Types of Startup Funding
This note describes the various types of funding startups are likely to encounter: revenue from the business, equity, debt, and grants.
The most common source of financing for a new venture comes in the form of revenue from the business itself, whatever that business may be. In the case of revenue funding, a startup offers some service or product, receives money for that service or product, and uses that money to finance subsequent provision of the service or production of the product. This sort of financing has been described by terms such as: internal financing, self-funding, or even bootstrapping (the subject of a blurb in this section).
Recognizing that the daily financial dealings of a startup are one of the sources of financing is more important than it may seem. Each and every dollar that flows into the venture through the business operations arrives with a decision: Should this dollar be used to pay salaries, buy supplies or equipment, pay dividends to the owners, invest in new opportunities, or something else?
Directing monies away from salaries, or profits, or operations, and towards new opportunities is a choice that has consequences. It is also the sort of choice for which the terms are not altogether clear. Nonetheless, the great majority of startups in any year find their growth capital through the daily business of the venture, rather than through outside sources.
In its most general form, equity is a stake or claim in a venture. These sorts of stakes or claims can exist explicitly (e.g., in the legal/financial form of shares in the business) or implicitly (e.g., in the social/cultural form of apparent obligations like “sweat equity”).
Legally speaking, every startup that exists as a corporation in the United States comes into being through the creation of equity, usually in the form of stock, and the purchase of that equity by the founder(s). That means you acquire your initial stake in your own company! Albeit, in most cases that initial purchase is at a minuscule price per share.
The issuance of equity by a corporation to individuals or other entities involves the exchange of something for a claim on the net assets of the company—those assets that remain after the liabilities of that company have been paid off or otherwise resolved. A quick reference to the basic equation of accounting should make the equity context clear:
Assets = Liabilities + Stockholder Equity
Set Liabilities = Zero
Assets = Stockholder Equity.
The “something” that is exchanged might be cash, services, or anything of value for which the firm is willing to sell, grant, or otherwise transfer shares in the company to someone or something (like another corporation).
Equity comes in a variety of species (e.g. ,common versus preferred) that can cohabit with any number of derivative species (e.g., stock options and convertible debt). These species are discussed in a separate note titled, Varieties of Startup Equity.
The issuance of debt involves the exchange of something for an obligation. As is the case with stakes/claims on the firm, obligations of the firm can exist explicitly (e.g., in the legal/financial form of loans to the business) or implicitly (e.g., in the social/cultural form of apparent obligations like, “you owe me, dude”).
In most cases, this obligation takes the form of a loan, which is simply a transfer of funds in exchange for the obligation to repay those funds in certain amounts according to some schedule over some period of time. Loans often include some assurance in the form collateral, which is/are assets of the firm (or individuals) upon which the lender has a claim should the obligation not be repaid according to the terms.
The schedule and period of payments related to a loan imply some underlying interest rate. Alternatively, some underlying interest rate combined with some period of time over which payback should occur suggest some schedule of payments, if each of those payments are to be made regularly and be similar in value.
While the last sentence of the prior paragraph may seem a bit arcane, it is important to recognize that debt is simply an exchange of something for an obligation. If that something is a pile of money, we often speak of “the loan” as having an obligation in terms of interest rates and time periods (e.g., 6% annual interest rate paid over 48 months). We do not have to speak of loans in terms of interest rates and time, however.
For example, some cultures—such as those engaged in Islamic banking—will not speak in terms of interest rates or even use the word “loan.” Instead, they will speak of the asset, the period of time over which payments are to be made, and the value of each of those payments. Since explicit loans are not appropriate, culturally, there is only an implied interest rate to this financial obligation. Furthermore, in many countries there is no law that would prevent you from agreeing to an obligation that lasts forever.
As with equity, debt comes in a variety of species (e.g., straight or convertible)cohabiting with a variety of related species (e.g., warrants). These species are discusses in the note titled, Varieties of Debt.
Grants involve the exchange of something for impact. That something that is exchanged is usually money, but you could imagine grants involving products, assets (e.g., paintings donated to a museum), or even services (e.g., volunteer work). What separates grants from equity or debt is that the exchange does not result in (a) a claim on the assets of the firm, or (b) an obligation that if left unmet results in claims on collateral or other assets. Grants can and often do expect accountability, however, as would other obligations of and claims on the firm.
Importantly, grants are not “free money.” In fact, grants can be harder to come by than equity or debt in many cases.
THIS NOTE IS STILL UNDER CONSTRUCTION