Funding types for Start-ups in General

There are different ways for funding for startups. Usually, an entrepreneur will start business with own saving and borrowings from family and friends. Later on when the business idea is more mature and need to grow, entrepreneur may turn to the other ways to seek for funding to enable its further growth, which can be categorized as public funding and Private funding. Besides public funding and private funding, there is also frequently discussed topic for funding through customers which usually apply innovative business models to help startups with positive cash flow. Funding via customers would be treated more properly as the consequences as successful bootstrapping.

Funding can be done as a result of equity investment or as debt. Apparently funding via customers is the best for entrepreneurs because it gives positive cash flows without asking for equity or without paying back with interests. However, gradually when startup growing in scale like AirBnB, it still needs to seek funding from the private market and public market, even though it started with innovative prepaid business model (successful customer funding). We will illustrate each funding types in brief below.

1.Public funding

Public funding is by word meaning to get financial support from the public. Public can be a general term to represent both public organization and public market. Public organization like Business Finland can offer both grand and debt financing to companies. Individual investors can buy company stocks when they are issued via initial public offering in the public market, as known as secondary market.

Public grants and debt financing

Startups can acquire funding through public grands for example from EU Horizon 2020 or Business Finland, which normally do not require firms’ equity and paybacks. This is an ideal way of acquiring funding, however the competition for startups is very high. Debt financing usually requires startups to pay back together with some interests, however, it is quite commonly used because for startups it is relatively cheaper than equity financing because there will be no influence on company operations and decision making, unless facing financial distress.

IPO

When company is ready to go to the public market, they will use services from investment banks to help them with initial public offering in the primary market, after which individual investors can purchase and sell the company’s stock in the secondary market. Some companies also choose to list by themselves known as direct listing, or via Special Purpose Acquisition Company (SPAC). The detailed comparison to go public by IPO, SPAC and Direct listing is explained in the appendix.

The benefits of listing are the ability to raise funds for internal uses or acquisitions, liquidity, proper price discovery, and analyst coverage. The cost of listing includes fees for listing on an exchange, regulatory requirements, expenses related to mandatory disclosure, the competitive risk of revealing information useful for competitors, and investor relations. In addition, executives may feel the burden of delivering short-term results, having a higher profile in the media, and subjecting themselves to the scrutiny and potential action of activist investors. Many of these costs are fixed and have been on the rise. (Mauboussin & Callahan 2020).

2.Private funding

Private funding by word meaning is funding through private market. For example, funding through angel investors, venture capital funds, corporate ventures, and crowdfunding. There are also other channels to get the funding from private market which can alert regulatory challenges, for example peer to peer landing and shadow banking. We will only mention the most often used types here.

Angel investment

Angel investors are wealthy individuals who provide capital to fund concepts or very young companies that need to complete prototypes or attract initial customers. (Madison Park Group n.d.). Angel investors usually involve in the early stage of startup investment and thus they carry on lots of risks. However, in case the investment is successful, they also enjoy higher expected returns on investment. An angel with strong operational expertise in a start-up’s industry can often relate better to entrepreneurs and offer mentorship, more patient capital, and better valuations (Madison Park Group n.d.). However, compared to institutional investors, angel investors can have limits in knowledge, ability to scale up the business or back up strongly from financial perspectives.

Venture Capital Investment

Venture capital is equity financing provided by institutional investors that either manage a fund on behalf of large institutions (usually pension funds and insurance companies) or have their own proprietary pool of capital (Madison Park Group n.d.). Venture capital firms invest equity into young companies that have prospects for attractive growth and value creation (Mauboussin & Callahan 2020). Moreover, venture capital fund has its own life circle, usually 10-15 years. All the venture capital funds are aiming for bring extraordinary returns to its limited partners who invest in the fund. The general partners are carrying fiduciary roles to actively searching for promising startups to invest in order to bring positive returns on investment.  Venture capital firms usually consists of experienced investment experts and technology expertise that invests in specific field/fields. Such expertise can guide entrepreneurs in business operations, growth and building valuable networks for the business.

