3 Funding Options (Pros and Cons of Subsidy, Loans, and Fundraising)
It’s always way cooler to sell your product than to sell your shares. It’s always way cooler to sell your product than to get distracted with subsidies or loans that you have to repay. The main thing to say about raising funding is always: only do it when necessary.
Before taking someone else’s money it is worthwhile sketching out a rough growth plan which includes what you want to achieve, in what amount of time. That will allow you to make a rough estimate of how much money you need for each goal you want to achieve. If you can get the funds by selling your product or your MVP, that’s great. However, startups often really do need external funding, no matter how great their business idea or product is.
This blog gives an overview of which funding options are available to you and what are the pros and cons of each. As a part of our Startup Survival blog series, we prepared a list.
A subsidy is a sum of money granted by the state or a public body to help a business. The upside of subsidies is that you’re not selling your shares and you’re getting access to an amount of money that you might not get access to that easily. It’s a good way to speed up the development of your product. Another pro is that sometimes subsidies also come with a network of people.
The downside is that the decision-making is a bit of a black box. You spend a lot of time writing an application. You submit it, and it gets processed. You don’t really know what will happen until you get an answer. And that answer will likely be a binary yes or no. There is usually very little room for negotiation or adjustments of your story as you go. It’s just not a negotiated process.
With subsidies, it is usually best to see them as a ‘nice to have’. Don’t choose subsidies as a main stream of income, because you have very little control over whether you’re going to get them or not. It could be good news – you got the money and you can survive. Or it could be bad news – you didn’t get the money and you will have to go without cash. It is not a good policy to bet the whole company on that one type of funding.
Another downside with subsidies is that sometimes they come with quite rigid conditions: e.g. you’re not allowed to change your business plan, or you can only spend the money on research and development but not sales, or you have to be located in a specific region, or etc. Those rules make a lot of sense for the organization giving the subsidy, but they may not make sense for your business situation over time. Your company might get pushed into a shape that is not really market or customer-driven.
The concept of a loan is easy. A lender, let’s say a bank, loans the money to a borrower, let’s say a startup. It is clear that the borrower eventually has to pay back the loan, and in the meantime, the lender receives an interest as a reward for letting someone else use their capital.
The upside of borrowing money is that you’re not selling your shares. Selling shares is a bad idea in general. Every share you sell is normally gone forever. Another pro is that a loan is sometimes faster to set up than a subsidy or equity fundraising. Contractually speaking, loans are simple. Often a lender doesn’t feel the need to do as much checking of the company as a shareholder, since they won’t be involved as long and are not taking as much risk.
However, in general, it’s very difficult to get a loan as a startup. Why? Well, basically most startups fail. That means that the risk to the lender is very high. If half of the startups fail then the lender would have to charge enough interest to make back half of his loans. That means the interest paid back will simply be as high as the loan was in the first place.
Even if the startup is able to get a loan, it may not be a good thing if it is not set up right. You don’t want to pay back your loan and interest too quickly since you want to use the cash in your business. Often it is agreed that everything is paid at the end. Unfortunately, it is rare that a startup can simply repay the whole loan in cash when the time comes. So that means that bankruptcy is a real risk. If the reason you need money is to repay a loan then you will find it very hard to find interested investors. Investors like to see their money go into building the business, rather than fixing problems from the past. Having a big loan on the balance sheet can actually cause equity investors to walk away. Now the loan is a permanent scare-crow on your balance sheet.
The most natural way for startups to raise money is to sell their shares. Of course, selling your shares cannot go on forever: this is a temporary solution. The shares that you sell, you will likely never get back. So only do it when you see long term advantages.
But the advantages are clear. By selling shares you can get the cash you need in the earliest stages of developing your company. The investors are taking on the full risk of the company, so they are in the same boat as the founders. They also get the same upside, so they will likely want to support your business in other ways than just providing capital.
High-quality Angel investors can help transform your organisation because they can add knowledge and experience. Often experienced investors can help a founding team to expand beyond their native country, by providing contacts in international target markets. Often high-quality investors are able to identify holes in the skills of the founders and can provide ways to make sure the additional abilities are brought into the team.
Good Angel investors will have a reserve of capital and they will be able to re-invest in future funding rounds also. That means that you are getting long term benefits from building a relationship with them.
Of course, there are also the cons of this form of funding option. The main thing to watch out for is that the founders shouldn’t give away too many shares too quickly. You want the founding team to feel it is ‘their company’ for several years. Also, the contracts that are used for closing an equity round can be very complicated, you can easily make mistakes if you do them on your own. Equity fundraising is usually done either through convertible notes or through a priced equity round. Leapfunder offers standardised contracts that save you time and possible issues further down the line. Those are based on the standard contracts of experienced startup lawyers in the various jurisdictions where Leapfunder operates. Of course, you can also hire one of those experienced lawyers, and that is what startups usually do once they start doing multi-million VC rounds.
When you set up your funding round it is important that the startup team should learn about the different contract structures that are possible. We have more about that here. If you need some practice to get good at using the financial tools you can join our Finance Academy, where we have a gamified introduction to how to use convertibles, structure different equity classes, and even set up debt safely, or read a shareholders’ agreement.