Understanding 7 Primary Types of Business Funding and the Varying Costs of Capital

Founders often find themselves in the endless cycle of seeking and acquiring capital. Whether it’s the first fundraise to get the initial idea off the ground or growth capital to support a company looking to expand into new markets, the questions surrounding the process are often similar regardless of stage—what types of funding are available to you, and which option is best?

Small businesses often find it hard to qualify for more than one funding source. If you find yourself in the common scenario where you don’t qualify for a specific type of capital, you need to explore other options. With so many different sources of capital out there, it’s hard to decide which one is best for you.

Types of Lenders and Business Funding: Debt

Each funding source has different methods of lending. Below you will find the mainstream lending options and their advantages as well as disadvantages.

Banks

Going through a bank for funding is usually one of the first thoughts most founders have when considering financing for their startup. Banks are great resources and offer various loans that might benefit you. They are ideal for people with asset-heavy businesses because banks usually require collateral to approve a loan.

Let’s look at a few different types of loans you can get through your bank, and the advantages and disadvantages of them.

Small Business Term Loans

Similar to a car loan or a mortgage for individuals, a business term loan is a lump sum of capital for entrepreneurs who need funding. Business term loans come in many different sizes. They can be as small as a few thousand dollars or as big as $5 million. Rates can vary, with an APR ranging between 6%–99%.

Term loans from the government (like SBA loans, which we’ll discuss in the next section) usually have the lowest APR but the most stringent requirements, while online lenders usually have a higher APR but a quicker approval process.

Pros:
  • You get the money upfront.
  • If you get a low APR, a term loan can be a great source for business funding.
  • If you pay off your term loans on time, this can build business credit for future lending.
Cons:
  • Likely requires collateral. Likely only available to asset-heavy companies.
  • You bear the risk of repayment regardless of how successful or unsuccessful your business is.
  • A high APR can make the loan very expensive to pay back.
  • Repayment begins immediately, regardless of growth.

SBA Loans

Small Business Administration loans (SBA) are made for small businesses. It is a unique type of government funding source offered by banks and lenders and guaranteed (or partially guaranteed) by the government (U.S. Small Business Administration).

There are many types of SBA loans, differing in size and requirements. Some cap the loan at $50,000, while others allow borrowers to get as much as $5.5 million.

SBA loans may be structured as a term loan, a line of credit, or a business grant. The SBA also offers programs targeting underrepresented communities, such as minorities, women, or veterans.

Pros:
  • You can borrow up to $5.5 million.
  • SBA loans usually offer borrowers a longer term to repay the principal, making the loan more affordable.
    • Inventory or working capital loans typically have a 10-year term.
    • Real estate loans can be a 25-year loan.
  • Offer some of the lowest interest rates.
Cons:
  • Business owners usually need to have personal investment in the business already.
  • The application process is lengthy and slow.
  • Requires high credit scores.
  • You may have to put collateral up to borrow.

Business Line of Credit

A business line of credit is like a credit card. It is a type of funding that is 100% based on your credit limit. Interest is paid only on the money drawn.

Let’s say you borrow a business line of credit for $200,000. You can draw up to $200,000 whenever you need it, and then repay the funds over a weekly or a monthly schedule. As long as you make payments on time, you can continue to draw on your credit line, as long as you do not exceed the original $200,000 limit.

There are two types of business lines of credit: secured and unsecured. With a secured business line of credit, you must provide collateral against the line, such as inventory or property. If you cannot make the payments, the lender can take what is owed! Unsecured lines do not require any collateral, but some may still ask for personal guarantees/liens, which allow the lender to seek your personal assets in the case of default, including your car or home.

Pros:
  • More flexible than a term loan.
  • Pay for what you use—no payment until you draw on the credit.
  • Access to funding when you need it, as long as it is within the credit limit.
Cons:
  • Usually requires collateral and/or personal guarantees.
  • Can be expensive. APRs are often above 10%.
  • The application process is lengthy.

Revenue Based Financing (RBF)

Revenue-based financing is an alternative financing tool that provides capital in exchange for a percentage of future revenues. Fees paid back above the principle are called royalty payments.

RBF is best for businesses with predictable, recurring revenue.