Startups use VC investment to go through different phases which include pre-seed, seed, Series A, Series B, Series C+, some needs Series D and E before going public. The challenge for entrepreneurs is to match their company’s stage of development and business prospects with the appropriate venture capital sources (Madison Park Group n.d.). Startups can gain positive attention and feedback from the public via venture capital investment since usually venture capital firms are investing in promising growth startups.

Corporate and Corporate Ventures

Corporate usually have specific investment targets directly related or indirectly related with corporate business activities, and it is an active player in Merger and Acquisition(M&A) activities worldwide. Corporate can invest in startups via equity investment directly or through corporate ventures. Direct equity investment is easier to understand, in which corporate can invest directly to startups as stakeholders and participated in management board. Corporate or corporate ventures invest in startups to further strengthening their competitiveness and market position. There are various objectives for corporate or corporate ventures to collaborate with startups, among which investment and acquisitions are two of the reasons for corporate-startup collaboration with objectives to solve business problems quicker and at lower risk, and expand into future markets by accessing new capabilities or channels (Bannerjee & Bielli & Haley 2016). The reason to pursue a merger or an acquisition is to achieve a better competitive position in the marketplace-a lower cost structure, for example, or a better platform for growth (Harvard Business Review 2001,62).

Crowdfunding

Crowdfunding is the use of small amounts of capital from a large number of individuals to finance a new business venture (Smith 2021). There are basically four types of crowdfunding: equity, debt, rewards and donations. The differences of the four types of crowdfunding are shown in the picture below:

Different types of crowdfunding (Invesdor 2014).

Crowdfunding has become very popular funding tool for startups which are willing to raise capital but having limited financial track records. Startup can also use crowdfunding platforms to attract attention from target customers thus raise its brand awareness. In order to be qualified to raise capital through crowdfunding platforms, massive information on operation, finance, and development need to be disclosed to the public, which could be also considered as a risk to make information public to its competitors.

Customer funding

However, not every startup is going through pre-seed or seed funding phase, because not all startups require funding from outside sources immediately in their initial business development. Entrepreneurs may wish to remain autonomous in their business operation, or they simply think it is less profitable to get investors involved in the early stage of development. Such funding behavior generated by the startup funders themselves is named as bootstrapping. Successful bootstrapping can be achieved through innovative business models, such as revenue received on pre-paid basis from the customers. There are successful examples of startups directly go Series A funding after a few years of bootstrapping with proven tractions. For example, SuperMatrix in Finland.

Global Regional Comparison of VC investment 2020 (PWC&CB Insights 2021)

As a matter of fact, startups generate funding to further develop their business ideas. Depending on the different startups, the funding needs and the channels can vary case by case. It is not always the ultimate goal for every startup to go for IPO, which depends on complicated factors internally and externally, despite of the fact that IPO is the ideal scenario for investor to achieve successful exit. In the Internet age, in which organizations change at the speed of light, this ability to learn and adjust constantly may be the difference between the organizations that succeed and those that don’t (Harvard Business Review 2001, 202).

Reference:

Harvard business review on mergers and acquisitions. 2001.Boston: Harvard Business School Press.

Madison Park Group. No date. Guide to Venture Capital.

Michael, J, Mauboussin and Dan, Callahan.2020. Public to Private Equity in the United Sates: Morgan Stanly Investment Management A Long-Term Look. Counterpoint Global Insights.

Siddharth, Bannerjee and Simona Bielli and Christopher Haley. 2016.Scaling Together: Overcoming Barriers In Corporate-Startup Collaboration. Nesta. March.

PwC and CB Insights. 2020. MoneyTree ™ Report Q4 2020

Invesdor.2014. What is crowdfunding. Accessed on 6.4.2021. https://www.invesdor.com/en/what-is-crowdfunding

Tim, Smith. 2021. Crowdfunding. Investopedia. 18 March. Accessed on 6.4.2021. https://www.investopedia.com/terms/c/crowdfunding.asp


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