Startup Financing: How It Works and How to Get It

This post was originally published on October 19, 2022, and has been updated for relevancy on June 4, 2024.

So far, 2024 has been a year of cautious investment. There has been a 20% decline from the previous year, with venture funding totaling $66 billion in the first quarter. 

Although there are broader economic uncertainties up ahead, specific sectors such as AI and healthcare continue to attract more funding because of their promising growth potential.

The current investment landscape is showing selectiveness, suggesting that investors are focusing more on younger companies that present promising opportunities, particularly in high-tech and sustainable industries.

DealRoom works with firms looking for startup funding and the companies that fund them.

In this article, we look at how these transactions tend to play out and the best ways to achieve startup funding.

What is startup financing, and why is it important?

Startup financing is the money that startup entrepreneurs invest in their businesses. Most commonly, this funding is used for working capital, technology, hiring, and marketing.

However, depending on the industry the company operates in, it could also be used for capital investments such as real estate, furniture and fit-outs, tools, and equipment.

When companies develop a minimum viable product, look to build a niche in the market, and grow into that niche, they burn through cash (hence the expression ‘burn rate’).

The more talented the team, the more complex the technology, and the more ambitious the market, the greater the burn rate will be.

This is where startup financing comes in.

It enables companies to pass through the pre-revenue period and the period which follows where revenue isn’t enough to sustain the high costs required to grow the company.

This money typically helps startups to hire more engineers, get help from various product development services, expand sales, expand their marketing team or involve a marketing agency to help.

Of course to get this money you have to pass through the startup due diligence process.

Statistics underline this importance quite clearly. CB Insights data show that 38% of startups failed because of a lack of cash or failure to obtain startup financing.

How big is the startup financing market

In 2023, the global startup financing market faced a downturn, with total venture capital funding reaching $285 billion. This figure shows a 38% decrease from the $462 billion invested in 2022, which is the lowest level of funding since 2018.

In the U.S. alone, venture funding for startups was $138 billion. As mentioned above, this figure reflects a broader economic slowdown and a more selective stance from investors globally. The drop in funding affected all stages of startup investment, from seed rounds, which was reduced by more than 30%, to late-stage funding.

Although it has been a challenging environment for this year, certain sectors still and will continue to attract significant investment, such as AI, with nearly $50 billion of investments in 2023. Other sectors like fintech and healthcare are also among these sectors that have become popular.

Since startups had to be extra careful with their spending due to the decrease in available funding, startup businesses had to focus on making sure their business operations were financially sustainable.

Business owners looking to be funded this year need to be well-prepared for the tighter funding climate. It’s key to prepare and present robust business plans and clear strategies for growth and profitability for a kickstarter. 

Despite the challenging landscape, there are still opportunities for well-prepared and resilient startups to secure the business financing they need.

What are the options for startup financing?

Getting the right funding for a startup company can feel like navigating a minefield. High levels of funding bring high expectations from investors for performance and returns. While significant funding can provide a startup with numerous advantages, it also comes with its own set of challenges that need careful management.

Here are startup financing options to choose from, each with its own set of advantages and considerations.

Friends and family

Loans or investments from friends and family can come with fewer formalities and more flexibility when it comes to repayment. That makes it most viable for early-stage startups who are in the concept or prototype stage, who need smaller capital to get the business started, and ventures where the business model relies heavily on the trust and credibility of the founders.

Unless you’ve exhausted this option, many more sophisticated investors will wonder why they should extend you funds when your nearest and dearest won’t. In essence, a founder’s new business idea should be attractive enough to make it an investment opportunity for those in their inner circle.

Aside from the financial assistance for the business needs, friends and family can offer the moral support a startup would greatly need in the early process of launching a business. They can also open a network of potential investors, customers, and partners.

However, it’s important not to overlook the fact that this type of startup funding involves personal relationships, which can lead to tension and conflict. Expect that the amount raised from this funding option will be smaller than what can be obtained from angel investors or venture capitalists.

