For decades, entrepreneurs have followed a traditional stair-step of financing methods to vault their companies through successive stages of growth. Starting with personal savings, they would often then raise seed money from personal contacts, move on to banks, angel investors and/or venture capitalists. Eventually, a successful start up would offer shares to investors and become a publicly traded company.
But openings onto that well-trodden path are narrowing. Banks and venture firms are less liberal with funds since the financial crisis of 2008. Initial public offerings of shares are also harder to float.
However, new fundraising mechanisms have been springing up. The DIY culture of social media has produced hybrid online platforms with elements of contributing, investing and marketing. Through Kickstarter and Indiegogo, business innovators rely on the kindness of web strangers to back their projects. And Congress has just approved another “crowdfunding’’ model, through the JOBS Act that would permit private online sales of company shares.
While supporters celebrate the new opportunities, some experts see dangers of investor fraud, as well as possible pitfalls for unwary start ups.
Click ahead to see what the various forms of funding are, and what entrepreneurs have used to build successful companies.
By Bernadette Tansey, Special to CNBC.com
Posted 2 May 2012
Entrepreneurs can “fund’’ the first stage of their business by using their own unpaid labor and resources to create value. Rather than contributing cash, they might write code for a new iPhone app or build a workshop in their garage.
They did it: Facebook is launched from a Harvard dorm room by Mark Zuckerberg, Dustin Moskovitz, Chris Hughes and Eduardo Saverin.
Advantages: By investing your own resources without outside funding, you develop an idea on your own time. You control the decisions and any intellectual property you create.
Cautions: If you have partners, make sure you get full credit for your contributions. Draw up a written “deal memo’’ on the ownership percentage for each partner. A truly original idea conceived in an instant can be worth hours of computer programming, says M.J. Bogatin, an Oakland, Calif., attorney who has advised Bay-area start ups.
The initial funding for a fledgling private business has often come from its founders. A budding entrepreneur might draw on a personal savings account to finance an indie film, or plunk down a credit card to pay for the machine tools needed to build a sample product or prototype.
They did it: Convenience store clerk Kevin Smith sold part of his comic book collection and charged as much as he could on his credit cards to finance his 1994 film, “Clerks’’ at the New Jersey store where he worked, according to IMDb.com. He raised $27,000, including contributions from friends and family. The film grossed more than $3 million.
Advantages: You retain control of your project. You’re also proving to future funders that you’re willing to put your own money at risk to launch your business.
Cautions: If you’re not already keeping careful books, start now. Unequal financial contributions or sweat equity among the partners may change their views on the ownership shares they deserve. Clear agreements can avoid multimillion-dollar lawsuits years later if the enterprise takes off. Bogatin tells clients to watch “The Social Network,’’ a fictionalized film account of the legal battles among early claimants to big stakes in Facebook.
When a young enterprise produces promising early results, the founders’ friends and family have often been the first outsiders who chip in money to help it grow. The entrepreneurs’ parents may give them a loan, or their college friends may buy small ownership stakes.
They did it: Young screenwriter Edward Burns shot most scenes for his early film "The Brothers McMullen" at his mother’s house on Long Island, where his friends were part of the cast, according to IMDb.com. The movie won the Sundance film festival's Grand Jury Prize, and was sold to 20th Century Fox's Searchlight Pictures. It was named the most profitable film released in 1995.
Advantages: Friends and family often help because they want to support you, not for an expected profit, says Arkansas Securities Commissioner Heath Abshure, a former attorney for early stage businesses.
Cautions: It’s best to have a written agreement. The uncle you thought was giving you a no-interest loan may think he’s now part-owner of your company, with voting rights.
Innovative businesses can now use social media sites such as Kickstarter and Indiegogo to appeal for financial support through “crowdfunding’‘ campaigns. Entrepreneurs attract backers by posting their imaginative plans, and often, by promising perks to those who pitch in some money. Those perks range from product samples to an invitation to join a company-sponsored activity.
They did it: Scott Wilson couldn’t get conventional watch manufacturers interested in the designs for his LunaTik kits to convert iPod Nano’s for use as wrist watches. He campaigned on Kickstarter to raise $15K in 30 days; but the pledges reached nearly $1 million, LunaTik's website says.
