Types of Funding for Startups

A great idea can give birth to a startup, but only funding can sustain it to maturity. And unless you’re independently wealthy, you’ll need outside financing to develop and grow your business.

Fortunately, many sources of financial backing are available. Some—venture capital, bank loans—are widely known. Others you may not be aware of. This article reviews them all. It discusses:

• Government funding
• Philanthropic support
• Intermediary organizations and non-governmental organizations (NGOs)
• Anchor institutions (such as universities)
• Private capital (including accelerators, angel investors and venture capital)

If this subject interests you, you might want to consider enrolling in my online course Beyond Silicon Valley, which discusses all these funding sources and more in detail.

Government funding

As you contemplate funding sources for your startup, the government may not spring to mind. We tend to think of government support solely or primarily in terms of assistance to the needy.

In fact, state and local governments actively encourage and support new businesses, and for good reasons: emerging enterprises create wealth, jobs, and tax revenues, triggering beneficial ripple effects throughout their communities and beyond.

20 years ago, my hometown Cleveland was not exactly known as a startup hotbed. Entrepreneur Magazine placed Cleveland dead last in its annual ranking of friendliness to entrepreneurs in 2002.

Since then, however, the city and state have focused on helping entrepreneurs raise money to start businesses. In 2002, the State of Ohio launched Ohio Third Frontier to address the lack of support for entrepreneurs and startups. Its mission was to provide financial support to key technology sectors where Ohio possessed strengths relative to the US and the world. The program replaced an assortment of fragmented strategies with a unified $2.3 billion, voter-approved program that created a pool of money and additional resources.

Ohio Third Frontier filled a void, delivering funds and services that were otherwise unavailable in the local market. In many cases, its most important function was getting the ball rolling. Once the innovative companies the program funded launched and demonstrated promise, follow-on funding from other sources, including private investors and banks, ensued.

Consider CardioInsight, a medical device company that developed a novel 3-D technology for mapping cardiac disorders. Co-founder Charu Ramanathan developed the technology at a Case Western Reserve University lab in the early 2000s. Government funding played an important role in the launch of her company, providing roughly 10 percent of the financing raised by CardioInsight.

“If your project is sound, and you’re able to articulate exactly what you’re going to do in a paper, in [the state government’s] format, you get the money,” she said. Charu feels strongly that if her company had to exist solely on private financing, it would have had to move out of Cleveland. Medtronic acquired the company in 2015 at a cost of $93 million.

How do we know when government funding has provided benefits? Lisa Delp, former executive director of Ohio Third Frontier, explains: “Three key metrics are considered: job creation, tax revenue, and the amount of follow-on capital that’s raised by entrepreneurs after the state investment.”

Philanthropy

Philanthropy has played a major role in Cleveland’s development, a tradition that continues to this day. In the mid-nineteenth century, energy monopoly Standard Oil operated from Cleveland. Its leader John D. Rockefeller was the wealthiest person in America; he helped establish the modern, systematic approach to philanthropy through the creation of foundations. Cleveland benefited greatly.

Skip ahead to lawyer and banker xx Frederick H. Goff, who in 1914 established The Cleveland Foundation, the first community foundation in the US. Initially, it supported cultural institutions like The Cleveland Orchestra and The Cleveland Museum of Art. It subsequently evolved to support a wide array of community and economic efforts. The success of The Cleveland Foundation inspired the creation of similar community foundations in other cities nationwide and now in countries.

A downturn in Cleveland’s manufacturing base led to a period of significant economic decline. Philanthropy ebbed as if in sync. The Ohio Third Frontier program was conceived in 2002 to stem those losses. Two years later, Burton D. Morgan Foundation and other Cleveland organizations came together to form the groundbreaking Fund for Our Economic Future —groundbreaking because it sought to change the trajectory of the regional economy through a massive resource infusion. Leading foundations in Northeast Ohio came together and agreed to pool their economic development resources, focusing especially on entrepreneurship because entrepreneurship is an important, albeit long-term, engine of job creation.

Today, startups in Northeast Ohio benefit from the Fund for Our Economic Future and many individual philanthropic organizations, such as The Cleveland Foundation and Burton D. Morgan Foundations.

Philanthropists differ from private investors in several significant ways. They make their grants to intermediary organizations, usually not to startups directly. They aren’t in the business of owning equity or debt in a for-profit company or making operating decisions for a company. One grant to an intermediary organization may be the first and last stage of a donor’s participation.

