[Note: This is the second article in a series on how to fund a technology startup. Part 1 is here.]
To quickly review, in the last article we looked at funding your technology startup from your own funds, and also how and why technology companies should consider applying for grants through the Small Business Innovation Research program.
Basic Categories of Company Funding
All of the funding strategies available to a technology startup (or any company, for that matter) fall into one of three buckets:
- A grant requires neither repayment nor the sale of any part of a company. Although grants may (likely will) have requirements, they do not need to be repaid, and they do not dilute or cloud ownership.
- This is a loan, which has specific terms under which it needs to be repaid.
- This is a purchase of a part of a company.
Grants, which we covered in Part 1, are clearly the most beneficial, but even companies that do attain grants will likely also use debt and equity funding at some point. Let’s look at debt next.
Most debt requires some form of collateral, i.e., something that will be used to repay the lender should the company become unable to repay its debts. The exception might be debt from a friend or family member, who is giving the money with faith in you as an individual. Otherwise, you will likely be called upon to personally secure or back the debt from your own net worth, for example, with the equity in your home.
Debts = Serious Personal Risk
That important fact means that a failure of the business means that you lose that money, or whatever part of it has not been paid back. If you back a debt with your home, you may lose your home if the debt cannot be repaid. If the business fails, you may find yourself losing everything.
Some forms personal debt can take are direct loans from you, from readily available sources, home equity lines of credit, and loans or lines of credit from banks, backed by you. (Another type of “debt funding” that often surprises new entrepreneurs is the request or sometimes requirement to guarantee commercial leases. We’ll talk more about that in future posts.)
Although debt funding that is directly from you is technically not different from Funding Out of Pocket, which we discussed in Part 1 of this Funding Technology Startups series, it differs in terms of perception and timing. Out of pocket funding generally includes expenses before you have formed a business entity, whereas debt funding is (or should be) more formal. Once you have a business entity, you will also (presumably!) have a set of financial books and records for that entity. The debt shows up on the balance sheet of the company, as a liability. That is of course crucial if you have more than one owner, but even if there is a single owner, and you take additional funding, the liability to you will still show on the books.
If you later take equity funding, be aware that venture capitalists in particular, and likely also angel investors, are going to make sure that your debt is completely behind any repayment to them, and in some cases you may be required to remove the debt from the books. They may argue that your investment into the business, in terms of both cash and time, is part of the overall negotiation with them regarding the value of the shares they are buying with their investment.
Loans from a bank or other 3rd party, even if secured by you, will not be treated in this fashion by potential investors. So if you can secure a loan or line of credit to the business with your own credit rating, that is possibly a lower risk than making a direct loan.
What about the Small Business Administration (SBA)? Don’t they make loans?
One of the “great American business myths” is that the SBA is ready to loan money to help businesses get started. The SBA loan program is a loan backing program. It is designed to make it easier for banks to lend money to businesses by guaranteeing the loan. But here’s the big catch. In order for the US Government to back a loan to your business, they are also going to require that you also back it. (Although technically it is supposed to be possible for an SBA loan to have no collateral, it just doesn’t happen.)
I am not down on the SBA program – but it is greatly misunderstood. I have benefited from an SBA-backed loan. It was secured by the inventory owned by my business at the time, so I had no personal guarantee. Technology startups rarely have any assets similar to inventory, however, so you will likely end up as the personal guarantor on an SBA or other bank loan.
The place to start with debt is your bank. Do business with a bank that has a business department or that specializes in business. See what form of credit you can get, whether SBA backed or conventional. But definitely be very cautious with debt that you are personally backing. Even companies with great plans and great futures can and do fail due to surprises and circumstances beyond their control.
Friends, Family, (and Fools)
Friends and family are a source that may or may not be available to you. To my mind, the only true “angel” funders are those who invest in you, with either a loan or an equity stake, because they know you and believe in you. Presumably (hopefully) they are only loaning or investing money they can well afford to lose.
The main advice that I have here is to treat these loans or investments as seriously professionally as you treat any investment. If it’s a loan or a line of credit, have an attorney draw up an agreement concerning the terms of repayment, interest rate, default circumstances, etc. If it’s an equity investment, spend a few hundred dollars to properly record the sale or shares and units, so their interest and yours are protected in the future.
That’s the end of Part 2 in my Fund a Technology Startup sequence. Be sure to read Part 1, and be on the lookout for the next section, where we cover the new kid on the funding block: Crowdfunding.
If you have questions, ask them below – you’ll be automatically entered into my monthly free book contest.