When people talk about startup funding, they often mention venture capitalists (VCs) as a funding source. There's a good reason for this: in the first quarter of 2023 alone, VCs invested US$44.4 billion in startups. But VCs aren't the only option for funding a new business with aspirations of growth.
VCs don't invest in every type of startup, nor do they tend to fund companies below a certain threshold of development and proven market viability. We'll explain this in more detail and describe some of the main funding options available to startups as alternatives to venture capital.
What's in this article?
- Common fundraising challenges for startups
- What do venture capitalists typically invest in?
- Reasons to look beyond VCs for startup funding
- Alternatives to venture capital
- How to create a funding plan for your startup
Common fundraising challenges for startups
Each startup is different, and the startup environment is constantly changing. As a result, fundraising challenges vary between startups and have evolved over time, too. That said, there are consistent obstacles that many startups face, including:
Limited network reach: Startups often struggle with establishing connections to potential investors. This can be particularly challenging for new entrepreneurs, who may not have an extensive professional network. Building relationships with angel investors, venture capitalists and other sources of funding requires time and effort – often diverting attention from core business activities.
Pitching difficulties: Entrepreneurs must pitch their business idea persuasively, showing its potential profitability and scalability. They need to balance technical details with a clear, engaging narrative that resonates with investors. This can be especially tough for tech founders, who may not have strong storytelling skills.
Market validation: Founders must demonstrate that there is a demand for their product or service. Investors look for evidence that the startup has a viable market. They often ask startups to show traction through customer feedback, early sales or other market validation metrics, which can be hard to obtain in the early stages.
Regulatory compliance: Depending on the industry, startups may face complex regulatory environments that can affect their fundraising efforts. Navigating these regulations and ensuring compliance can be costly and time-consuming, and any missteps can be detrimental to fundraising efforts.
Valuation challenges: Determining the valuation of a startup is complex and often contentious. Entrepreneurs need to strike a balance between a valuation that is attractive to investors and one that reflects the potential of their business. This requires a deep understanding of the market and negotiation skills.
Investor expectations: Investors look for financial returns and also often have specific criteria related to the stage of the company, industry sector and growth prospects. Making a match with the right investors who share the startup's vision can be a major hurdle.
Dilution concerns: Raising capital often means giving up equity in the business. Founders need to carefully consider how much equity they are willing to give up and at what stage. Balancing the need for funds with retaining control of the business is a delicate act.
Economic fluctuations: The broader economic environment can affect fundraising. In times of economic downturn, investors may be more risk-averse, making it harder for startups to secure funding. Conversely, in a booming economy, competition for investor attention can intensify.
Intellectual property protection: Investors want to see that a startup has protected its intellectual property. This can involve patents, trademarks or copyrights, which can be costly and time-consuming to obtain.
Long-term sustainability: Investors are increasingly looking at the long-term sustainability and social impact of startups. Companies need to show not only profitability, but also how they contribute to social and environmental causes. This can be challenging for businesses focused primarily on growth and market capture.
What do venture capitalists typically invest in?