Philanthropic donors have their limits. Keeping them engaged can pose big challenges because job creation and other economic development results of their funding are best measured over decades and even generations. This extended timeline and need for large resources can create so-called “donor fatigue.”

Even so, Northeast Ohio offers some excellent examples of donors committing funds to the intermediaries that aid startups. Wireless Environment (aka Mr. Beams), an innovative lighting company, indirectly benefited from philanthropic funding when it received a $400,000 investment from JumpStart, the Cleveland-based venture development organization funded by philanthropic donors and the Ohio Third Frontier program. The company was acquired by Ring in 2019.

Intermediary organizations and non-governmental organizations (NGOs)

An intermediary organization acts as a liaison or “go-between” among other organizations for a variety of reasons. In the entrepreneurial ecosystem, NGOs often form in response to laws or rules that forbid direct funding of entrepreneurs by governments or donors. NGOs, which are often referred to as nonprofit organizations in the US, can act as intermediaries.

These types of organizations play an increasingly important role in the maturation of entrepreneurial ecosystems. The NGO JumpStart, for example, works to unlock the full potential of diverse and ambitious entrepreneurs to economically transform entire communities. It offers business services, including expert help and mentoring, to leaders of early stage businesses. It also offers “scaleup services,” which assist companies with high-growth potential in multiple ways, from loans to talent acquisition to long-range planning. It invests in people as much as it invests in ideas, technologies, products, and services.

JumpStart also makes equity and debt investments in startups and helps them recruit talent. And it promotes diversity and inclusion by investing in women and minority-owned businesses and helping entrepreneurs and small business owners start and grow their businesses in Cleveland through its Core City: Cleveland Impact Program.

JumpStart typically provides funding at the pre-seed and seed stages, helping startups that otherwise wouldn’t have a chance to get off the ground. Organizations like JumpStart can be real game changers in any transitioning economy. Since 2010, companies supported by JumpStart and its partners have generated $10.3 billion in economic output.

Another unique feature of JumpStart’s investment model: the investment gains on its portfolio companies go back into the fund to be invested in new companies. This concept, called an “evergreen” fund, differs from private investment funds in that there are no actual equity partners who receive return on investment.

Does it work? JumpStart can point to the tremendous success of a company that it helped during its early stages—CoverMyMeds, which started in Cleveland.

In 2010, JumpStart invested $250,000 in the startup, the brainchild of pharmacist Sam Rajan and developer Matt Scantland, who saw a need to improve the outdated, paper-intensive, slow methods of drug prescription “prior authorization.” They describe their mission simply and succinctly: to “help patients get the medication they need to be healthy.”

Seven years later, CoverMyMeds, a healthcare IT company, became Ohio’s first “unicorn” company—the term for a venture-backed tech company that reaches $1 billion in valuation. It was acquired by McKesson for $1.1 billion in 2017. Although JumpStart did not disclose the return on its investment in CoverMyMeds, it is widely understood that the exit returned the entire fund, allowing it to continue to invest in new companies.

Anchor institutions (such as universities)

Anchor institutions, which include universities and hospitals, are so named because they anchor a region’s economy and they tend to stay in one place—they are “anchored” to the region in which they are located.
My home institution, Case Western Reserve University, was established in 1826 in Cleveland, where it remains to this day. It attracted $472 million in research funding in 2021-2022. While that may not be a lot compared to behemoths like MIT and Stanford, the amount is certainly meaningful in the context of our regional economy.
Case Western Reserve University is hardly the only anchor institution in Northeast Ohio. Cleveland State University, the University of Akron, Kent State University, and other major research and idea-generating universities are important anchor institutions as well.

Additionally, Cleveland Clinic ranks first in the world for treatment of cardiovascular disease and is well known for many other areas of medicine. University Hospitals (UH) is another leading health care provider in our region. UH has the widely-known Rainbow Babies and Children’s Hospital; Seidman Cancer Center; and MacDonald Women’s Hospital, Ohio’s only hospital for women.

Universities exist, in part, to drive research, making them natural sources of innovation and entrepreneurship. Likewise, hospitals pioneer discovery and development. In aggregate, anchor institutions enrich the entrepreneurial environment of a community.

