A startup is a newly formed, high-growth business that develops innovative solutions in the form of a single product or service that it offers to massive markets to achieve exponential, rapid growth. In other words, it’s a company in its first stages of operations that’s characterized by innovation and technology, high scalability, speed, and market disruption.
However, all of these come with risk, high uncertainty, and a substantial capital requirement, which is needed to offset high initial costs and limited early revenue. Because of this, startups continually seek funding not only during the initial phase but as it grows too.
Funding is a critical factor for a startup to succeed, most notably, collateral based business loans. Research from CBInsights revealed the most common reason why startups fail: It’s experiencing financial issues, such as failing to raise new capital, running out of cash, or cash flow problems. In short, a startup runs out of money and is forced to shut down operations.
Startups can secure funding from various sources, such as venture capitalists, angel investors, and crowdfunding. They can also turn to credit providers like banks and other financial institutions or credit providers that dole out small business loans, including those that require a collateral.
Common Uses of Collateral-Based Loans for Startups
Because startups aim for rapid or exponential growth in such a short time, they will lack a long-term credit history or multi-year track record which are necessary to unlock capital. So, pledging a valuable asset to reduce the lender’s risk allows startups to qualify for business loans.
Startups commonly use collateral-based business loans in the following ways:
Purchasing Equipment and Machinery
A startup that manufactures its own innovative products can use a collateral-based equipment or machinery loan to purchase physical machinery, specialized tools, computers, or other technology. Also known as equipment financing, the machinery itself will serve as the collateral for the loan.
Many lenders will finance 80% to 90% of the equipment’s value. The difference will be paid by the company as down payment. Equipment financing typically has a fixed rate and comes with repayment terms of up to 10 years or longer.
Funding Inventory Purchases
A startup that is expecting a peak sales season would like to buy stock in bulk ahead of time. This is where an inventory-based loan comes in, and companies use it to finance inventory purchases. This is typically a short-term loan that takes a startup’s inventory or physical stock as security for the borrowed funds.
Similar to equipment financing, inventory-based loans rarely lend 100% of the inventory’s value, but lenders will advance 20% to 80% of the appraised or wholesale value of the stock. Depending on the lender, the cash advance will either be deposited into a company’s business account or will be used to pay the supplier directly.
Working Capital and Cash Flow
A collateral-based business loan used to cover short-term working capital gains and smooth cash flow fluctuations is called a working capital loan. It is an asset-based loan that uses a company’s short-term assets, typically its inventory and accounts receivables, as security for the loan.
This funding is usually used to cover daily operating expenses, vendor bills, and payroll while the company waits for its customers to pay, especially when those payments are late. Part of the arrangement for this loan are in-depth appraisals and regular reporting on the assets used as collateral.
Leasing or Upgrading Real Estate
Startups can also use a collateral-based business loan to pay for office or physical storefront leases, secure a production facility, or upgrade real estate. If it’s a real estate purchase, the property automatically becomes the loan’s security.
Large-Scale Growth Initiatives
As startups grow, they need more funding for regional expansion or major marketing campaigns. So, pledging a valuable asset they have on hand for more money can fuel their growth and potentially catapult the company to the next level or phase.
Seed Round Vs. Growth Round Funding
Acquiring capital to get started on their idea happens in the seed round. Seed funding helps startups build out their idea and validate its potential in the market.
But, to keep funding their growth, startups will need another round or series of rounds of capital fundraising. This phase is known as the growth round. Startups use the funding they get in this phase to grow the business, in particular to reach more of the customers they have already identified during the seed round.
Startup Seed Round Funding Sources
In the seed round, startups typically get their financing from a mix of the following sources:
- Venture capitalists
Seed-stage venture capital funds finance the startup to help it validate product-market fit. Venture capitalists will only invest in companies they believe have high growth and market leadership potential. In exchange, they will receive equity.
- Angel investors
Angel investors are high net worth individuals who invest their own capital into the startup. They also bring mentorship and industry connections to the table.
- Crowdfunding
Startups can also get initial or seed round funding by using online platforms where they can collect small financial contributions from a large pool of people. This is called crowdfunding.
These platforms can be reward- or equity-based. A reward-based crowdfunding platform allows startups to give their backers non-monetary perks, such as early access, discounts, or the product itself (acts like an upfront pre-order). Meanwhile, in an equity-based crowdfunding platform, startups give their backers shares or ownership equity in the company.
- Accelerators and incubators
Startups can also tap accelerators and incubators for initial funding. These are programs that provide funding, resources, and mentorship in exchange for an equity stake in the company of usually 3-7%.
Growth Round Funding Sources for Startups
During the growth round, startups typically apply for loans or debt financing. After proving product-market fit, they now have predictable cash flows or active scaling metrics required to service debt.
This typically comes in the form of venture debt or bank loans. Both allow the company to extend their runway (number of months before it completely runs out of cash), fund capital expenditures, or finance inventory without further diluting founder equity.
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