This article is part of a larger series on Business Financing.
Funding for your startup is essential for the survival of your new business. However, not every startup will qualify for startup business loans. Companies that might be too new to show sufficient income, or startups in niche industries, might have to rely on alternative forms of funding to get a business off the ground.
For businesses uninterested in getting a small business loan, here are five options for alternative startup financing and what each is best used for:
- Friends and family: Best for borrowers with friends and family who are interested in investing in their business
- Small business grants: Best for startup business owners who can qualify for funding they won’t have to repay
- Crowdfunding: Best for startups with a strong brand or dedicated customer following and little-to-no revenue
- Angel funding: Best for startup business owners willing to sell some of the ownership in their business for funding from nonprofessional investors
- Venture capital: Best for startup business owners willing to sell some of the ownership in their business for funding from a professional investment firm
1. Friends and Family
While this option won’t be available to all startups, you may choose to borrow startup funds from friends and family. These types of loans usually have very lenient repayment terms and excellent rates. However, they often come with unwanted involvement in the business by those giving the loans, so documentation is critical to safeguarding the business. Failure to do so can create legal problems down the road and complicate both business and personal relationships.
Loan Costs & Qualifications
In January 2022, the required minimum interest rates are:
- Short-term loans (less than three years): 0.33%
- Long-term loans (up to nine years): 1.37%
The above rates come from the IRS Index of Applicable Federal Rates, which updates monthly. The index provides the minimum interest rates the IRS expects on all loans. Even if the friend or family member doesn’t want to receive interest for the loan, it’s essential to pay interest on it. Otherwise, the IRS may see the money as a gift and tax it accordingly.
One of the few perks of borrowing from friends and family is there are no required qualifications for the borrower. To avoid the IRS seeing the loan as a gift, be sure to structure the money as a loan or as a sale of shares of the business. Unless your friends and family are sophisticated investors, taking money as a loan is generally cleaner than selling them a share of the business for three reasons:
- Unwanted business advice: If a family member or friend has shares in the business, they will also want input in the long-term business strategy. This may be less than ideal.
- Potentially unrealistic business valuations: Business owners often overvalue the new startup, which gives family and friends an unrealistic expectation of a return on their investment.
- Loan obligations for owners: Selling business shares to family or friends may require them to be liable personally for future financing applications.
2. Small Business Grants
One of the most coveted types of startup financing is a small business grant. It’s offered by federal and local government agencies, banks, lenders, and other organizations. Grants don’t have to be repaid, so they make an excellent funding source for startup businesses. When considering a business grant, examine all available options and apply for those that best fit your business purpose. Qualification requirements will vary depending on the individual program.
Where to Find Grants for Small Businesses
- Federal government: While the availability of federal grants isn’t always obvious or advertised, there are grants available for a wide range of purposes. Go to grants.gov to see the federal grants list and begin the application process.
- State government: States offer grant money to help grow business development in the respective state. Grants vary by state and finding the grants on individual state websites and the application process can vary as well. Starting with your state’s dot-gov website can be an excellent place to begin your search.
- Local government: Local towns, cities, and even township governments offer grants to grow business development in their area. Nonprofit organizations also assist local governments in grant awards for community development. Contact your local government for more information.
- Lenders: Banks of all sizes offer small business grants as part of the community reinvestment act program. Reach out to your local bank for more information on potential grants.
- Other businesses: Some large companies offer grants to small businesses, although they tend to be smaller than grants awarded by other entities. Official web pages of large corporations should have information if they have available grant programs.
One of the fastest-growing startup business funding methods is crowdfunding: the act of raising small amounts of money from a large number of people. This is usually done through an online platform, with the business owner offering goods or rewards in exchange for the funds.
Costs, Terms & Qualifications
Through a crowdfunding website, you use the strength of your product or service to inspire people to subscribe or donate to your business. The costs involved are usually a flat fee of 5% to 10% of the total money raised, a charge per transaction, and the costs involved in the rewards or goods offered by the business.
Crowdfunding campaigns usually are reward-based or equity-based.
Where to Find Crowdfunding
There are numerous websites available for crowdfunding, with Kickstarter and Patreon being two of the most popular sites. Every crowdfunding site has its own regulations and requirements, so research carefully to ensure they will work well with your startup business.
4. Angel Funding
Angel funding is the act of raising startup funds from nonprofessional investors who provide personal capital in exchange for part ownership in your business. It’s less formal and takes less effort than raising money from professional investors, such as venture capitalists.
Angel funding is usually used as seed money to accelerate the growth of a startup. The median funding in 2020 was just above $300,000.
|No monthly payments: Angel funding is not a loan but rather a pledge of capital to be repaid upon the occurrence of a specific future event.||Reduced ownership equity: Angel funding is often given in exchange for an ownership stake in the business. This won’t affect the initial owner’s control of the company—provided they maintain the majority, but investors will want to be consulted on major decisions.|
|A network of other investors and founders: Angel investors can provide you with an established network of strategic partners, future investors, and potential customers. These connections can be highly valuable to your business.||May not be a good long-term match: A rushed deal could result in conflicting perspectives on the company and what roles everyone plays in its development.|
|Advice on business decisions: Many angel investors are established entrepreneurs themselves. Their expertise can help your business as much as the money they provide.||Can take a long time to get funding: The process of securing angel investment funding typically takes a month or more. With larger networks, funds, and multiple investors, it can take as long as nine months before your startup is funded.|
|Potential for future investments: If your business needs additional funding, the same angel investors may invest in your company again.||Possible rejection: Because investing in a startup is risky, there is a chance that the angel investor will deny your request for funding. Be sure to have a strong business plan before pursuing angel investment funding.|
Where to Find Angel Funding
There are many websites available for angel funding. You might even find angel investors through connections on LinkedIn. AngelList is the largest startup community on the internet. Check out its website for more information.
5. Venture Capital
Venture capital firms provide funding for high-growth potential companies in exchange for equity in the company. It’s a much more formal process than angel funding and requires a considerable amount of work from the startup business owner to secure funding.
There are two types of venture capital investments:
- Equity Venture Capital Investments: These are settled with company equity. When a company is acquired or starts trading on a public exchange, venture capital firms liquidate some of their holdings in the company to make a profit. The startup business owner makes no payments in this scenario.
- Convertible Venture Capital Investments: Convertible debt is repaid at either a future funding or liquidity event. The investor can receive payment in the form of cash or equity in the company. A liquidity event can be an acquisition, an initial public offering (IPO), or another fundraising event.
|A large amount of capital: Venture capital funding typically provides more funding than any other option on this list.||Dilutes your equity: Most investors will convert to equity if your startup is successful. Later rounds will usually exchange capital for equity in the company, reducing your ownership of the overall company.|
|No interest payments: Without interest payments, your company’s cash flow is improved, allowing you to reinvest and create more growth.||Reduces your control: When you raise a venture capital round, you will usually need to provide board seats to your investors, giving your board ultimate control over broad strategic decisions at the company.|
|Additional guidance and resources: Just like angel investors, venture capitalists are experts who can provide you with guidance beyond just the funds provided.||Can be difficult to qualify: For most startups, venture capital is the last funding stage before an acquisition or an IPO. It’s typically raised when the company is growing, in an expanding market, with a scalable product or service.|
For businesses looking for alternatives to startup business loans for funding, each of the five in this article has its highlights and drawbacks—and you should consider all options before moving forward. In addition, because some of these don’t involve taking debt, your business might consider more than one of these choices at the same time to provide funding for your startup business.