Money to build the business is the number one challenge for most startups. Don’t believe the urban myth that you can sketch your idea on a napkin, and professional investors will throw money at you. In reality, only 3 out of 100 companies who apply are successful with Angels, and the success rate with VCs is even lower. A large percentage of startups never apply to either.

You need to explore more common and more productive approaches for getting your startup moving forward. Of course, every approach has pros and cons. For example, with any outside investment, you give up some ownership and control, and with bootstrapping your growth curve will likely be longer and more organic.

Yet, I find that startup founders often fixate on one or two sources, often to the detriment of their business. Following is my prioritized larger list of sources, with some “rules of thumb” which may save you a lot of time and energy:

1. Bootstrapping. Self-funding is the preferred source of cash for your startup – if you can do it. The advantage is no time and effort searching and preparing for the other alternatives, and you don’t have to encumber yourself or give up control of your company. Just don’t quit your day job before your new company is producing revenue.
2. Friends and family. After bootstrapping, friends and family are the most common funding sources for early-stage startups. Use this approach before you have a real valuation, a real product, or any real customers. As a rule of thumb, it is a required first step, as outside investors will not normally consider providing any funding until they see “skin in the game” from one of these first two sources.
3. Small business grants. This source often gets overlooked, but it should be a major focus these days due to government initiatives on alternative energy and technology. It’s not a quick solution, but state and federal funding agencies do not want ownership or interest payments from your company. Related sources include local business development agencies. You have to be relentless in this pursuit to win.
4. Loans or line-of-credit. If your company needs only a temporary or small infusion of cash, you should try for an SBA loan, or a bank line of credit. Many people are afraid to tap into debt sources because they don’t want to be burdened with the debt if the startup fails. However, if you don’t believe in the company enough to place your own credit behind it, why should anyone else?
5. Startup incubators. A startup incubator is a company, university, or other organization which provides resources for equity to nurture young companies, helping them to survive and grow during the startup period when they are most vulnerable. These resources would likely include office space, consulting, and even a cash investment.
6. Angel investors. If you are looking for $25,000 to $1 million, the next step is to tap into a local angel network. If you don’t know any “high net worth” individuals, use your advisors to find them. Networking is key here, and you need to find an angel who understands your industry and shares your passion.
7. Venture capital. As a rule of thumb, don’t try this one in the earlier stages, and don’t try it unless you need more than $1 million. An investment from a venture capital firm is usually expensive, in equity and control. If you go for venture capital, don’t expect a quick fix, so prepare to spend at least six months searching for and closing the deal.
8. Bartering services for equity. Bartering technically means exchanging goods or services as a substitute for money. An example would be getting free office space by agreeing to be the property manager for the owner. Exchanging equity for services is worth negotiating with legal counsel, accountants, engineers, and even sales people.
9. Partner with distributor or beneficiary. A related company may see the value of your product as complementary to theirs, and be willing to advance funding, which can be repaid when you develop your revenue stream. Consider licensing and “white labeling.”
10. Commit to a major customer. Find a customer who would benefit greatly from getting your product first, and be willing to advance you the cost of development. The advantage to the customer is that he will have enough control to make sure it meets his requirements, and will get dedicated support.

Just remember that you don’t get ‘something for nothing’ in any of these cases. All funding decisions represent complex tradeoffs between near-term and long-term costs, ownership, control, and time and effort. Your funding strategy is a key part of every business plan, so don’t hesitate to check out the real alternatives.

The name “investment bank” somehow always sounded like a place where I could somehow deposit my investments, and maybe even earn a little interest. Then I learned that these banks really negotiate investments and collect fees on the transactions, sort of like commercial banks do with loans to businesses. None normally work for or provide funds for early-stage startups.

Many investment banks even call themselves “boutiques.” As near as I can tell these are smaller ones, who don’t sell clothes, but typically sell companies and securities in a particular set of industries. All investment banks have to be staffed by licensed specialists, called broker-dealers. Very confusing.