Friends and family may be limited in terms of their level of business acumen, mentorship, and networking, unlike professional investors, so propelling the business forward can be challenging. This funding can be a great initial boost for the startup and a stepping stone to more substantial future investments.

Credit cards

Personal or business credit cards are also another way to get funding without formalities and procedures. Many startups opt for this route, as it is easy and seamless, especially if they are buying equipment or materials. Just swipe your credit card and you are good to go.

However, this is extremely high-risk. The interest rate of credit cards are ridiculously high, and if you are not able to pay within your next billing cycle, interest payments could compound, leading to financial ruin. 

SBA microloans

The Small Business Administration (SBA) offers ‘microloans’ of up to $50,000 for small local businesses and entrepreneurs with limited funding options for the acquisition of materials, supplies, equipment, or for paying working capital. 

In 2021, 4,510 of these loans were extended. Be warned, however: The SBA only extends these small business loans to companies with cash flows.

The U.S. Small Business Administration (SBA) backs these loans, which are issued through intermediary lenders, typically community-based organizations with experience in lending and technical assistance.

SBA Microloan intermediaries also offer developmental assistance for new entrepreneurs who need guidance in the early-stage of their business, such as business training and planning resources. 

This startup loan option often has more favorable interest rates, and when successfully repaid, SBA loans can help a business build a good credit history.

Bank loans

Startups with steady revenue, those with assets for collateral, and startups in low-risks industries are better positioned to meet the repayment requirements of a bank loan. This type of funding is more viable for later-stage startups who have a well-documented business plan and financial forecasts. 

Bank loans can provide larger amounts of capital with lower interest rates for startups who need it for manufacturing, inventory, or scaling operations. At the same time, it can enhance the startup’s credibility in the business community since successfully managing a bank loan also helps build relationships with financial institutions.

There are several forms of bank loans ranging from personal loans to business term loans and business lines of credit. Of these, a personal loan is the most viable for startups, with interest rates still competitive enough to make them viable (although moving fast on this one is a good idea…).

For startups that want to pursue this funding option, it’s best to consider that banks have strict lending criteria, which can include detailed financial records, positive cash flows, and a good credit score. Unlike equity financing, bank loans must be repaid within a fixed period of time.

Crowdfunding

Crowdfunding is another great source of funds for startups in the early to growth-stages or product-ready startups, which involves the collective financial support of a large number of individuals, typically via the internet. 

This method allows startups to build a community of supporters and gauge consumer interest in their product or service, which can also increase their exposure and visibility to investors or media outlets.

There are a plethora of crowdfunding platforms for startup founders to choose from, enabling entrepreneurs to pitch their concept to a crowd. This is a relatively low risk way of establishing whether the concept has legs before investing too much time and money on the concept. Just be careful about the exposure if you’re looking to protect some aspect of your business model.

Unlike venture capital firms, crowdfunding platforms don't require the owner to give up equity, although equity crowdfunding options do exist, and more crowdfunding models such as donation-based and rewards-based crowdfunding.

More than a fundraising platform, crowdfunding is also a great way to build a startup’s brand, validate product ideas in the real market, and establish a solid customer base. However, it requires intense effort during the campaign and startups need to fulfill the responsibilities afterwards.

Private debt

Startup funding from private debt involves borrowing money from private lenders rather than banks or public financial institutions. Unlike traditional bank loans, private debts offer more flexible terms and fewer regulatory hurdles, so it can be secured faster. Through private debt financing, startups can preserve their equity. 

Private debt is particularly viable for growth-stage startups that have moved beyond the seed-stage and have stable revenue streams. These companies show great eligibility since they can handle their regular interest payments and repay the principal eventually as per agreement.

