, even though the process itself was cumbersome. "When I got the result back, I was like, I wonder if I just didn't do it right — especially because there wasn't a specific reason."

Parker is far from the only business owner who's dealt with confusion related to the program, and her experience underscores just how much it failed many small businesses. PayPal did not immediately respond to a request for comment.

According to August survey results that the advocacy group Small Business Majority provided to Vox, the program appeared to reach a lower proportion of Black-owned businesses in particular. In that poll, 23 percent of Black business owners who did not receive PPP or Economic Injury Disaster Loans said their PPP applications were denied, compared to 9 percent of white business owners, 13 percent of Latino business owners, and 9 percent of Asian American business owners. And in Michigan overall, only 3 restaurants that received PPP loans of $150,000 or more self-identified as Black-owned, compared to 223 that self-identified as white-owned, according to the Detroit Free Press.

It's worth noting that the current demographic data that's available on PPP is incomplete because business owners were not required to submit this information when they applied, and roughly 75 percent of businesses did not do so. The Small Business Administration has also emphasized that the average loan size in the program was around $100,000, an indicator that it helped serve smaller businesses. Because minority-owned businesses are smaller, on average, this could mean that they benefited strongly from the program.

Independent survey results and analyses of the geographic distribution of PPP loans, meanwhile, have highlighted some disparities. An analysis by the New York Fed's Claire Kramer Mills and Jessica Battisto found that multiple counties with high amounts of Black business receipts including Wayne County, Michigan — where Detroit is located — and Prince George's County, Maryland, were among those to see lower rates of PPP allocation. In Wayne County, where more than a third of businesses are Black-owned, just 12.9 percent of businesses obtained loans, while 18.9 percent of businesses nationwide did per an updated review Kramer Mills and Battisto shared with Vox, which includes August data released by SBA.

These gaps were driven by a couple of factors including systemic inequities in banking, a chaotic application process that overwhelmed many small businesses, and restrictive terms on the loans that put off some business owners from pursuing them at all. The distribution of PPP was among the factors the New York Fed researchers examined in trying to understand why an estimated 41 percent of Black-owned small businesses became inactive during the early months of the pandemic, more than double the 17 percent of white-owned businesses that did.

"Access to capital and money has always been an issue with respect to Black enterprise, that's nothing new," says Rev. Horace Sheffield, the head of the Detroit Association of Black Organizations. "The pandemic has exposed or exacerbated that disparity."

Disparities in banking were apparent in PPP, too

The role that big banks had in the program — particularly early on — posed a huge obstacle for many small businesses especially in the first wave of funding. Rather than applying to the Small Business Administration directly, businesses were required to pursue the PPP through a third-party lender, including a bank, credit union, or fintech company like PayPal. That lender would then play a role in approving the application for a business to move forward.

According to the SBA data released in August, lenders with assets of $10 billion or more were responsible for 47 percent of the loans that were made, a sign that larger lenders — including banks — had a strong presence in the program. The top three lenders in the program, per the agency, were JPMorgan Chase, Bank of America, and PNC, comprising just over 10 percent of loans. Lawmakers worked to ameliorate access issues in the second wave of funding, which contained a $60 billion set-aside for community development financial institutions and other entities that work with underbanked communities, including rural and minority-owned businesses.

"The big challenge is finding a lender. The banks have been inundated," says Sheffield, who notes that this is where multiple businesses got held up. "Some of their applications got caught up in the queue, didn't necessarily go through, and the bank had their own vetting process."

As PPP got underway this past spring, many large banks declined to take applications from anyone who wasn't already a customer. Bank of America, Chase, and TD Bank were just a few that limited the applications they would accept to customers who had prior accounts or lines of credit. And while they were likely doing this for volume control and their own review purposes, that meant that business owners who did not have an established relationship with these institutions would effectively be barred from pursuing PPP through them.

"TD Bank's existing customers with a business deposit account or loan were eligible to apply for the PPP through the bank," a TD Bank spokesperson said. "To support our PPP lending process, TD digitized the SBA's application and strove to provide equal access to the funds by only accepting applications through our digital portal and by keeping the application open throughout June and July." "In July, we expanded who could apply for a PPP loan through us. We opened it to people who only have a business credit card with us, or who told us they own a business but only have a personal checking account with us," a Chase spokesperson told Vox. Bank of America did not immediately respond to a request for comment.

Although businesses were able to apply for the loans through community development financial institutions, community banks, and tech companies, as well as other outlets, the restrictions imposed by larger banks cut off many from one key source for the program.

"Initially, PPP really fortified banking pipes to disburse funds in communities," Kramer Mills told Vox.

The program's reliance on banking is one that disproportionately hurt Black-owned businesses, the New York Fed report found. According to that report, "1 in 4 Black-owned employer firms [had] a recent borrowing relationship with a bank" prior to the pandemic, while 1 in 10 Black-owned non-employer firms did.

Because an overwhelming majority of Black-owned businesses are non-employer firms — or companies that don't have paid employees — that meant a large proportion of businesses were starting as new customers at these banks and were blocked from even pursuing PPP there. As a point of comparison, one in four white non-employer firms had set up a recent banking relationship.