Advantages: Some start ups have raised significant sums made up mainly of small pledges from large groups of well-wishers. Your online project plan may also attract press coverage and new collaborators.
Cautions: Your windfall may be taxable as personal income, or as profits of your business. The Internal Revenue Service has not yet published specific guidance.
Banks and credit unions make loans to small businesses that need cash to fund their next growth spurt. If the small company is already profitable, lenders may advance the cash for business expansions, such as new store locations, that will increase profits.
They did it: Retired engineer Oscar Wong was producing 6,500 barrels of beer a year at his craft brewery, Highland Brewing Company in Asheville, N.C. With the help of $1.9 million in loans from two financial institutions, Avista Business Development Corporation and Wong's bank, Banking Branch & Trust Co., he recently built a state-of-the-art production facility that can make 30,000 barrels a year. Highland's lagers, ales, stouts and other beers are now sold in seven southeastern U.S. states.
Advantages: You may qualify for loan guarantees or lower interest rates through programs of the Small Business Administration or local economic development agencies. The bank takes no ownership share of your company.
Cautions: Banks see small business loans as risky investments. To get a loan on favorable terms, you need a solid business plan, extensive documentation of your creditworthiness, and possibly assets to post as collateral, according to the National Federation of Independent Business. To help entrepreneurs navigate the loan process, web-based outfits such as Multifunding.com are now offering to connect you with lenders, guide your choice among banks or facilitate your loan applications.
Web commerce and social media have given rise to Internet companies that offer small businesses an alternative to bank loans. These web outfits spotted a large potential customer base among small enterprises that have been turned down for bank loans in a tight credit market.
Some small business borrowers can get loans from alternative lenders even if they don’t meet bank criteria. While banks look at the personal credit score of the business owner, the New York-based company On Deck considers other factors such as cash flow and timely bill payments. On Deck, which makes the loan itself, is backed by venture capital firms. Its borrowers repay their loans through daily electronic bank debits.
Another alternative lender, the San Francisco firm Prosper.com, puts a crowdfunding spin on business loans. Prospective borrowers describe their project and their funding needs online, and Prosper sets the interest rate after a credit evaluation. The money comes from individuals who may lend as little as $100 toward the total funding goal of the applicant of their choice. Prosper.com dubs this “peer-to-peer lending.’’ Some lenders may help particular applicants because they like the product offered, or the community where it’s sold.
They did it: Seth Perlman’s company, Gaines Motor Coaches in Las Vegas, took out a $35,000 loan from On Deck last fall to refurbish one of the big buses it rents to transport the crews of rock bands on tour. The green bus called Emerald had been booked much less often than the company's other motor coaches until the loan financed the installation of a new lounge in the back. Emerald is now rented for more than 320 days of the year, and the On Deck loan repayment reinforces the company’s credit history, Perlman said. He now hopes to qualify for a bank line of credit at lower rates.
Advantages: A small business may more easily get a short-term loan of 12 months or so to expand or meet seasonal cash flow needs. The application process may be simpler and quicker than a bank application. For example, On Deck makes loans in as little as two days.
Cautions: Although some alternative lenders say their interest rates are competitive, rates can exceed 30 percent depending on the borrower’s circumstances. Quick access to funds may not be a boon if a business is headed for failure. Meeting with a banker for a detailed review may reveal weaknesses in a business plan and help an owner avoid taking on debt for a nonviable enterprise.
Wealthy individuals called angel investors like to make financial bets on early stage private companies that are capable of rapid growth, but that are still too small to seek millions from venture capital firms. Angels, who may belong to groups such as the Vermont Investors Forum, often take an ownership stake in exchange for their private investment of personal funds. Such sales of company shares are called “private placements.”
They did it: In 1998, Sun Microsystems co-founder Andy Bechtolsheim gave Larry Page and Sergey Brin a check for $100,000 to support their work to found Google Inc.
Advantages: Angel investors are often experienced entrepreneurs, who can become valuable advisers to a young company.
Cautions: Any financing round that involves selling shares to new investors can reduce the entrepreneur’s freedom to make business decisions unilaterally. The new ownership structure may also limit valuations and options for the next round of financing. Privately held shares have traditionally been hard to sell to others, but new online businesses, such as Xpert Financial and Second Market, have arisen to serve as trading platforms.