The sheer scale of funds available at private debt companies now makes them more open to startup investments than ever. The business plan will need to be near perfect, and you’ll need to show a path to steady returns within 2-3 years, but private debt companies are sitting on so much dry power that now is a one-off time to pitch a business idea to them.

Bootstrapping

Startups who find it hard to secure funding due to lack of history or proof of concept may also consider startup funding from personal funds, also known as bootstrapping. 

However, know that the amount of money available through personal financing is limited to what the entrepreneur can afford to lose. That’s why it’s most viable to startups with low initial capital requirements.

This self-funding approach that uses personal resources, such as personal savings or home equity loans to fund business activities, allows entrepreneurs to maintain full control over their business operations.

If you’re an entrepreneur who has substantial personal resources, this financing option is a great consideration. Just make sure it doesn’t jeopardize your financial stability. 

Angel investors

Angel investors are typically affluent individuals who provide capital for startups, often in exchange for ownership equity or convertible debt. Their core advantages include providing essential early-stage financial support, more flexible repayment terms, and they often bring valuable industry experience, mentorship, and networks, too.

These investors invest their own money and might take a more personal interest in helping a startup succeed. Startups in the seed and early stages, and those that have started generating early revenues are the most suitable ones and attractive to angel investors. 

For young startups navigating initial business challenges, angel investors are one of the best go-to people for funding. Be prepared for thorough due diligence processes and focus on building relationships with potential investors whose experience and network can add value beyond their monetary investment.

Venture capital

Venture capitalists can invest millions of dollars to drive growth in a startup, more than what individual angel investors typically provide.  They often engage in long-term partnerships with their portfolio companies through multiple rounds of financing. 

The catch is that venture capitalists typically require substantial equity stake in the companies they invest in. They are also very selective, funding only a small percentage of startups that pitch to them. 

Startups using VC funding might be under pressure since VCs look for a return on their investment typically within 5 to 7 years. The exit valuation matters to them because it determines their return on investment.

Startups that are ready to scale their operations, are moving at a rapid pace, and needing substantial capital to seize short-term market opportunities are the best candidates for venture capital.

Startup incubator

Startup incubators don’t necessarily directly offer funding in the traditional sense of loans or equity investments. They offer startups access to essential resources including office space, administrative support, and sometimes even legal and management guidance.

Many incubators have connections with venture capitalists and angel investors. They regularly facilitate introductions and pitching events, which are beneficial for very early stage startups looking for networking opportunities that can boost them during the ideation or development phase of the business. 

However, getting into a startup incubator can be highly competitive and will require a significant time commitment. There happens to be many more applicants than available spots. 

Incubators help startups grow through set programs, which may include training and mentoships, perfect for entrepreneurs seeking guidance and reduced operating costs.

Government grants and subsidies

Another financing option for startups are government grants and subsidies, including specific programs like small business grants. These are non-dilutive types of funding, which means startups can maintain control over their business. 

Receiving a government grant or subsidy can imply that a startup’s business is credible because it validates their potential and goals, making it easy for them to attract other types of funding. This funding option is well-suited for early to mid-stage startups that need help in scaling initial production. 

Sometimes, too, this type of funding is tied to specific projects or objectives like technological innovation, environmental sustainability, or social impact, which are valuable for some nonprofit organizations.

Startups looking for government grants and subsidies must meet a certain set of criteria and must be able to navigate through the complex, time-consuming application process with no guarantee of success.

Microlending and peer-to-peer lending

Microlending and Peer-to-peer (P2P) lending are viable financing options for small or early-stage startups that may not qualify for traditional bank loans due to their lack of credit history. Both financing options offer flexible terms and an easy application process unlike that of traditional banks.

However, these alternative financing options are quite different in terms of operations, sources of financing, and their target borrowers.

On one hand, microfunding involves smaller loan amounts often funded by microfinance institutions, NGOs, or banks typically aimed at helping borrowers start small businesses associated with social goals.