None of these investment banks offer traditional banking services, as you would expect from one of the following:

• Retail banks
• Commercial banks
• Credit unions
• Savings and loans

As startup founders, you first need to deal with one of these banks, probably a commercial bank. Commercial banking is also known as business banking. That would be almost any bank that provides checking accounts, savings accounts, and money market accounts to businesses, and also makes loans to businesses. It may be the same physical bank that you deal with for your personal account, except in the personal context it is called a retail bank.

Most retail and commercial banks offer investment services to their customers, but these services have nothing to do with investing in your business. Typically, their service is to help you invest in stocks, bonds, or mutual funds, much like independent financial advisors.

A few, like Silicon Valley Bank (SVB), actually do provide management services to startups, invest in startups, or provide early-stage venture capital, but that is not called an investment service and is part of a function called Emerging Technologies, or sometimes Private Equity.

So unless your business is well established, and ready to sell or go public (Initial Public Offering – IPO), you should steer clear of investment banks. Officially, the investment banks mission is to raise money for companies by issuing and selling securities in the capital markets, and providing advice on transactions such as mergers and acquisitions.

Investment banks normally charge fees consisting of three components. There is an upfront or monthly retainer, and maybe a closing fee, of at least several thousand dollars. In addition, they will likely take between 3% and 10% of any capital raised. For these fees, they will develop a business plan, solicit investors, and negotiate term sheets to a closing.

Another service of investment banks is the buying and selling of “derivatives,” which many believe to be some arcane financial products to dodge government regulators, encourage foreign currency speculation by pension and mutual funds, disguise risky gambles with AAA Standard & Poor’s ratings, and avoid capital gains taxes for wealthy individuals.

After the banking fiasco surfaced a couple of years ago, resulting in the failures of Bear Stearns and Lehman Brothers, investment banks seem to most of us more like a place to avoid, rather than a place to entrust with the keys to our investment livelihood. I’m not sure whether derivatives per se were the problem, or the fact that they were often backed by worthless subprime mortgages.

Startups looking for an Angel investor, or a Venture Capital investment usually realize that neither of these sources of funds normally has any connection with a bank. Yet every business needs to have a good relationship with a bank, for day to day operations. I guess it’s no wonder that banks are struggling these days with their public image. Their message and mission is confusing, even to professionals. As your business evolves, don’t let that happen to your own message.

Most entrepreneurs have learned that it’s almost always quicker and easier to get cash from someone you know, rather than angel investors or professional investors (VCs). In fact, most investors “require” that you already have some investment from friends and family before they will even step up to the plate.

You see, investors invest in people, before they invest in ideas or products. Since they don’t know you (yet), their first integrity check on you as a person is whether your friends and family believe in you strongly enough to give you seed money for your new idea. If they won’t do it, they why would I as stranger invest in you?

Friends and family will likely not expect the same level of sophistication on the business model and financials as a professional investor, but they do expect to see certain things. Here is a summary of some key items to think about as an entrepreneur before approaching friends, family, or even fools:

1. Don’t be afraid to ask, carefully. If you set around quietly waiting for someone you know to offer you money to fund a startup, you will probably have a long wait. On the other hand, if you open every conversation with “I need money,” you won’t have any friends or any money. Practice your “elevator pitch,” and end it by asking for the order.
2. Be upbeat and respectful. Nothing kills everyone’s optimism and desire to help quicker than a negative or arrogant attitude. If they are going to put cash into your company, chances are that they will expect to spend a fair amount of time together, either helping you or certainly discussing progress. Nobody likes a downer.
3. Be passionate about the idea. Friends and family will quickly detect your level of sincerity and thought behind the idea. You need to convince them that you have been working on this vision for a long time, and have done the “due diligence” on all the potential knockoffs. Daydreams and “the idea of the moment” won’t get much respect.
4. Demonstrate progress and your own “skin in the game.” Saying that you need money to start is not nearly as convincing as saying that you have built a prototype on your own dime, but need more to roll it out. We all know people who can talk a good game, but never get around to building anything.
5. Ask for the minimum rather than the maximum. We would all love to have a million dollars of funding to “do it right” and build the company of our dreams. But your chances are minimal of finding someone who will give you that much to start. Set some milestones for three or four months out, and show what you can do, then ask for more.
6. Communicate the risks, and write down the agreement. Be honest with naïve family members and friends about the inherent risks of a startup – at least 70% fail in the first five years. Don’t take money from family or friends who can’t afford to lose it. Think hard about the consequences of a possible startup failure and the loss of their funding.
7. Show some incremental value along the way. Look for ways to get some traction with a minimal product, while you are still developing the main event. In high technology, this is called “release early and iterate,” which allows you to make corrections as you go, as well as adjust for the market changes. It also shows progress to early backers.
8. Network to build investor relationships before you ask for money. Having a real project, rather than just an idea, is a strong positive when networking for angels or VCs. Now you really have something to discuss, and real credibility as an entrepreneur. Build the relationship first, ask for advice on a real project, then maybe money later.