The New York Fed report emphasizes that this disparity in banking ties isn't the result of Black-owned firms applying for financing at lower rates, but a product of their applications getting rejected by banks more frequently than those of white-owned firms in the past. According to a report from the Guardian, Black-owned businesses are twice as likely to be turned away for bank loans as white-owned businesses due to discriminatory practices.

PPP, because it relied in some ways on businesses' established banking relationships, amplified these gaps.

"There is a structural flaw in this program. It uses banks as middlemen. Any time you create a big program and give banks the ability to choose which customers it prioritizes, you're going to have disparities," Mehrsa Baradaran, a law professor at the University of California Irvine, told NBC News. "Credit disparities are where past injustices lead to present disparities."

A study from the National Community Reinvestment Coalition that examined PPP loan applications captured specific examples of these biases. In some instances, it found that Black business owners with a comparable financial profile as white ones were less likely to be told that they met the qualifications needed for a loan.

Small businesses that had established relationships with these banks didn't necessarily fare better, either. A lawsuit from a group of California businesses alleges that Bank of America, US Bank, JPMorgan Chase, and Wells Fargo gave preferential treatment to companies that applied for larger loans — and approved them first — because it meant the banks would receive higher fees. In a CNN report, Bank of America and US Bank denied the allegations, while JPMorgan Chase denied the allegations on its website and Wells Fargo declined to comment.

Parker notes that others in the entrepreneurial community had advised her to apply for the program through PayPal and said she had heard "horror stories" from other business owners about their experience with how banks handled these applications. Other business owners, including those whose applications were approved by banks, similarly encountered an arduous and complicated process.

"The communication was so poor with the PPP, it alarmed me," said chef Omar Mitchell, the owner of a Detroit fine-dining restaurant called Table No. 2.

Flaws in the program made some businesses wary of PPP

The different reactions to PPP in its first and second waves also highlight why some businesses may have opted out. When the first wave of $349 billion in funding was made available in April, that money ran out in less than two weeks. But after Congress approved another round of $310 billion, demand for the program appeared to slow. As of August 8, the deadline for applying for a loan, tens of billions still hadn't been allocated.

Fewer businesses may have either applied for or accepted the loan in the second wave because they had concerns about how the money could be spent. According to an SBA Inspector General report released in May, some of the initial PPP rules could have led businesses to take on more debt.

PPP was first established, after all, with a specific goal: to help companies keep workers on the payroll even as their revenue took hits during the pandemic.

That goal, while an important one, failed to account for the broader challenges that many small businesses faced during the pandemic. A significant proportion of the loans — 75 percent — for example, initially had to be used on payroll costs in order for the loans to be forgiven. If a business didn't comply with the limitations, it would ultimately have to pay the loan back. (Congress has since loosened those restrictions so only 60 percent of the funds have to be dedicated to payroll, but the earlier rules deterred many small business owners.)

"It didn't suit what we were doing," says Janet Webster Jones, the owner of Source Booksellers in Detroit. "I disliked the idea it was a grant until you didn't spend it right."

In the end, a number of small businesses were worried that obtaining a loan would simply mean more debt if they weren't able to meet the forgiveness requirements. "To take on more debt, it was very hard for them to say, 'I'm going to take a chance on this,'" said Khalil Rahal, the assistant county executive in Wayne County's Office of Economic Development.

The restrictive design of the program, too, could have had an outsize impact on Black-owned businesses, which went into the recent economic crisis in weaker financial positions, on average, compared to white-owned businesses, according to the New York Fed report. Because of this dynamic, fewer Black-owned businesses may have pursued the loans due to concerns about qualifying for them and the worry of bringing on more debt.

During the pandemic, Wayne County, as well as other regional organizations such as TechTown Detroit, also offered thousands of small businesses grants that didn't have to be repaid, a move that helped many address some financial shortfalls.

Outstanding questions about the utility of the PPP, coupled with the surge in local funds, may have led to more businesses in the region declining to participate in it.

If there's another wave of funding, it should come in the form of grants

Business owners and experts emphasize that they sorely need another wave of PPP, but they argue that any new funds should explicitly be grants, not loans.

"Just give people the money," says Webster Jones.

Currently, small-business owners have to apply for loan forgiveness after receiving PPP support — and they'll only get 100 percent of it if they meet the program's requirements. This means they must use a majority of the funds they're given on payroll, for example.

If the funds were a grant, they'd be much more accessible, especially as the challenges businesses are facing during the pandemic keep changing. For some businesses, many of their primary costs may be spent on operational needs, including personal protective equipment.

"I think PPP ought not to be a loan at all," Sheffield emphasized. "I can't count how many businesses I know are closed."

Businesses also stress that funds should be set aside for companies that have seen explicit revenue losses, as well as those that are smaller businesses — which could be measured by size and revenue — to prevent larger ones from taking up a disproportionate amount of the aid. Prioritizing funding dedicated to Black-owned businesses, too, could help guarantee a more equitable distribution of support.

"It hurts to go through what I'm going through," says Mitchell.


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