Founders will receive a pre-established percentage of their recurring revenues (usually 30% of annual recurring revenue) and make ongoing payments. Repayments are a percentage of their monthly cash receipts, with payments flexible as revenue goes up or down each month.

RBF is ideal for companies with predictable MRR and annual recurring revenue (ARR) business models.

Pros:
  • You maintain 100% control of your company.
  • Your monthly payment may be flexible and is based on your actual cash receipts.
  • Eliminates bias/discrimination, as RBFs is algorithms-based and available to anyone with increasing, predictable cash receipts.
Cons:
  • Limited to certain industries or business models.
  • Require ARR minimum to qualify.
  • Monthly payments begin immediately.

Friends and Family

When starting your business, often the only available capital is your own money, or that of friends and family. Asking friends and family to invest in your business can be an excellent but potentially tricky option. It is important to be upfront with your family that there is risk involved, and to have honest conversations about the funds they are providing.

Talk about what happens if your business fails. Put your agreement in writing. Define what the plans are for the return on their investment (you should provide a return). Do they see the funds as a debt or equity investment?

Pros:
  • Friends and family are likely more supportive than other investors, providing the most flexible terms.
  • Potentially a quicker route to funding.
  • Potentially the most favorable financing terms available.
Cons:
  • Friends and family may not understand the risk of losing money, which can damage your personal relationships, should things not work out as expected.
  • It may add extra stress to manage friends/family investors.

Types of Lenders and Business Funding: Equity

As mentioned, “Friends and family” funding may be agreed to as debt. But it may also fall under equity financing if your family would like to get paid a multiple of their investment when you exit. Terms for that investment should be documented as part of your capital stack, as if they are any other equity investor.

Below are profiles of other types of equity investments. Founders can think of venture/equity investments as a series of rounds that follow a predictable sequence. An investor provides a check which they expect will help you grow to a specific, pre-determined inflection point. If you’re successful getting to that next growth stage, you might seek the next round of capital, which will get you to the next inflection point. Those cycles are repeated until your company is either acquired, or in some cases, goes public.

As a founder, your goal will likely be to delay taking venture capital as long as possible. Why? Because the cost of capital will be lowest the further along the growth path your company is. So, if you can self-fund, or access capital from friends and family to get your product all the way (or close) to market—and have a track record of growth—you may be able to hold off equity investment until late seed or Series A round, when your cost of capital will be lower.

To break down equity investing further, let’s look at the earliest potential types and rounds you might seek for your investable company.

Venture Capital (VC)

Venture Capitalists (VC) is an excellent option for startup funding, especially when large amounts of capital are needed for product development, or other big ticket spends. A significant difference between the types of capital covered so far and venture capital is that VCs receive a portion of your company in exchange for the capital they provide. This is not debt funding—as a founder taking equity investment, you will not be making monthly payments to your investor(s). The investment goals of VCs are quite different from those of debt providers.

Venture capitalists only get their investment return when the company is acquired or goes public. If the company does not grow quickly enough to be an acquisition target, or does not go public, the VC loses their capital. Because they are now part-owners of your company, they will likely be hands-on:  offering guidance, introductions, etc. It is critical that you find VC partners with whom you want to work, because you will be working closely with them throughout the life of your company!

Venture capitals typically focus their investments in industries in which they have expertise, and for growth stages that are within their investment thesis. For instance, a VC may only invest in very early-stage SaaS companies, including those who are yet to have paying customers. Or their investment thesis may be that they invest only in health-tech companies who have at least $3M in revenue. VCs specialize, so it is critical to research which VCs focus on companies like yours.

The stage of venture capital a company may qualify for depends on their revenue growth. The earlier investors receive the best terms because they assume the most risk. Earlier investors typically write smaller checks because the goal is to get these smaller companies to the next milestone. Later stage investors write larger checks and assume less risk because the company has a successful track record of revenue generation.

Below are the most common funding phases you need to be aware about in relation to VC:

Pre-Seed and Seed

Pre-seed funding will likely come from angel investors—individuals who make equity investments in pre-revenue companies, in industries they are knowledgeable about. Angel investors assume the greatest risk as the company generally lacks a finished product or track record of revenue. The goal of this capital is to complete an MVP (minimum viable product), and to launch a pilot, or beta test in the market. Pre-seed capital is typically amounts of $100,000-$300,000. For their greater risk, these investors are often rewarded with more favorable deal terms and a higher potential return if the company is successful.

