Ask Christa! Business Basics Series (3/6) - What's the Best Funding Model for Startups? (S3E28)

Introduction and Listener Question

Hi everyone and welcome to Ask Christa! the place where you can ask questions about how to work through business challenges and workplace issues. I’m Christa Dhimo and today’s listener question is another one I get a lot, “What’s the best funding model for startups?”

My short answer is: whichever one will enable YOUR success as a founder AND your clients’ success as paying customers.

My more thorough answer often intimidates people, and that’s to learn about which funding model is best for you and your business at various times in your business’s development. People think that by learning about the many funding options, they’ll ALSO have to learn about deep, technical financial models, but that’s not true, so hang tight with me for a few minutes. 

This is the third episode of my Business Basics Series, episode 3 of 6, where I’ve consolidated some of the most common listener questions I’ve received since launching 3 months ago. 

What is a “Funding Model”?

Here’s what I want you to keep in mind: if you learn about different funding models, you’ll not only feel more confident about business, but also realize there are A LOT of options for entrepreneurs that most people don’t know about.

Funding overall and funding models sounds super complicated, but it’s not. 

Here we go…

When I hear the term “funding models,” I interpret that as meaning ways to fund your business to get the best chance of creating and building value for your organization by way of getting… FUNDING.

It’s a model or a framework for receiving the funds, or the money, to operate and grow. Depending on HOW you are funded, there will be an understanding for HOW those funds will either be repaid, with interest, or returned to the investors with a higher value of their investment because their investment enabled you to BUILD and GROW value of your business.

And there ARE times when the investors offering the funds, especially early on, aren’t expecting repayment. They are offering low investments to see you succeed or at least get started. A “friends and family” round might be part of this, or certain types of grants.

Now, I’m not going to get technical about the potential source of money, or capital, such as grants or venture capital (often referred to as VCs). I’m also not going to go deep into the type of capital such as equity, which is a type of ownership. And I’m not going to go into repayment structures listed in the terms and conditions of funding, but I will put some resources in the show notes if you’re interested in going deeper into those topics. There are plenty of resources to help you learn about those aspects of funding.

What I DON’T see a lot of, and what’s NOT as easy to find, are the questions you should be asking and the ANSWERS you should KNOW as you consider which funding model is right for you and your business. 

Most founders think the ONLY source for funding is through VC, but as my friend Allison Byers, the founder of Scroobious, always says and is quick to remind others, and I quote, “Venture capital has its own business model and is only appropriate for a subset of startups.” I’ll put a great 2 minute panel discussion in the show notes also. She very clearly articulates what VCs were originated to do, and which business types they are generally good for.

On that note, I do want to emphasize that as a founder, you have options and choices, and a lot of them are not the “GO BIG OR GO HOME” option, so when you ARE ready to seek out funding, it’s important to know what will be the best strategic fit for your goals. So as always, start with your OBJECTIVE.

Matching your business objectives with a funding model leads you to the right SOURCE and TYPE, for you.

What Questions Should I Ask?

To get to the objective for funding and determine which funding model might be best for you, I’m going to focus on three perspectives and questions you should consider—and the name of the game is finding a strategic fit. 

#1: Pace and Timing. Do you have to hurry up and build? Most don’t. 

If you believe you have to hurry up because you want to catch the wave of a fad that’s happening RIGHT NOW, this might cool your jets: after the first three products are in the market, you likely need a new and DIFFERENT product to break into that market and break the loyalty and proliferated use of the fad products already in the market. 

It will be hard to compete with two products, and nearly impossible to compete with three that are already competing amongst each other. The barriers to entry, as we say, will be high, and there are reasons for that.

The first company out is the pioneer, which almost always launches a first product with spurs and burs, but as the first one out of the gate, they have what we call “first mover advantage.” If it’s a good enough product, they get the loyalty and the purchase and use habits of the consumers IF the product is easy to find and buy, if the product is easy to adopt and use, and if the intended consumer perceives the value of the product to be in line with the price of the product. 

The second company out will effectively compete with the first, pioneering product on one or all of those first mover advantages: is the second product out more accessible-- easier to find or buy? Is it easier to use? Is it reasonably priced for the perceived value when compared to the first product out? and by the way, reasonably priced doesn’t mean cheaper or less expensive. There are times when customers may pay the same or even a little more for a similar product that offers a better experience, maybe better features, or more options, or better quality. Simply put, if the perceived value is higher, and consumers are often willing to pay a little more. Those are the aspects of a second product out that can disrupt or break consumer loyalty with the first product.