This new form of crowdfunding authorized by Congress recently through the JOBS Act will allow private sales of company shares through social media sites and other intermediaries. Companies could raise as much as $1 million a year through small private investments from an unlimited number of people. Crowdfunding websites are expected to crop up after the Securities and Exchange Commission formulates the regulations they must follow.
They hope to do it: These fundraising platforms are expected to emerge after the SEC draws up regulations for them to follow. Indiegogo has expressed interest in supporting Equity Crowdfunding.
Advantages: The regulatory requirements, such as financial disclosures, would be less stringent than general SEC rules for registering securities or for making an initial public offering of shares.
Cautions: Your many new shareholders have rights under federal and state laws. Complying with those rights could soak up company time and money. A start up’s crowdfunding investors may also look like a cumbersome burden to some venture capital firms you’d counted on for your next round of financing.
Venture capital firms, such as Draper Fisher Jurvetson, can devote several million dollars to the growth of a young company that has established its potential to market valuable new technology, goods or services. Venture firms invest pools of money, raised from wealthy individuals, in enterprises with potentially high rates of return.
They did it: Robert Swanson, a then-29-year-old partner at the venture capital firm Kleiner & Perkins, recognized the commercial potential of a cutting edge technique in academic research: recombinant DNA technology or “gene splicing.’‘ In 1976, he joined with UC San Francisco biochemist Herbert Boyer to found Genentech, which used gene splicing to produce drugs including human insulin and human growth hormone. The VC firm now known as Kleiner Perkins Caufield Byers contributed early funding to Genentech.
Advantages: Venture firms bring management expertise and guidance in realizing the full financial payoff for investments in fast-growing companies.
Cautions: In exchange for risking their capital, venture firms seek a substantial ownership stake, and often, seats on the funded company’s board of directors.
An entrepreneur’s tiny private company may reach its next stage of growth by becoming part of a large corporation that offers to buy it. Big companies often acquire creative enterprises whose new product or service dovetails with their own business activities. For example, Google’s You Tube acquired Next New Networks, an independent producer of online video programming.
They did it: Instagram was purchased recently by Facebook for nearly $1 billion.
Advantages: You, your partners and your investors get a cash payout for betting on a winning idea and bringing it to life. After this “exit’‘ from your investment, you can use your financial gains to start another company, or to rest from your labors.
Cautions: You may forfeit even greater financial rewards that might have been reaped from retaining control of your company and offering ownership shares to the investing public in an IPO. And if the acquiring corporation doesn’t ask you to stay on, other people will explore the full potential of the business you nurtured.
A privately owned company can raise a substantial amount of fresh capital for further growth by offering shares to the general public in an initial public offering. The private enterprise becomes a publicly traded company whose shares can be bought and sold on the New York Stock Exchange, the Nasdaq or other trading platforms. After the IPO, the pre-existing ownership stakes of the company founders and early investors have a specific value determined by the stock’s daily trading price.
They did it: Mark Pincus founded social media game maker Zynga in 2007, and its games, including FarmVille and CityVille, took off. In December 2011, Zynga announced an initial public offering of 100 million common shares at $10 apiece.
Advantages: Your company can fund new growth opportunities. You and other shareholders may benefit if share prices rise with profits. But also, founders and early investors, such as venture firms, have opportunities to cash out, or “exit’’ from the investment by selling their shares on a stock exchange.
Cautions: The value of company shares may fall well below their initial offering price, depending on the ongoing performance of the business and economic conditions. Registration as a publicly traded company brings new requirements for frequent public disclosures of financial reports, and compliance with other SEC rules. However, the JOBS Act will reduce the regulatory requirements for up to five years for “emerging growth companies’’ that conduct IPOs. These companies can delay compliance with certain SEC rules, including some auditing requirements. But they must comply fully once they reach annual gross revenues of $1 billion, or meet other milestones.
The JOBS Act also allows companies to delay SEC registration as a publicly traded company while raising funds from private investors. Formerly, companies could not sell shares to more than 500 investors without registering and complying with SEC rules governing public companies. That shareholder threshold has now been raised to 2,000.