VCs who specialize in seed-stage investing have an investment thesis that allows for the greater risk of this early stage. The amounts of investment are smaller, and the goal of the capital is typically to get the product into use by a small handful of early customers, to test the founder’s thesis. Funds usually are used for product development, sales and marketing. Typical seed funding amounts are in the $250,000-$1.5M range.

If you are building a company with the goal of scaling quickly to quickly gain traction in the market and become an acquisition target, you will likely need seed funding. Seed funding is ideal for businesses in need of new staff, equipment, office space, and other business-scaling tools.

Pros:
  • A potentially great partner who believes in your startup and takes risks with you.
  • VCs often provide hands-on support, expertise or introductions that can help you scale more quickly.
Cons:
  • Repayment terms can vary by investor and stage of growth, and can be complex.
  • Give up equity in your company
  • The investor may have a different vision for your business.

Series A

Series A capital is typically used for sales and marketing efforts. These may be the most common VC stories you have heard. Venture capitalists are not investing in just brilliant ideas at this stage, but a strong business strategy and proof of concept to monetize on that brilliant idea.

In short, Series A investors are looking for companies that have shown product market fit.

What is product market fit? In simple terms, it means the market (customers) has shown significant demand for what a company is selling. Investors can see a clear path to market dominance.

For a successful product market fit, there need to be paying customers, minimal churn (customer loss), and proof that the company has a product and sales process that is locking in new deals at a predictable pace.

This also means companies have the potential to scale, because they are growing and have minimal churn (customer loss). Series A helps startups do more of what is working.

Additionally, Series A investors are looking at your competition and how you are distinguishing yourself in the market. VCs want to know how big the overall market is, and how much of that market you believe you can capture (aka: TAM – total addressable market).

The valuation is a key part of Series A funding, as it determines how much funding you are getting and more importantly, how much of your company (equity) you are giving away in the future. It is a multiple of your expected revenue. Founders will have an idea of what their company is worth, but ultimately investors set the valuation. It can take months to secure Series A funding, so starting before capital is needed is critical.

Series B

Similar in many ways to Series A, Series B funding is the next in a series of capital investments that are about growth and expansion. Series B typically offers significantly more funding than Series A. According to the Funz study, the median valuation of companies that were considered for Series B funding in 2021 was $40 million.

Pros:
  • Terms are more favorable than in earlier stages
  • You will benefit from VC connections and resources. Partial funding may come from the same investors who earlier contributed.
  • Larger checks in the B round allows faster growth
Cons:
  • You will give up additional equity to get funding.
  • Fundraising is less competitive than earlier rounds because most capital will come from your prior investor network.

Series C

Series C is funding for companies that are already succeeding, and is often about merger & acquisition or funding opportunities to allow investors to head toward an IPO or seek an acquisition or merger.

Investors involved in Series C often include hedge funds, investment banks, and private equity firms.

Pros:
  • Large chunks of capital to further fuel growth.
  • Gets attention from financial institutions with deep pockets.
Cons:
  • Highly time-consuming and difficult to get funding.
  • Stressful to manage investor relationships.
  • Additional equity must be provided.

Private Equity (PE)

Private equity (PE) is capital that is invested into private companies—those that are not publicly traded. Similar to VCs, PEs are not loans but will purchase a stake in a company and then draw profit from the increased value of that company when it sells the business.

Lower Middle Market PE

Lower middle market refers to the lower end of the middle market segment of the economy by a company’s yearly revenue. These are by no means startups, but instead established companies that earn $5 million to $50 million annually.

Middle Market PE

As the name indicates, middle market PEs invest in the middle market segment of the economy by companies’ yearly revenue. They typically invest somewhere between $50 million and $500 million.

Pros:
  • Get a large amount of funding without risking high-interest loans.
  • Get the working capital needed.
  • Receive funding and resources.
Cons:
  • Fundraising is extremely competitive and can take a long time.
  • Loss of ownership stake and management control.

Types of Lenders and Business Funding: Grants

Government and Non-Profit Grants

Government and Non-Profit grants can be highly appealing to startups because they do not require repayment or equity sharing.

