THE BLOG
03/27/2014 02:20 pm ET | Updated May 27, 2014

The Hidden Terms of Startup Capital

When you are starting a business, where you get your money from has mostly to do with who is willing to give it to you. Most entrepreneurs just want to get funded, and often don't think through the ramifications of their funding source. Whomever gives you money is now in a relationship with you -- and it's important to know what hidden terms come along with that relationship so you're prepared for what happens once the check is in the bank.

1) Bootstrapping/self-funding.

Who can do it. Anyone whose product doesn't require a huge investment to get to a basic product. Most companies do a little bit of bootstrapping so they have something to show to potential customer and to possible investors.

The appeal. If you can start your company without taking outside capital, then you should. This is independence! The key is being able to get to revenue quickly. Or getting to a key proof point with your product that will give you momentum into your first funding round.

The hidden terms. Bootstrapping may prevent you from keeping up with market conditions. And it may wear you down -- a founder worried about paying the rent, who is skimping on everything, develops a scarcity mentality and can get exhausted. Not good for playing the long game.

Read more. The Basecamp (formerly 37Signals) team is passionate about bootstrapping and profiles lots of great companies on their blog. Read and be inspired.

2) Small business bank loan.

Who can do it. Someone operating a traditional business with predictable cash flows, who is also willing to pony up a personal guarantee.

The appeal. Banks aren't going to want to weigh in on what your logo looks like. This is a financial transaction and your bank will stay out of your way as long as you make payments on time.

The hidden terms. Bank loans can be difficult to secure. Banks are not in the business of funding risky ventures; they are in the business of solving cash flow problems for sound, profitable companies. Because of the personal guarantee, for most entrepreneurs there is little difference between getting a bank loan and reaching into your own pocket, except the amount of paperwork required.

Read more. There's a lot out there about how banks want to finance small companies. I haven't run across any pre-revenue companies being able to secure bank financing that wasn't just a personal loan secured by personal collateral. The Small Business Administration has a lot of good information about its various loan programs.

3) Rewards crowdfunding..

Who can do it.
Anyone wanting to make a product people want to buy or a media piece that people want to consume.

The appeal. Raise money from your future customers, without giving up any equity. Prove (to yourself and other possible investors) that there is a market for your product. Get early buzz.

The hidden terms. You actually have to ship them the exact product you promised exactly when you say you are going to. There's very little room to alter your game plan when you have 1,000 active Kickstarter or Indiegogo backers waiting to get their lime green arm warmers. So if you have a lot of unknowns in your plan, this may not be the right funding source for you. While backers know you are a startup and will have some patience with you, the public relations issue on your hands (not to mention possible legal problems) if you can't deliver will be huge. And career-damaging.

Read more. You don't want to be on THIS LIST, but being one of THESE COMPANIES would be great.

I'll be talking about equity crowdfunding in a later post.

4) Friends and family.

Who can do it. Anyone whose friends and family are willing to back her venture with equity or debt.

The appeal. This can be the easiest sort of financing (or in many cases the ONLY available financing) for non-tech small businesses and also for tech businesses as seed capital. Most new ventures, in fact, are financed by friends and family.

The hidden terms. It may be difficult to set up boundaries with family and friends about how involved they should be in the business and what your availability is to discuss it with them. Some F&F investors may be expecting to work in your company or otherwise be involved. Make sure these expectations are addressed upfront and you are all in agreement.

More significantly, if you lose money for your friends and family, the relationships can be permanently damaged. You will need to make sure that F&F equity investors can afford to lose 100% of the investment and that they are very clear on the risks. Also think through how you will feel if the investment is lost. Could you live with that? The reality is that 90% of startups fail. Make sure you are prepared for that outcome even as you plan and work towards success.

Read more. Fred Wilson talked about F&F investing on his blog a few years back. There is also practical advice on this offered by the Small Business Administration and NOLO.com.

5) Angel investors.

Who can do it. An entrepreneur with a business concept that has the potential to achieve massive scale may be able to attract professional angel investment. Angel capital is generally available for either (1) innovative technology concepts with a huge potential market or (2) in rare cases, unique concepts in other categories such as retail, consumer product, restaurant or service industry.

The appeal. Backing by professional angels provides more than just capital -- angels can bring valuable coaching and network contacts to your company. If you can work with an experienced angel, it's usually a great move because it increases the chances that your venture will succeed.

The hidden terms. Not all angels are created equal -- do your due diligence! Some angels may not provide you with any help and may be looking for a quick exit. Others may disagree with your strategy and pull their support if you don't heed their advice. Talk to some other entrepreneurs who have worked with a particular angel before you close a deal. And remember that they are professional investors experienced at negotiating terms, so make sure you get legal advice.

Read more. Here's some great advice on working with angels from professional angel investor Dave Berkus and a look at it from the angel's point of view from the Wall Street Journal.

As you talk to potential investors and partners -- banks, crowdfunding participants or angels -- be transparent and direct, and ask the same from them. Remember that these relationships, and your reputation, are the asset you will have going forward whether or not the company itself succeeds.

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