Overall, don’t think of friends and family funding only as a last resort. There are massive advantages, like sharing profits with friends and family, as well as the strategic credibility than can be gained from funding from someone you know, rather than from a professional investor.

I hope all of these points seem like common sense to you, and you wouldn’t think of handling it any other way. Yet, I’m continually amazed at how often I am approached as a professional investor by strangers asking for a million dollars to fund an idea, without hitting even one of the above points.

We can all recount horror stories of families and friendships torn apart by money lost on someone else’s speculative dream. In these cases both the entrepreneur and the funding partner are the fools. Don’t be one.

I’m hearing more and more these days about a new type of small business, called a “microbusiness” (or microenterprise). These are usually characterized as owner-operated, with five employees or less, and less than $250,000 in sales. With the low cost of e-commence entry, and powerful Internet technologies, they require minimal capital to start, perhaps as little as $500.

I see the potential for these to become big business in this entrepreneurial and struggling economy. According to The Association for Enterprise Learning in Chicago, microbusinesses added more than 2.5 million jobs to our economy in the last two years. Microbusinesses are usually run out of the home, and range the gamut of consulting services to e-commerce.

Dal LaMagna, in his humorous new book “Raising Eyebrows: A Failed Entrepreneur Finally Gets It Right,” leads with the foundational principle of microbusinesses, which is to start small. This allowed him to learn enough from all his early mistakes to hit it big with a global beauty tools company called Tweezerman. He offers several additional principles as follows:

1. Tailor the business to you. Do you love antiquing? Fishing? Cars? Cooking? Now, think about what pursuing this passion might mean for your lifestyle. Think how you want to spend your day; where you want to live; whether you want to work with people or alone; in the morning or at night, and so on. Eliminate any aspect of your business that doesn’t create your preferred lifestyle — and will work against you.
2. Be frugal. Don’t spend money you don’t have. Don’t invest in anything you don’t need. If this means baking cupcakes in the local church basement and delivering your signature pastries by bicycle to local stores — two dozen at a time — do it. Take the money you make and put it right back into the business.
3. Record every expense. From the dollar you gave to the homeless guy on the way to meet a prospective client, to the new tie you bought to look professional, write down every single penny. The key to launching a microbusiness is to keep expenses under control and fully accounted for.
4. Keep a monthly profit-loss. For the first two years of your business, complete a monthly profit-loss statement. This helps you stay on top of where your business is going, where it could do better, and why it fluctuates.
5. Find free stuff. Many items needed to start and run your small business are available for free or next to nothing. Be creative. Use freecycle.com; ask friends if they have an old computer or printer; or visit a thrift shop for office furniture or office supplies.
6. Write down agreements. With a very small business, your clients sometimes make the assumption that they don’t have to sign an agreement. Wrong. Get in the habit of thinking like a company founder and get promises in writing. And while you’re at it, keep your side of agreements.
7. Keep it simple. When Dal first started Tweezerman, he did nothing but focus on tweezers and selling them to cosmetic counters, one store at a time, which he did very well. If you can do one thing well, don’t dilute your efforts until you have been turning a large profit over a consistent stretch of time.

