The landscape for startup financing has changed considerably over the past few years as both the availability of financing and the cost of various options were affected by various trends in the industry. And those trends are going to continue to wield influence on the financing arena in the coming year. To help you stay up to date, here's a look at some of those trends and how they can help you get money to fund your business.
1. Angel investing will continue to grow.
In the late 1990s, angel investing came out of the funding closet and entered the financing mainstream when technology companies appeared to provide supernatural returns on investment. It seemed as if everyone knew someone who knew someone who was an early investor in an internet startup that cashed out just in time. Today, there are about 250,000 angel investors in the U.S. investing in approximately 50,000 small companies each year. Next year, you should expect that angel investing will continue to grow in popularity.
This growth may be fueled in part by tax incentives and behavioral attitudes related to how investing patterns are changing. In 2007, Congress will debate a bill recently introduced by Senators John Kerry and Olympia Snowe that will provide a tax credit for high net worth individuals who make private investments. Whether these tax incentives make it into law or not, the investment behavior of high net worth individuals, I believe, has fundamentally evolved to the point where they regard startup investments as a viable part of most investment portfolios--financial advisors and attorneys now frequently screen and recommend startup deals for their clients. The bottom line is, angel investing is here to stay.
2. Valuations and investment terms can't get much better.
If you're in doubt that we're living through another startup financing bubble, consider the following statistic provided by the Center for Venture Research : The yield rate on angel investments (the rate at which investments presented to angels result in funding) increased from 10 percent in 2003 to 23 percent in 2005. (At its historical peak in 2000, the yield rate was also at 23 percent.) Either companies are becoming more worthy of funding, or the bubble is back. Pre-launch startup valuations involving first-time entrepreneurs have climbed to more than $5 million, rather than their post-bubble levels of $1 million to $2 million. You should expect them to stabilize at $2 million to $3 million in the near future.
3. Business credit scores will supplement personal credit scores.
For those seeking debt financing, credit cards continue to be the most popular source of capital. In the past, credit card issuers have traditionally made financing decisions for small-business applicants based largely on the personal credit score of the business owner. More recently, however, credit data for the business itself has been aggregated in data repositories. The Small Business Financial Exchange (affiliated with Equifax) [link: http://www.sbfe.org/inquiries/], for instance, collects data based on the performance of small businesses on their loans, leases, lines of credit and credit cards. And banks and other lenders are increasingly using this data on the business itself to supplement their existing underwriting criteria of the entrepreneur. In fact, almost all the top 20 banks in the country now use data from small-business data repositories to make lending decisions. This trend should continue as additional credit reporting agencies aggregate business data and the predictive ability of this data becomes clearer.
4. Getting $50,000 in funding continues to be difficult.
According to the Global Entrepreneurship Monitor, the average amount of startup capital used by small businesses in industrialized countries is currently $53,000. But the reality for most entrepreneurs is that credit card financing isn't sufficient for raising $50,000, and angel investors tend to avoid being the only investor in a company that's poorly capitalized.
So where are entrepreneurs getting the money they need? At CircleLending, we constantly see clients who are facing this issue turn to relatives and friends to help fill the gap. And while some seek government funding, those options may not be as available as they were in the past: The SBA Microloan Program was originally designed to serve this capital gap. However, funding for the program has been on the chopping block lately and hasn't been aggressively marketed by SBA lenders, so it's unclear whether the program will be revitalized in the future.
Nonprofit microlenders have traditionally struggled to get to scale and compete with banks to serve this niche. One promising trend might help level the playing field: The microlenders are banding together to convince the credit bureaus to include performance of microloans in credit scores, making these loans a more viable option for those who want to use small loans to build their credit.
5. Low credit scores are no longer a constraint on financing, but patient capital continues to be a critical barrier on success.
I've often lamented how the four Cs of credit (cash, credit, collateral and character) have been reduced to just one C: your personal credit score. If you have a good business idea but a mediocre credit score (or no credit score because you're too young or too new to the country), your options in the past were limited. And unless you were willing to bet your home equity on the business, your cost of capital would be considerably higher than it would be for someone with good credit.
However, online lenders and nontraditional person-to-person lenders have developed some genuinely unique options for entrepreneurs with poor credit as I described in a recent column . And while the cost of capital continues to be higher for borrowers with no credit or low credit even with these new options, the accessibility of credit options has never been easier.
But perhaps a more critical problem is the lack of patient capital (funding from people who don't expect short-term liquidity from their investment) and long-term financing options for entrepreneurs with sub-prime credit. Paying interest rates exceeding 20 percent on loans becomes unsustainable if your business can't generate 20 percent earnings growth. For most startups, this is a pipe dream in the short-term (two to three years) but seems more plausible over the long-term (four to six years) after the business is established. In my view, patient capital is one of the most important financing needs for startups and among the hardest to find. Unfortunately, I don't see this trend changing anytime soon.
Asheesh Advani is CEO of Covestor, an online marketplace for investors. He founded CircleLending, which was acquired by Virgin.