VCs tend to have parameters for what kinds of startup they invest in. While individual VC funds often have a specific focus – health tech or female founders, for instance – here are some broad parameters that apply to most VCs:
Scalable business models
VCs look for startups with business models that can scale up rapidly. VCs invest in businesses that they believe can provide a substantial return on investment, which requires substantial growth. This often means that VCs focus on technology-driven or innovative business models that can reach large markets.High growth potential
Startups that attract VC funding usually operate in markets with high growth potential. VCs are interested in companies that can capture significant market share in a growing industry. This indicates a higher likelihood of profitable exit opportunities, either through acquisition or a public listing.Strong management team
VCs often invest in management teams with a proven track record, deep industry knowledge, and the skills to execute the business plan effectively. The team's ability to adapt to changing market conditions and overcome challenges is also a key factor.Innovative technology or business approach
Startups that offer innovative solutions or disrupt traditional industries are more likely to receive VC funding. VCs are attracted to companies that challenge the status quo with novel technologies or unique business approaches, as these companies can potentially redefine markets and create new opportunities.Proof of concept or traction
VCs usually prefer startups that have moved beyond the idea stage and have some form of proof of concept or market traction that demonstrates the product or service's viability and appeal. This could be in the form of an operational product, early sales or user growth.Exit strategy
VCs often look for clear exit strategies before investing. They typically expect a return on their investment within a specific time frame, usually through a sale or initial public offering (IPO) of the company. Startups that present a clear and plausible path to a lucrative exit are more appealing to VCs.Risk tolerance and investment stage
VCs vary in their risk tolerance and the stage of startup that they invest in. Some prefer early-stage investments, accepting higher risks for potentially higher returns, while others invest in more established startups with lower risk profiles.Sector focus
Many VC funds specialise in specific sectors, such as health tech, fintech or clean energy. These VCs seek startups that fit their sector expertise and investment thesis, believing that their focused knowledge and network can add value to these startups.Geographical location
Some VCs prefer to invest in startups based in certain geographical regions, often because of familiarity with the local market, regulatory environment and access to relevant networks.Regulatory and legal compliance
Startups must demonstrate compliance with relevant regulations and legal frameworks. VCs are cautious about investing in companies that might face legal challenges or regulatory hurdles, as these can affect the business's growth potential and risk profile.
Reasons to look beyond VCs for startup funding
While VC funding is ideal for some startups, it's not always the right fit, as different investors bring their own unique expertise, goals and values. Let's take a look at some specific reasons why startups might look beyond VCs.
Equity dilution
VC funding typically involves exchanging a portion of equity in the startup for capital. This can dilute the founders' ownership. Founders may find it more advantageous to seek funding options that don't require giving up a substantial share of equity, especially if they wish to retain more control over their company.Pressure for rapid growth
VCs often expect rapid growth and a quick return on their investment. This pressure can push startups towards unsustainable growth models or divert focus from long-term stability to short-term gains. Alternative funding sources might offer more flexibility, allowing startups to grow at a pace that suits their specific business model and market conditions.Misalignment with goals and values
Funding sources should match a startup's overall goals and values. For instance, a startup focused on social impact might benefit more from impact investors or grants that support its mission, rather than traditional VCs, who may prioritise financial returns over social goals.Limited focus
VCs often have specific interests or focus areas. If a startup operates outside these areas, it might be challenging to attract VC funding. Alternative funding sources, such as industry-specific investors, crowdfunding or strategic partnerships, can provide more targeted support and resources.Competitive environment
The VC funding environment is highly competitive. Many startups struggle to stand out and secure VC funding. Exploring other funding options may be a more pragmatic and less time-consuming approach, especially for startups that don't fit the typical VC investment profile.Long-term commitment
Engaging with VCs often means a long-term commitment and agreement about proposed exit strategies, which might include acquisition or an IPO. Startups that want more control over their exit strategies might find other funding sources to be a better fit.Regulatory and compliance issues
VC funding can involve complex legal and regulatory requirements. Startups may find these processes cumbersome and prefer funding sources with more straightforward compliance demands.Focus on a diverse funding base
Relying solely on VC funding can be risky. Diversifying funding sources can provide more stability and reduce reliance on a single type of investor. This might include a mix of angel investors, government grants, loans or crowdfunding.Cultural fit
Cultural fit is a key part of a startup's relationship with investors. Startups might find that alternative investors or funding sources are more in line with their company culture and operational style.Access to different networks and expertise
Different types of investors bring varied networks and expertise. For example, industry-specific investors or strategic partners can provide valuable insights and connections relevant to the startup's sector.
Alternatives to venture capital
Angel investors
Angel investors are high-net-worth individuals who provide financial backing for small startups and entrepreneurs. They are often retired entrepreneurs or executives who may be interested in angel investing for reasons beyond pure monetary return. These include mentoring another generation of entrepreneurs and making use of their experience and networks.