My net recommendation is that if you consider yourself a do-it-yourself entrepreneur, preferring to do things yourself rather than forking over money to consultants, then definitely the microbusiness approach is for you. The down side is that you business will probably grow slowly and more organically.

If you prefer to rely on others for most things, or want to get there fast, the investor approach may be the best answer, but the price is higher in time, dollars, and control. It’s your choice, but remember that the wrong choice probably won’t get you there at all.

Too many entrepreneurs develop a new product without regard to market demand, then build an entire strategy based on creating a need, rather than acting on an existing market need. Investors characterize this approach as a “solution looking for a problem.” These don’t get funded.

The best startups find a way to drive the market with their technology, rather than push their new technology-driven ‘solution’ on the marketplace. An example of market-driven technology is the basic automobile, but combining a car with an airplane is technology looking for a market.

New technology really doesn’t have any value, until it is integrated into a market-driven solution. Here are a few thoughts on a process that will keep you on the right track:

• Get real customer input first. Temper your product with actual market and customer feedback. Everyone’s personal perspectives and interests are different, so the key is starting from market problems, and going from there to technology – not vice versa. Show your prototype to real customers, and listen.
• Quantify the pain points. Measure the major pain points in time or dollars, based on feedback from intended users of your product or service. Users that ‘like’ your product, but have no pain, will not pay real money or endure change for your product (early adopters won’t make a market).
• Keep it simple and easy to use. Have you solved the user problems in the simplest possible way, with the fewest possible features? Or have many features been thrown in, just because the technology can deliver them? Easy to use and lots of features are usually contradictory statements.
• Analyze how competition will react. If you are tempted to respond with “We have no competition,” then you almost certainly have a solution looking for a problem. Think about how your customers have survived all these years without your product, and how many will pay your price to change. Will your competitors quickly copy you, or under-price you?
• Experience the pain first-hand. The best entrepreneurs solve problems that they and their team have personally experienced. This will keep you laser-focused on the solution, and make you more effective and credible in selling the solution.

I’m sure that some of you are thinking by now that if all entrepreneurs followed these guidelines, the world would have missed many great leaps in technology, like the laser, television, and the Internet. These are usually called ‘disruptive’ technologies.

Disruptive technologies and grand new solutions can ultimately change the world, and create a large opportunity, but they are not exciting to early-stage investors for the following reasons:

• Fundamental changes take a long time to happen. According to the Gartner Hype Cycle, every major new technology goes through four stages before reaching general acceptance, and that can take as long as 20 years. Investors are looking for a big return in five years. Only people and organizations with their own big resources will survive.
• Creating a need is much more costly than marketing to an existing need. To build a new market, you have to educate people on the concept, create the “need” in their mind, and solidify it by constant repetition. This means building a brand, viral marketing, and multiple expensive promotions. Early-stage investors won’t risk this much.

So, if you have a new technology that you believe can change the world, you need to team with someone who has really deep pockets. Angel investors can’t help you, and most venture capitalists won’t be interested in contributing the first several million.

Perhaps a better alternative is to focus on existing problems with real pain points, and customers that have money to spend on a better solution today. You will get help from investors, feel the near-term satisfaction of success, and build your skills and your bank account for that earth-shaking new technology the next time around.

If your startup desperately needs an investor, you may not care if the investor is a so-called “angel” investor, or a venture capitalist (VC). The money is the same color in either case. But I have found that making the right choice at the right time can have a major impact on your long-term success, and the decision process is complex.

The basics are simple. Angels are typically high net-worth individuals, investing their own money, interested more in early or “seed” financing of amounts starting as low as $25K. Venture capitalists are professionals, investing other people’s money from a fund, interested mostly in later rounds, in chunks of money from $2M up. Between these extremes is a large overlap.