However, the requirements to qualify are usually strict and limited, timelines to funding are long, and competition can be fierce. These types of federal grants typically are for certain market sectors. For instance, the federal government cares about healthcare, so will offer grants for the development of new drug therapies. If your company is building an innovative biotech product, you may qualify. Other areas of focus might be clean water or air, military defense.

Pros:
  • You do not need to repay grants.
  • You do not need to give up equity.
  • You can apply and receive multiple grants.
  • You can apply and receive ongoing grants.
Cons:
  • Extremely difficult to get as competition is fierce!
  • Grants applications are time-consuming to prepare.
  • Grants require lots of progress tracking and reporting.

Types of Lenders and Business Funding: Crowdfunding

Crowdfunding

Many new businesses are getting their funding from crowdsourcing. This involves receiving small investments from many individuals who read about the company and decide to invest a small amount of money. It can be anywhere from a few dollars to hundreds or tens of hundreds. There are many crowdfunding platforms online, making it easier to reach a broader audience, and pull capital beyond your own network. When you have many people investing small amounts, it can add up quickly.

Kickstarter

Kickstarter is one of the most popular crowdfunding platforms in the US. It is great for those who want cash fast and are looking for a sense of community as they launch their business.

Pros:
  • You keep control of your business.
  • You can get money quickly.
  • It is a good way to test product/market fit before investing in the business.
  • Your investors may become your loyal customers.
Cons:
  • It is difficult to get funded—if you do not reach the funding target, you do not get funded at all. Crowdfunding requires a large marketing campaign, which can be time-consuming.
  • This model favors consumer products. If you have a business-to-business company, it can be difficult to be funded.
  • Platforms like Kickstarter charge 5% of the funds raised, plus payment processing fees. These costs can add up and take a considerable chunk out of your funds.

How Do These Lenders Charge?

Once you know what type of lender you want to go with—or think you will qualify for—you need to know how they charge. Some options have higher fees than others, which you will factor into your decision.

Banks

Banks are allowed to determine the interest rate and repayment plan associated with all their loans. The factors they use often include your credit score, business assets, business’ revenue, if you have other loans, and more.

Venture Capital

The biggest cost of VC money is the equity share, and what percentage of the company it will add up to by the time the company has an exit. The equity shares are usually based on:

  • The valuation a company gets when funded.
  • How much money they need to get to the next milestone.
  • What stage of capital they are taking.

When the startups sign the deal, the term sheet defines the total cost for that investment.

However, it is important to note that companies will almost always need multiple rounds and each round of funding will have its own players and own terms.

Private Equity

As with most investing options, the fees can vary. For most PEs, the fees are 2% of the capital commitments during the investment period. This consists of the management and performance fees.

Revenue Based Financing

RBFs are paid back as a percentage of your actual monthly revenue: if you make more, you pay more, and if you make less, you pay less.

The rate is agreed upon upfront, but the dollar amount flexes with your growth. Generally, RBF deals require repayments up to 1.8x of your borrowed amount over the life of the loan—typically three years.

At Novel Capital, we cap our repayments at 1.5x. This flexibility is beneficial for startups as it reduces the risk of a high amount of payment during an off season or a tough time.

Angel Investors

Each angel investor is different. Because they are an early investor, and thus assume the most risk, they usually receive the most potential return on their investment. While they want a stake or portion of your company, the terms are negotiable. They may want convertible debt, or common stock, for instance. The ‘cost’ is in how much equity must be shared, and at what financial cost.

Government and NPO

Grants and NPOs do not require fees or payback.

Friends and Family

Borrowing from friends and family can be challenging. When doing so, you will want to set clear boundaries and deadlines. Unlike banks or other lenders, loved ones may not have strict guidelines or fees regarding when you need to pay or if you miss a payment.

Crowdfunding

There are fees that you will pay to use crowdfunding online platforms. Each platform can charge a different fee, but Kickstarter and other similar ones are approximately 5% of the amount raised.

Conclusion

If you are considering growing your business further, funding is necessary. The first step is to find out if and what kind of revenue-based funding (RBF) you qualify for. You can download our eBook to learn more about the best capital options for you and your business.

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