For startups, attracting and working effectively with angel investors requires a compelling idea, a strong team, a solid business plan and proactive networking. An angel investor can contribute to a startup in different ways than venture capitalists do, and angels are often better suited to an early-stage startup's needs and challenges.
Strategies for attracting angel investors
Develop a strong business proposition: Start with a business idea that is compelling, well-researched and addresses a clear market need.
Build a thorough business plan: Present a detailed plan that outlines your strategy, market analysis and financial projections.
Create a solid team: Show that your team has the skills, dedication and capability to execute the business plan.
Network: Participate in networking events, startup gatherings and online platforms to increase your visibility to potential angel investors.
Prepare for due diligence: Be ready to undergo thorough scrutiny of your financials, business model and market potential.
Working with angel investors
Rely on their expertise: Benefit from their experience and insights for strategic decisions and growth plans.
Use their network: Access their broad network for business development, partnerships and future funding.
Maintain open communication: Regular updates and transparency about business progress, hurdles and milestones are key to building trust.
Angel investors vs venture capitalists
Investment stage and size: Angel investors typically invest at earlier stages and with smaller amounts compared to venture capitalists.
Involvement level: Angel investors often take a more hands-on approach, providing mentorship and advice based on their experience.
Decision process: As individual investors, angels may have a quicker decision-making process than venture capital firms.
Return expectations: While they do seek a return on investment, many angel investors are also motivated by the desire to support emerging entrepreneurs and innovations.
Maximising the angel investment experience
Align expectations: Have clear discussions about expectations regarding involvement, communication and business goals to make sure that everyone is aligned.
Seek constructive feedback: Use their experience to gain insights and constructive feedback on your business approach.
Build a long-term relationship: View your angel investor as a long-term partner, not just a source of funding.
Bootstrapping
Bootstrapping involves building a company from personal finances or the operating revenues of the new company, without accepting external funding.
Benefits of bootstrapping
Bootstrapping allows founders to maintain complete control over their business, as they aren't accountable to external investors. It often encourages a focus on customer-driven growth, as financial success is directly tied to the company's ability to sell products or services effectively.
Another advantage is the cultivation of a disciplined spending mindset. Bootstrapping forces entrepreneurs to prioritise spending and focus on just a few key aspects of their business. This can lead to more sustainable long-term growth.
Examples of successful bootstrapped companies
Many successful companies began as bootstrapped ventures. For example, the email marketing service Mailchimp started in 2001 without any outside funding and grew into a company that was sold for US$12 billion in 2021. Similarly, Basecamp – a project management solution – was built as an in-house tool at a web design firm, funded by that business's revenue, and quickly became more profitable than the company's original services.
Tips for effective bootstrapping
Focus on cash flow: The business needs to generate enough cash to cover expenses and reinvest in growth.
Maintain lean operations: Keep overheads low. This could mean working from home, recruiting only essential staff or using cost-effective marketing strategies.
Implement a customer-centric approach: As initial revenue often comes from customers, a deep focus on customer needs and satisfaction can drive growth and profitability.
Incorporate flexibility and adaptability: Be prepared to adapt the business model based on what is working. This agility can give a bootstrapped startup an advantage over larger, less flexible companies.
Build a strong network: Networking can be a powerful tool for bootstrapped businesses. Building relationships with other entrepreneurs, potential clients and industry professionals can reveal new opportunities and provide valuable insights.
Reinvest profits: Reinvesting profits back into the business can accelerate growth. This reinvestment can go towards product development, marketing, recruitment or expansion of operations.
Keep a long-term perspective: Bootstrapping may mean slower growth in the early stages. Maintaining a long-term perspective is important, as the focus is on building a sustainable and profitable business model.