But beyond the numbers, there are many factual and subjective issues that you should be aware of before you step into the game. These include the following:

1. Investment control. Angels typically have simpler term sheets, don’t squeeze so hard on valuations, and are more realistic on time-frames. VCs tend to exert more control over the team and assert financial control over the company, its strategy and exit plans. Ultimately a larger VC investment can also narrow exit options.
2. Type of startup. Venture capitalists seek to fund businesses with the potential to be enormous. In addition, most venture capitalists want startups that have clearly defined economies of scale (such as software companies) vs. ones that scale linearly with some factor (such as service companies). Angels are less type-focused.
3. Expected return rate. Most venture capitalists tell you that they look for 30% annual return, or 10 times initial investment in 3-5 years. Another rule of thumb is a target of 50% IRR (a discounted cashflow calculation). Angels will look at lesser opportunities, but both recognize that many ventures fail, meaning the targets are high to improve the average.
4. Total money needed. I already mentioned that if you are looking for a specific raise of less than $2M, you are in angel territory. But it goes further than that. If the total money you’re looking to raise over the life of your company to be cash-flow positive is greater than $3M, or you will likely need money to scale, you need to work the VC territory.
5. Team experience. Successful serial entrepreneurs usually find it easier to raise money from venture capitalists. If you’re a first-time entrepreneur, that doesn’t mean you can’t raise VC money, but you’re going to find it more difficult getting VC traction.
6. Founder network. If you’ve never met a venture capitalist before and none of your colleagues have built companies with VC funds, you probably won’t get VC traction either. In contrast, if your best friend’s father is the CEO of a Fortune 1000 company, you might readily find a valuable set of angels.
7. Value-add. This is the most debated, but most important item. The value-add of both angels and VCs is totally dependent on the individuals involved, but on average VCs are likely to add more value than angels. They focus on specific business areas, have multiple deals running concurrently, understand deal flow, and usually have more current insights, connections, and resources.

Personally, I think it all comes down to the investor fit and the stage of the start-up game you are in. It’s definitely better to have people who have built businesses on your side. If you plan to exit in the near future, it’s important to have investors who have backed high-growth businesses.

For all cases, relationship is the key ingredient to a successful deal. It is very important to be able to communicate with your investors openly and honestly. If they respect and trust you as a person and you respect and trust them, it will be much easier to weather the inevitable storms. It’s easy to take any money that’s green, but in the end it can be more costly than it’s worth.

A common question I get is “How do I get a bank loan to fund my startup?” The default answer is that it probably won’t happen, because most banks just don’t make bank loans to startups. The failure rate is just too high, and startups typically don’t have the assets or revenue stream to back up the loan. That’s why angel investors are so sought after by entrepreneurs.

In my experience, some startup founders do overcome these odds, but you need to be realistic and do your homework. Here are some tips and rules of thumb to improve your odds and help you understand when a bank loan or line of credit is possible, and how to get it:

1. Write a good business plan first. Approaching a banker without a business plan, and asking for money, is a sure way to be rejected and leave a bad first impression. Pay particular attention to the financials, and have a CPA friend review for reasonableness before presenting.
2. Clean up your credit rating before you apply. Good credit ratings, both personal and business, are essential to getting a loan or line of credit. This is just common sense, since every loan has a repayment schedule, and your credit score reflects your track record of paying bills on time.
3. Pick a business domain that is squeaky clean. Certain business sectors have historical high failure rates and are routinely avoided by banks and investors. These include food service, retail, consulting, work at home, and telemarketing. Also, don’t expect enthusiasm for your gambling site, porn site, gaming, or debt collection business.
4. Show a significant personal investment. Most loan programs, and most investors, want to see that you have “skin in the game’ before helping you. If you have nothing at risk, your own level of commitment is suspect. As a general rule, your investment should be at least 20% of total projected loan requirement.
5. Demonstrate an ability to repay from revenues, not collateral. Bankers will insist that you have collateral to back the loan, like equipment, or even your home. They actually prefer to see that you have a revenue stream to repay the loan, since they don’t want to own another home. The most conservative ask for two years of positive cash flow.
6. Demonstrate experience in starting a business, ideally in this domain. Bankers, like investors, fund people rather than ideas. Your idea alone will not get you a loan, but your experience running businesses may get you a loan, even if not intimately related to the current proposal.
7. Conduct meetings at your site, not at the bank. You have an advantage if you can get them on your turf, and even get several key employees to tag-team the presentation. If you are a startup operating out of your garage or basement, you are likely too early in the cycle to get banks interested.
8. Eliminate your salary from the use of funds. Most startup founders don’t take a salary for the first year or two, since most investors as well as bankers won’t give you money so that you can pay yourself. The most positive use of funds is to buy raw materials to build product for existing customer orders. In fact, customer orders are great collateral.