The third company in with a similar product is often designed for the laggards or the last group of consumers who haven’t adopted the product: perhaps the third product is much less expensive, or has similar features without excessive options. Over the last 10 years a lot of smart watches have come out that are not necessarily associated with a big brand. They’re simply smart watches, more accessible in price, providing just enough functionality, and doing pretty well.

Tech moves fast, so a lot of tech has to hurry up and build, but if you DON’T have to hurry up and build—then don’t. I mean… don’t take FOREVER, but ease up on a fictional pace of how fast you need to go simply because you think that’s the way funding works for all products and businesses. 

And there are funding models for a slower pace of build—not a SLOW pace of build, but slower that fad products. For example, there might be a lot of things you can do to build your business with your own money, also called bootstrapping, that enables a responsible use of your personal funds without requiring the heavy commitment of big funding models.

But if you feel you have something of high value now that needs to get up to pace for fast launch and use in market based on who your consumers are, then… the answer might be, “Yeah, I need to get this moving fast.”

Know what your needs are relative to Pace and Timing. Those are important factors when you’re thinking about funding models for your startup.

#2) on perspective and questions you should ask is about ownership and leverage. 

Is it important to you to maintain ownership (or equity) for as long as possible as you increase the value of your business and your product? This again would be bootstrapping funding model, and the longer you build value under YOUR ownership, the more ownership and decision-making control you will have. You will also have more leverage when and if you DO seek funding, and you may see a higher pay out if you decide to sell your business. 

But there are disadvantages to bootstrapping, too, such as the high risk to your own funds, or simply needing more chefs in the kitchen to do the work ahead of you. If so, you may decide to go into a partnership model or a co-founder ownership model where others invest in your business alongside of you. 

This certainly decreases YOUR risk as a sole owner, because others are sharing the risk with you and offering their expertise to complement yours. They are also motivated to build value in their own ownership, or equity, and there are a lot of times when that matters for the future success—and future VALUE—of your business. 

You might decide to take out a small business loan, and if you have de-risked your business because you have a mature product ready for sale (and in selling your product you are in position to receive revenues and potentially make a profit), then you have some leverage. You will be a lower loan risk because you are closer to the start of generating revenue, and often THAT means the interest you pay back from a business loan, based on the likelihood of your success as a lower-risk borrower, will likely be lower, too. One thing to note on business loans, and I say this because I’m recording in the US, and we always need disclaimers—many of them have different terms and conditions, and I’m talking about this to showcase the different scenarios of different funding models for startups. Of course, you’ll have to speak with a business loan expert to receive up to date information from your lending source.

When thinking about and asking questions about ownership and leverage, it’s like HOW much of your house YOU own versus how much of your house YOUR MORTAGE LENDER owns. The more YOU own, the more home EQUITY (or ownership) you have. It also means if you SELL your house, you will receive a payment for what you own. The lender receives the remaining payment for what they own, or what is still being loaned to you. It’s similar with ownership in business.

#3) on perspective and questions you should ask is about size and complexity versus easy breezy. The bigger and/or more complex your product is, then the bigger and/or more complex your funding model might be. 

As products grow in size and complexity, it becomes more capitally-intensive. For example: if you‘ve engineered a “smart motor boat” designed to withstand the intensity of extremely cold environments, that will need A LOT of money and know-how and expert program management. THAT is capitally-intensive. There’s a lot you have to build, a lot of specific tools you will need, a lot of calibration equipment you have to maintain and validate, and a lot of complex testing during your product development—and that testing will have to simulate and be in the intensity of the extremely cold environment your smart boat is intended to function in.

But if you have designed a new sneaker that enables competitive cheer squads to have the same feel of a low-cut cheer shoe with far better support for all the intense flips, and tumbles, and throwing they have to do (throwing of each other, no less), that won’t be AS capitally intensive. At the least, the actual shoe will probably be able to be manufactured the same way other sneakers are manufactured, with modifications to the sole’s design.

When your funding needs are capitally intensive, you probably need large raises with sources that can support those large raises, and you’ll receive your funds in portions called tranches. You’ll likely spend cash on what is necessary for building your product quickly and within spec so you can make good on the capital you have raised. When you borrow that much money, you USUALLY have a tight timeframe.

As you can imagine, when your funding needs are less capitally intensive, so too is the complexity of how much you need and when. There’s also an inherent reduced risk during your development and the way in which you are creating and building value.

So…. when you think about funding models, I don’t want you to think about financial equations or future value metrics or anything you may THINK you need to THINK about. 

Funding models do not start with selecting a source of funding based on how much money you think you need to build something. That’s of course important, and how much you need will be in what you ASK for, but startups need to start with understanding the needs as a business and the needs of building a product and CREATING VALUE. 