Crowdfunding
Crowdfunding has emerged as a popular alternative to traditional venture capital for some startups. It involves raising small amounts of money from a large number of people, typically via online platforms. This method democratises the funding process, allowing startups to raise capital from a diverse group of investors, customers and supporters.
Crowdfunding platforms such as Kickstarter, Indiegogo and GoFundMe have become household names. These platforms allow startups to create a campaign, set a funding goal and then solicit small investments or contributions from the public. In return, backers may receive rewards, which can range from the product itself to unique experiences or acknowledgements.
Types of crowdfunding
Reward-based crowdfunding: This type offers backers a reward for their support.
Equity crowdfunding: This allows backers to become part owners of the company.
Debt crowdfunding or peer-to-peer lending: These are scenarios where backers lend money with the expectation of repayment.
Examples of crowdfunded startups
Several startups have successfully used crowdfunding to launch their businesses. Two examples are:
Oculus Rift: A virtual reality headset, Oculus raised more than US$2.4 million through Kickstarter and was later acquired by Meta (formerly Facebook).
Critical Role: The Legend of Vox Machina: Many crowdfunded creative projects have experienced major commercial success. This animated series raised more than US$11 million on Kickstarter and was then picked up by Amazon Prime.
Strategies for a successful crowdfunding campaign
Compelling story and clear value proposition
Successful campaigns tell a compelling story about the product or service and explain its value clearly. This helps potential backers understand the importance of the project and why they should support it.Effective marketing and promotion
Actively promote your crowdfunding campaign. This can include social media marketing, email campaigns and engagement with relevant online communities to spread the word about your crowdfunding.Realistic funding goals and timelines
Setting realistic funding goals and clear timelines builds trust with potential backers. Be transparent about what the funds will be used for and when the product or service will be delivered.Attractive rewards for backers
In reward-based crowdfunding, attractive, tiered rewards can motivate people to contribute. The rewards should be desirable and provide value for money.Regular updates and engagement
Keeping backers updated about the project's progress and engaging with them throughout the campaign builds a community and can help maintain momentum.Preparation and planning
Successful crowdfunding requires thorough preparation and planning. This includes creating a compelling campaign page with high-quality videos and images, planning the marketing strategy and preparing to fulfil rewards.
Government grants and loans
Government grants and loans offer an important source of funding for startups, distinct from venture capital. These funds can provide support for early-stage companies, especially in sectors such as technology, health care and clean energy.
Types of government funding available to startups
Grants
These are funds granted by government entities that do not require repayment. Grants are often given to companies that are in specific industries or involved in certain research and development activities or social initiatives. They are ideal for startups working on innovative projects or contributing to the public good.Loans
Government-backed loans typically offer more favourable terms than commercial loans, such as lower interest rates and more flexible repayment schedules. These are suitable for startups that need capital but want to avoid diluting equity.Tax credits
Some governments offer tax incentives for startups, particularly those involved in research and development. These credits can reduce the overall tax burden, freeing up more capital for growth.Competitions and challenges
Governments often sponsor competitions or challenges with monetary rewards. These can also offer publicity and networking opportunities.
How to apply for grants and loans
Applying for government funding usually involves several steps:
Research: Identify the grants or loans appropriate to your startup's industry and goals. Government websites and regional development agencies are good sources of information.
Eligibility check: Does your startup meet the eligibility criteria? These can include the type of business, size of company and specific use of funds.
Proposal preparation: Applications typically require a detailed proposal or business plan, outlining the objectives, methodologies, budget and expected outcomes of the project.
Documentation and compliance: Prepare all necessary documentation, which may include financial statements, tax returns and legal documents.
Submission and follow-up: Submit the application according to the guidelines and be prepared for any follow-up queries or requests for additional information.
Examples of startups that have benefited from government funding
Tesla Motors: Tesla received a US$465 million loan from the US Department of Energy for companies investing in electric car technology, which helped it establish manufacturing processes and scale up production.
Moderna: The biotechnology company received government funding to develop its COVID-19 vaccine, including grants that totalled US$955 million from the Biomedical Advanced Research and Development Authority.