Even if you can’t meet all these criteria, it’s definitely worthwhile to utilize the free services of the Small Business Administration (SBA) and SCORE in the US to get their help in preparing for the loan option. They have contacts with the more “startup friendly” banks in your area, and might even be able to arrange a “loan guarantee” if you meet some of these criteria.

In all cases, the loan option should be investigated before looking for an angel investor, since the “cost” of a loan is usually considered less than giving up a large share of your company equity and control to angel or venture capital investors. I’m told that 21 companies on the Inc 500 list started with bank loans, so you can do it too.

Many entrepreneurs are convinced that banks are not worth the effort for startups, especially early-stage ones that still don’t have a revenue stream, or collateral to back up their financing needs. A question I get all the time is “Can I ever expect any backing from my bank for a great opportunity?” The short answer is that some banks will help, if you do your homework.

The first thing to remember is that banks only do loans – they don’t do equity investments like angels and venture capitalists (and vice versa). To get a loan, you generally need to satisfy their 3 C’s – credibility, capacity, and collateral. That traditionally translates to at least two years of positive cash flow, with enough assets or receivables to cover at least 80% of the loan.

If you don’t have that, there are things that you can do to compensate. All banks are looking hard right now to get back in the game, and certain ones, like Silicon Valley Bank, are more focused on small businesses. I found a great discussion with Mark Horn, a former Silicon Valley Bank senior vice president, published by Jill Andresky Fraser some time ago, which outlines seven issues Mark says every startup must address when pushing the limits for a loan:

• A clear mission. You have to get past how great the product is to address clearly what your business rationale is, why it is different from the competition’s, and why it will succeed. Be concise as well as complete. Show focus and your understanding that your company is something more than just a good idea.
• A winning product or service. Provide a simple yet complete description of your product or service and its competitive marketplace. Include any empirical evidence–including market research or technical analysis, if that’s appropriate–in order to bolster your case about why you believe you will succeed.
• An impressive team. When we say ‘team,’ that’s what we want to hear about: a group of people who are working with the person who had the original idea to give this company its market advantage, including salespeople and finance people. If you don’t have a team on staff, then a banker is going to want to hear about outsourcing and advisors.
• Management with a strong track record. When describing each key person on your team, it’s important to describe his or her employment history, with an eye toward convincing the banker that the person’s experience will help your company achieve its goals. Here, too, focus on outside advisers as well as on key executives.
• Partnerships that lend credibility. Be comprehensive here. What a banker is looking for is validation of your idea. If you’ve succeeded in bringing savvy investors or corporate partners aboard, then that can be a pretty good sign that your idea can succeed in the marketplace.
• Money from other sources. This question gets to the heart of what bank financing is and isn’t supposed to accomplish. Bankers do not contribute equity. What they’re looking for is a situation in which others have already done that, so the bankers want to see the owner’s money involved.
• A realistic cash plan. What any banker will want to know is, basically, how much money you’ve already raised and how quickly you’ve gone through it; how much you’re currently spending; and finally, at what point you anticipate earning the revenues to sustain a positive cash flow.

Finally, remember that at almost any bank you’ll need to back up your financing pitch with audited financial statements, a well-thought-out business plan, credit check, and maybe even your personal tax returns as well. That’s just reality.

In case you hadn’t noticed, the items highlighted by this banker are equally important to equity investors, so you need to do the work in either case. In the long run, bank loans are considered “less expensive” than giving up equity and giving up control, so a savvy startup should never skip this alternative.