On the other hand, P2P lending is typically facilitated by online platforms that connect individual lenders to individual borrowers. These loans can offer more substantial amounts than microlending, which can be used for a broader range of purposes, business financing is only one of those. However, that still depends on the creditworthiness of the borrower. 

Still, both microlending and P2P offer a more accessible and flexible route to funding for startups.

Private equity

Funding from private equity is generally more common in the later stages of a startup’s growth. Just like venture capital and angel investors, private equity also brings in significant capital and a wealth of management expertise and industry connections. However, they offer a longer investment horizon than other options.

PE firms often provide a stable financial backing to help the company in pursuing long-term strategies. They focus on startups that are past the risky early stages of the business cycle and have established business models, and consistent revenue. 

They are mainly aimed towards making strategic improvements to make the company attractive for a sale and help them reach a new level of growth. Startups must know that PE firms often seek major ownership and management control to protect their investment. 

For companies looking for PE funding, it would be best that you align with the PE’s main goal to steer the company towards the desired outcomes and ensure a mutually beneficial partnership with them

How to secure financing for a startup

Securing financing is more than just obtaining funds. It means strategically positioning the business for sustainable growth, stability, and competitive advantage in the marketplace. Although it’s often one of the most challenging aspects of starting a business, it’s also a crucial one. 

Carefully preparing and effectively utilizing available resources can increase your chances of attracting the funds needed to grow your startup. Below are the crucial steps to secure financing for your business.

Determine how much startup financing is required

The only answer to ‘how much startup financing is required’ can be found through a well structured business plan accompanied by a month-by-month financial model outlining the funding sources and uses of funds.

Investors like to see a company that’s going to need cash (as that means higher returns) and to see where it’s going to be used and how it will be repaid.

Here are some precedents, which give some idea about the relatively small scale of startup financing that some well-known companies received early on in their journeys.

‍

Create a business plan

Showing your investors that you have a detailed understanding of your market, your business model, and your strategy for success are the first critical steps that will help you secure startup financing. This is the core of a comprehensive business plan. To attract investors, the business plan must have these crucial elements: 

1. Executive summary – highlights the key aspects of your business (business name, location, the product or service you offer, and the purpose of the business plan) and why it would be successful.
2. Company description – state in detail the problem that the business is trying to solve and what makes it stand out from competition. 
3. Market analysis – this shows how your business fits into the current market landscape and your strategy for capturing market share. 
4. Organization and management – provide a detailed business structure that shows the management team and their qualifications, and the legal structure and ownership of the business.
5. Service or product line – describe your product or service, how the customers can benefit from it, its lifecycle, and any intellectual property.
6. Marketing and sales strategy – explaining how you plan to attract and retain customers, where you market your product, the pricing and sales process.
7. Funding request - specify the amount of funding you’re seeking, how you will use it, and terms on how you’ll pay it back.
8. Financial projections – include statements about your financial predictions in the next three to five years.
9. Appendix – this is the part where any additional documents that support your business plan are attached, such as legal documents or product photos.
10. Review and revise – the market changes and your business will evolve for sure, so always keep your business plan up to date.

Preparing Key Documents

Wherever a company is in its journey, all of its interactions with investors, banks, or even family and friends, will need a professional set of documents.

These could include one-page teasers, pitch decks, business plans, extended business plans, financial models, cap tables, and more.

The stack of documents adds up quickly. Talk to DealRoom about how we can help you through this journey with our award-winning project management platform.

Choose the type of startup financing

When choosing a type of financing for your startup, it’s important to consider which stage you’re on and determine your immediate needs and long-term business goals.

For instance, in the seed stage, funding requirements are quite modest since it’s typically used for proving a concept or initial product development. In this budding stage of a startup, founders must consider low risk fundings and preserve their equity.  Their best options would be bootstrapping the business, or asking for family and friends to avoid heavy debts and interest payments.marami

In the early stage, startups may need to scale operations or expand market reach, which will need larger sums of capital. Startups can seek funding from venture capitalists or angel investors who can also provide valuable mentorship and network opportunities too. Only, they need to evaluate their creditworthiness.