These are STRATEGIC considerations, and in truth, your funding needs will change as you grow and develop, and the source or sources of your funding will change, and the type of ownership models will… likely… change…

And when it comes to building value, think of the points from Episode 27: de-risking your business through intellectual property rights, clarity and simplicity of business ownership, and understanding your market or who will buy for how long and how many versus who prefers your competition, those are great ways to build value. And when you de-risk your business, you are building value.

But What ARE the Funding Models?

Now, I’m going to review a few funding models, but this doesn’t always make for interesting media, so I’m going to start with this: most startups mix and match their funding, which is a type of “stacking” with their funding sources. 

For example, in science or engineering, they might start with grants, then maybe a small business loan to bridge some of the work that’s needed before going into their first big raise. Or perhaps they’ll start with an Angel Investor or a different Seeding model like crowdsourcing if it’s a straightforward product where it’s easy to demonstrate value and future use. 

There are incubator and accelerator models also that offer early stage funds for development, usually related to tech and products that need a faster pace, before moving onto bigger funding models.

When it’s more complex, then most start-ups eventually move on to a Venture Capital, or VC, model, which could be a standalone VC or a corporate VC where large corporations scout and hear pitches to offer capital to start-ups with a venture-based model. 

Just remember: the goal is to create value, and with each step (or stack) of funding, you are learning more about your product and market while developing your business and product and de-risking where possible. This sets up for not only knowing which funding model might be best for you and your business, but also which types of fundings might be best as you consider your growth path.

(and of course, hopefully you have the right advisors and supporters helping you along the way; I’m trying to give you an edge with my answers, not to replace the experts you need beside you)

Additional Resources 

For your resources, I’ve included in the show notes two articles and one blog that dive into the different ways a startup might stack their funding options over time OR just stick with one model: I’ve offered an article written by the founder of Chewy.com, Ryan Cohen. I’ve also included an article about Spanx’s from 2012 when it was declared a Billion-Dollar business—and you can find a lot of excellent business cases and write-ups about the innovative and creative ways Spanx developed from startup through growth and it’s sale. I also included a blog that reviews how MailChimp funded through… bootstrapping.

In the show notes you’ll also find a page from the US Chamber of Commerce, a page I often site, that offers information about free grants and programs for small businesses and start-ups looking to start up and scale.

And you’ll see an informative page from The Hartford from their business insurance segment—and I’m not affiliated with The Hartford nor do I directly endorse them. In fact, I’ve never done any business with them, but it’s a good page that offers an overview of some of what I’ve talked about by way of funding so you can learn more. The article includes very useful links to a lot of different resources also.

Last, I included a LinkedIn Post from Allison Byers, founder of Scroobious, that I mentioned early on. In that post is her two minute video while she paneled about founder funding and she talks about how the VC model isn’t for everyone. 

Final Thoughts

Here are my final thoughts: knowing your business inside and out, what you intend to offer, your customers… it means you are ready to make decisions about a funding model that matches your objectives and what will be best for your business and for you. 

Not all funding models are right for everyone or every business, and just because you see a lot of VC-based funding on TV on in the news and media: high risk, fast pace, high reward (or fast CRASH), doesn’t mean that’s the best way to go or the ONLY way to go. 

Personally, I like building businesses for value, for the sake of building a solid, healthy, strong business that will last for a hundred plus years in service to its customers and employees. As a strategist focused on organizational performance, I care more about the experiment of continuous improvement and strengthening of a business’s value by way of quality, reputation, and winning in all areas, including the employment experience, which is, of course, how you get the best talent.

But, that’s in Christa’s world. There are plenty who are simply looking for a fast build with enough value generated for a quick exit (where an “exit” means you and your investors sell at a high value and make good money off of your original investment). And guess what? There’s a model for that, too.

Just don’t be afraid to say what Allison says, “VC isn’t for everyone and shouldn’t be seen as the only way to go.” Well… I’m paraphrasing.

Wrap Up & Submitting Your Questions

OK, mid-way through our Business Basics series!! There’s episode 28. 

Remember: to submit your question, go to my show’s website, AskChrista.com, that’s Christa with a C-H, and click on the Submit a Question button. While you’re there, FOLLOW my show, which is available wherever you listen to your podcasts. And of course on my show’s site, you can view the videos, too.

While you’re there, sign up for my Sunday night newsletter called, “More Answers,” designed to prep you up for the work week. 

As always, thank you for your support. Keep the questions coming. And remember, if you have a business challenge or a workplace issue—Ask Christa!