One of the biggest problems early-stage tech companies face is securing funding to get the business off the ground without making unthinkable sacrifices in equity that may come back to haunt you down the road.
In the beginning, you may decided to bootstrap your way to success, forgoing a paycheck and even funneling income from a day job into your fledgling business. But bootstrapping and belt-tightening can only get you so far. And typically, they won’t get you far enough to qualify for a bank loan (if you're a SaaS business without tangible assets) or to pique the interest of venture capitalists, who are even more selective now than they used to be.
Fortunately, there are more alternative financing options than ever for early-stage tech startups. Here we review the pros and cons of the three most common funding sources.
Weighing the Pros and Cons of 3 Alternative Funding Sources for Startups
1. Online lenders
The "break glass in case of emergency" option
With traditional banks disinclined to make loans to new companies with minimal to no business collateral, online lenders have stepped up to meet this need. Lenders like Kabbage and OnDeck offer quick and easy loans with simplified online application processes.
Pros
The application process is very fast—sometimes you can get money the same day.
It’s possible to borrow small amounts when you need it, rather than a large, one-time influx of cash. These small, fast loans can save your company if an unexpected one-time event reduces your cashflow, threatening your relationships with customers, vendors, or employees.
Cons
The amount of money you can borrow is quite limited (typically less than $100,000).
Interest rates are high. Complicated fee and payback structures make it hard to tell exactly what the interest rates are. We dissected a few loans from one of the most popular lenders and found APRs of 50% to 100%.
Because payback begins immediately—often the next business day—these loans carry significant cash risk for small businesses if you don’t understand the implication of payback structure.
These loans are also designed for unexpected cash crunch, not long-term growth.
2. Crowdfunding
The "extended friends and family" option
Entrepreneurs make a pitch online for their company and product to a wide audience, where potential investors can invest relatively small amounts of money in exchange for products, interest, and/or equity.
Pros
Crowdfunding decreases the need to rely heavily on family and friends for cash, enabling entrepreneurs of more modest means to still have a shot at getting the funding they need.
Entrepreneurs won’t need to create elaborate pitches for high-stakes investors, instead building one pitch for one platform to showcase your idea.
Crowdfunding for product launches is a great way to test market demand, giving you the money (and confidence) to move forward when crowdfunding is strong—or perhaps encouraging you to pivot if there’s a lack of interest.
Equity crowdfunding is an alternative to equity investment from angel investors or venture capitalists, which can be hard to land at an early stage.
Cons
When you receive funding from hundreds or thousands of people, you now have to deliver a product that satisfies those hundreds or thousands of investors, on the agreed upon timeline. Crowdfunding is replete with stories of disgruntled project backers.
It’s not for every company. Crowdfunding can be effective for B2C or product-based models, but much less effective for B2B, more technical solutions, or services.
If you’re doing equity crowdfunding, you won’t be able to receive the same kind of support and mentorship that you would with traditional equity investors.
There is some legal risk with equity crowdfunding. Regulations are in flux. In some cases, even these small investors will need to be qualified accredited investors. Before you launch your crowdfunding campaign, consult with an investment lawyer.
3. Revenue-based financing
The "sustainable growth and momentum" option
Revenue-based financing is a revenue sharing agreement between investors and a business. It’s usually debt capital that is secured by the recurring future revenue of the business rather than hard collateral or personal assets of the entrepreneur. The loan is paid back based on a percentage of the company’s monthly revenue instead of a fixed interest rate.
Pros
Provides the benefits of a significant injection of capital without the need to give up equity or control in the early stages of your business.
With no personal guarantees or debt covenants, it’s less risky than a traditional bank loan.
Payments fluctuate with your monthly revenue, so you’ll never get hit with a massive payment that you can’t afford.
Cons
You need at least $200k in annual recurring revenue to qualify.
Places a consistent (though small) drain on your operating capital.
Get the Complete Guide to Raising Capital for Tech Startups
Raising venture capital isn't the only path to a successful exit, and statistically, it's least likely to be the golden ticket for your startup. Get a comprehensive look at all the components of a successful fundraising strategy that delivers the outcomes you want—on your terms—in our Guide to Raising Capital for Tech Startups.