Incubators and accelerators
Accelerators and incubators can be excellent resources for startups seeking guidance, resources and networking opportunities to fuel their growth. They offer a structured path for development, although startups should consider the intensity of the experience and equity requirements.
Incubators: They offer a supportive environment for startups in their earliest stages. Incubators typically provide office space, mentoring and access to a network of investors and industry experts. They help startups develop their business model and strategy over an extended period of time, often without a set end date.
Accelerators: These are more structured programmes that usually last for a few months. Accelerators offer intensive mentorship, education and resources – culminating in a pitch event or demo day where startups present to investors. They are designed to accelerate the growth of more developed startups, often in exchange for equity.
Benefits of joining an incubator or accelerator
Mentorship and expertise: Startups receive valuable guidance from experienced entrepreneurs and industry professionals.
Networking opportunities: Connections with fellow entrepreneurs, potential investors and business partners can be invaluable.
Resources: Many programmes provide office space, funding and other key resources.
Market exposure: Pitch events and demo days offer exposure to investors and media.
Challenges of joining an incubator or accelerator
Equity requirement: Some accelerators require equity in exchange for participation, which startup founders need to consider.
Intensity and pressure: The fast-paced nature of accelerators, which focus on rapid growth and development, can be challenging.
Competitiveness: Getting into top accelerators can be highly competitive, with a rigorous selection process.
Notable incubators and accelerators
Y Combinator: Known for its highly selective programme, Y Combinator has helped launch companies such as Dropbox and Airbnb.
Techstars: This accelerator offers programmes in various locations worldwide and has a strong network of mentors and alumni.
500 Global: Previously known as 500 Startups, this global accelerator has a diverse range of startups and focuses on marketing.
Plug and Play: Known for its extensive corporate partnerships, Plug and Play provides startups with access to a wide network of potential clients and investors.
Revenue-based financing
Revenue-based financing is where investors provide capital in exchange for a percentage of ongoing gross revenues. In revenue-based financing, the repayment adjusts according to the company's monthly revenues. If the business does well, the payment is higher; if revenues decrease, the payment is lower.
This approach can be particularly suitable for startups with consistent revenue streams that wish to avoid the equity dilution that comes with traditional venture capital. It can also be a good fit for startups that are not yet profitable or large enough to secure traditional debt financing or attract venture capital.
Unlike traditional equity financing, where investors take a share of the company and often have a say in business decisions, revenue-based financing doesn't require giving up any ownership or control. This means that founders retain full decision-making power and benefit from maintaining their company's equity.
However, as payments are tied to revenues, startups with unpredictable or seasonal revenue streams might find this model challenging. It's also typically more expensive than traditional loans because of the higher risk taken by the investors.
How to secure revenue-based financing
Maintain strong revenue generation: To be attractive for revenue-based financing, a startup should have a solid track record of generating revenue. This assures investors that the company can make regular payments.
Keep transparent financial records: Investors will scrutinise the company's revenue streams, growth potential and financial health before committing funds. Clear and transparent financial records ease the process of securing funding.
Have a clear business plan: Demonstrating a clear business plan with projected revenues can increase a startup's chances of securing financing. Investors want to see how their investment will drive further growth.
Find the right investors: Find investors or financial institutions that understand the startup's industry and are comfortable with the revenue-based model. Networking, research and approaching firms that specialise in this type of financing are good starting points.
Negotiate terms: The terms of revenue-based financing can vary greatly from one startup to another. Negotiate terms that are favourable but realistic, considering factors such as the percentage of revenue to be paid, the cap on total repayment and the duration of the agreement.
Peer-to-peer lending and microloans
Peer-to-peer (P2P) lending and microloans offer more flexible and accessible funding options for startups. They are particularly beneficial for startups that are at an early stage or that need smaller amounts of capital.
