Matching your type of funding to your objective–to your exit–is the key to success.
There are three main types of funding: grants, debt, and equity.
A grant is money that is just given to you–usually by some sort of governmental or socially-responsible agency–to perform a task that is judged to be desirable to society even if it’s difficult or impossible to monetize. If you fill a particular niche that is deemed important by the powers that be, you might find some initial funding through grants.
Debt is money that you borrow, usually from a bank. You have to pay it back. The bank does not care how successful your business is or how many customers you have lined up or how you’re going to be worth millions someday. On the 1st of the month, your payment is due with interest. If you miss it, the bank can shut you down. At the very least, they may increase your interest rate and charge you a penalty.
It is hard to get debt financing without having collateral to invest, since banks like to keep risk minimal. In other words, if you want to borrow $50K, it helps if you already have $50K saved so you can pay it back if need be.
Small business owners will often use the one thing of value that they own as collateral: their house. This is a spectacularly bad idea, for several reasons, unless you have a lion-tamer level of risk tolerance and incredible certainty in your success.
First, most businesses fail. Second, you should try to keep your personal finances and business finances separate, both for liability reasons, and for ease of exiting the business should you choose to do so. Third, all entrepreneurs will tell you that it is best to start a business with other peoples’ money: investors know that not all of their investments will succeed, and are able to spread out that risk. The risk of losing your house is very, very real, and will hurt you much more than losing some cash will hurt them.
The last kind is equity financing. This is the part everybody thinks about when they think of entrepreneurs. They dream of owning a percentage of the Next Big Thing, then cashing in their stock to retire early, or they have nightmares of the business going under and them having nothing to show for it but worthless stock certificates.
They’re not far off. Equity financing means that you give up a portion of your business in order to get funding. This is not a decision to make lightly: you are giving up some control over running the business, and you may find it difficult or impossible to extract your investor from the relationship later on.
It’s not always a good idea to pay employees in stock–are you absolutely certain you want the bargain-basement web designer you hired in your first week of business to be a part of your company for the next 5+ years? Furthermore, there are plenty of contractors who were either burned in the dot-com bust–or who have a realistic idea of how unlikely it is that ownership in your company is ever going to amount to anything–and will therefore not work for anything other than cold, hard cash.
So if you don’t qualify for a grant, you don’t have collateral to take out debt, and you don’t want to give up ownership of the company, how do you fund it?
Again, wrong question: what funds do you have access to? Can you borrow from the traditional trio of Friends, Family and Fools? Do you have savings from your current “real” job? Can you bootstrap?
Bootstrapping, or starting a non-capital-intensive company with minimal funding, is a popular way to start a business; something like 90% of technology companies are bootstrapped. Do you need to buy a color printer right away, or can you use Kinko’s? Can you work out of a home office? Can you do most of the work yourself? Can you sell enough goods or services to give you enough cash to make some small profit which you can then reinvest to grow the business?
That last strategy is called “customer financing.” Yes, you might be able to grow faster if you had a sudden injection of cash. And if you had wings, you could fly. At any rate, there’s no more traditional way to run your business than by growing organically and reinvesting your profits.