In the growth stage, capital is needed for scaling operations widely or entering new markets. If the startup has steady revenue streams, larger venture capital rounds or debt financing through banks are common. It’s important to consider your startup position and competition for this stage.

In the later stages, startups might be looking to exit to grow more. They might be looking towards an IPO, acquisition, or other exit strategies. Other financing options, such as private equity can come into play to prepare the company in the final growth phases before the exit.

Each stage demands different considerations. The key is for startups to evaluate the cost of each type of financing, keeping in mind their control and independence, and the regulatory and compliance requirements involved in the entire process.

Map out a plan to pay it back

It's important to ensure you have a plan to pay back any borrowed money when securing startup financing. Understanding the terms, such as the interest rate, repayment schedule, and any penalties for late payments, before securing any form of financing is paramount.

Include your repayment obligations in your business’s budget from the beginning to meet your repayment deadlines with ease. It also helps to regularly forecast cash flows to ensure you have enough to cover your repayment obligations.

In case of unexpected shortfalls in cash flow, set up a contingency fund so that it doesn’t affect your ability to repay debt. Don’t forget to regularly review your business’ financial performance and stay on top of your financial health. 

Communicate and build strong relationships with your creditors so that if you anticipate any challenges in meeting your repayment schedule, you can inform your creditors or investors early. 

You can also opt to refinance your loan if you find better terms with lower interest rates, which can reduce your repayment burden and free up cash flow. The goal is to meet your repayment obligations while still growing your business.

Challenges in startup financing

The startup landscape is highly competitive. There’s only a limited pool of available funding so startups must stand out in a crowded market to secure funds. Many startups lack collateral that can give them a leverage advantage to secure funds, which is also a challenge.

Sometimes too, startups don’t have the creditworthiness or financial history required to attract bigger funding and better investors. Not only that, but it’s also difficult to choose the most suitable funding option in what stage.

When lucky, startups that have secured funding will have to consider maintaining equity and control, which involves a lot more negotiations, regulatory and legal hurdles, and costlier challenges. 

Startups will need to brace themselves for the unpredictable economic and market conditions we have today, which can impact the availability and terms of funding, and affect their current business operations as well.

Securing the funds alone is challenging, how much more meeting investor expectations right after? This is probably the most challenging part of startup financing since startups are required to show a return on investment to investors. 

However, with careful planning, a strong understanding of the financing landscape, and strategic decision-making, it’s less difficult to overcome these challenges.

What’s the best financing option for Startups 

When choosing the best financing option for startups, it always depends on the stage and specific needs of the business. That also includes the industry, stage of development, financial stability, and long-term goals. Some of the most commonly recommended options include venture capital, angel investors, and crowdfunding.

VCs are often the most prominent choice for startups that are scaling rapidly, and have clear, high-growth potential. They’re most suitable for companies striving to become major players in industries like tech or biotechnology, which are two of the most popular sectors today.

Angel investors are the best for startups in their early stages of growth since they offer a more accessible form of equity financing. However, they require a portion of equity and they can influence decision-making

For startups that need to validate their products to a broad audience, crowdfunding is the best option, allowing you to hit three birds with one stone. It’s becoming a more popular option of funding now since it allows businesses to raise funds while simultaneously marketing their product and boosting their brand presence. 

Understand that each financing option serves different purposes and comes with its unique sets of benefits and downsides. Your specific needs and goals should dictate what’s best for you.

Preparation is key

Wherever a company is in its journey, all of its interactions with investors, banks, or even family and friends, will need a professional set of documents.

These could include one-page teasers, pitch decks, business plans, extended business plans, financial models, cap tables, and more.

The stack of documents adds up quickly. Talk to DealRoom about how we can help you through this journey with our award-winning project management platform.