Advantages of P2P lending platforms
P2P lending platforms, such as Prosper, connect individuals who need to borrow money with those who are willing to lend.
Accessibility: These platforms operate online, making them accessible and efficient.
Competitive rates: Borrowers can secure loans without going through traditional financial institutions, often at competitive interest rates.
Higher returns than savings accounts: Lenders can invest their money with the potential for higher returns than those of typical savings accounts.
Advantages of microloans
Microloans are small loans, often provided to businesses that may not qualify for traditional bank loans. Organisations such as Kiva and the US Small Business Administration offer microloans to support small businesses and entrepreneurs.
Accessibility: Microloans are typically more accessible than traditional loans, especially for startups with little to no credit history or collateral.
Lower amounts: The smaller size of microloans makes them ideal for startups needing a modest amount of capital for initial expenses – without accruing a large amount of debt.
Community and network building: Many microloan providers also offer networking and educational opportunities, helping entrepreneurs build connections and gain business knowledge.
How to approach P2P lenders and microloan providers
Research and select suitable platforms: Start by researching various P2P lending platforms and microloan providers to find those that best match your startup's needs and qualifications.
Prepare a solid business plan: Even though these lending options may be more accessible, you'll still need to create a well-considered business plan. The plan should outline how your startup will use the loan and how the business expects to generate revenue to repay the loan.
Understand terms and conditions: Carefully review the interest rates, repayment terms and any fees associated with the loan. It's important to fully understand these details to avoid any future surprises.
Build a strong profile or pitch: For P2P platforms, your profile and loan request should be compelling and clear, highlighting the potential of your startup and how you will use the funds. For microloans, a strong pitch or application can increase your chances of approval.
Consider the impact on credit: For P2P lending, consider how taking out a loan might affect your credit score. It's important to make loan repayments on time.
Seek additional support: If available, take advantage of any additional support or resources offered by the microloan provider, such as business training or mentorship.
How to create a funding plan for your startup
Each startup should create a customised funding plan that fits the specific needs of the business. Here's how to do that:
Assess your funding needs
Start by understanding how much funding your startup requires. Conduct a detailed analysis of your business plan, including initial setup costs, operational expenses and projected growth. Be realistic about how much capital you need to reach your milestones without overextending your financial commitments.Understand your stage of development
The stage of your startup influences which type of funding is most appropriate. Early-stage startups might consider angel investors, crowdfunding or bootstrapping, while more established startups might aim for venture capital or revenue-based financing.Match funding types to business goals
Your funding choices should fit your long-term business goals. For instance, if maintaining control is important, bootstrapping or loans might be preferable to equity financing. If rapid growth is the goal, venture capital might be more suitable.Consider the cost of capital
Each funding source comes with its own set of costs and obligations. Equity financing might dilute your ownership, while loans come with interest payments. Weigh these costs against the potential benefits and choose the option that's aligned with your business model and future plans.Prepare for different scenarios
Have a plan for different funding outcomes. This might include a mix of funding sources to provide flexibility and reduce dependence on a single type of financing.Build relationships with potential funders
Start building relationships with potential investors early on. Attend networking events, join startup incubators and participate in online communities. Strong relationships can make all the difference in securing funding.Develop a strong pitch
Whether you're seeking investment from venture capitalists or launching a crowdfunding campaign, you need to create a compelling pitch. The pitch should clearly articulate your business idea, market opportunity, competitive advantages and how the funding will be used.Maintain financial discipline
Regardless of the funding source, be disciplined about your spending. Efficient use of resources can extend your runway and make your startup more attractive to investors.Stay informed about funding trends
The startup funding environment is dynamic. Stay informed about the latest trends and changes, such as new investor preferences or emerging funding platforms, to make sure that your strategy remains relevant.Plan for legal and regulatory compliance
Understand and plan for the legal and regulatory implications of your chosen funding sources. This includes shareholder agreements for equity funding, loan terms for debt financing and compliance with crowdfunding regulations.