So how do they foster startups? Let’s consider a Cleveland-based example. LineStream Technologies, an embedded software company, “was buried in a research lab [at Cleveland State University] for 12 years,” according to CEO Dave Neundorfer. Then Early Stage Partners, a venture capital fund, supplemented by state capital and some foundations, provided the resources and talent to help the company spin out. “I believe we were, if not the first, then one of the first spinout companies that [Cleveland State University] had,” Dave explains.

LineStream codes software for the controls of electric motor-powered equipment, reducing power consumption. It is part of the Internet of Things, the interconnection via the internet of computing devices embedded in everyday objects, enabling them to send and receive data. Without the research conducted at anchor institution Cleveland State University, the LineStream core technology might still be an idea in a notebook. The company entered into a partnership with and was eventually acquired by Danfoss.

Private capital

We’ve explored the roles of government, philanthropy and private donors, intermediary organizations, and NGOs. It’s time to dive into private capital.

Seed accelerators

Seed accelerators are unique in that they are cohort-based, mentorship-driven, last for a fixed amount of time, and culminate in a graduation or “demo day.” This combination of features makes them different from incubators, angel investors, and seed-stage venture capitalists.

An exemplary modern seed accelerator can be found in Y Combinator, started in 2005 by Paul Graham and other Silicon Valley denizens. This privately held organization provides carefully chosen portfolio companies with access to talent, business development partners, and follow-on investors during its startup program.

Entrepreneurs apply for admission to seed accelerators based on their ideas. If accepted, they receive mentorship, training, and support over several months in exchange for yielding an ownership percentage of their company to the seed accelerator. Because seed accelerators are invested in the success of the startup, their teams try to provide portfolio companies with access to talent, business development partners, and follow-on investors.

Angel investors

While the emergence of private and public seed accelerators has provided access to initial seed capital and mentoring, high-growth, innovation-oriented entrepreneurs often find they need additional investment to grow and scale their businesses. Cue the angel investors.

Unlike venture capital funds, which pool other investors’ money, angel investors use their own resources. Sometimes they fly solo, sometimes they pool their funds with other angel investors.

The best angel investors don’t make investments with a short-term view. They typically want to give back to a community that means a lot to them as much as they want to generate return on investment. Cleveland has made slow but steady progress in building its angel investor base.

Angel investors typically are not family members (that’s the “friends and family” round of capital) and often have never met the entrepreneur before hearing the pitch for investment. Silicon Valley has generated hundreds or thousands of successful and wealthy entrepreneurs who want to invest in other startup companies. These investors often do this either individually or through organized angel funds.

Elsewhere, finding wealthy individuals to become angel investors poses stumbling blocks. Investing in startup companies is inherently risky, and this throws off many potential angel investors. According to an analysis done by the US Bureau of Labor Statistics, only about 35 percent of startup companies in the US reach their ten-year anniversary.

To address this challenge in a transitional economy, in 2004, Ohio leaders introduced several programs to stimulate angel investments. These included a tax credit for angel investments and matching funding from the state, designed to catalyze the formation of angel funds.

In Cleveland, startup founder Tom Lix (Cleveland Whiskey) exemplifies the immediate impact that the rise of angel investors has had. Lix knew that traditional whiskey can take up to a dozen years to age. His radical idea was to use “disruptive technology” to age his whiskey in 24 hours, making it the first ever “just-in-time” whiskey.

“The industry isn’t happy,” Lix states, tongue-in-cheek (I think), on his website. Lix talks about how he went about getting funding for this new technology, which allows him to offer the industry something completely different. Having a whiskey company, he says, made it “easy for me to start conversations. I wrote a business plan, did all the right things that an entrepreneur has to do to attract investors. People are willing to introduce you to other people [in Cleveland],” he says. “And that was a big part of it.”

Timing was critical. Ten years earlier, Lix might have struggled, because the area offered very few angel funding options. By 2013, however, Ohio had introduced a pre-seed capital program that matches funds offered to private investors who commit to invest through an organized angel investment fund.

Venture capital

Venture capital is a global industry but a relatively local phenomenon. The majority of venture capital investors look for companies close to them to facilitate governance and mentorship. The East and West Coasts have what some people call “a near monopoly” on venture capital in the US. The Midwest has been wryly referred to as “the flyover zone” because venture capital investors travel from one coast to another to network, invest, and co-invest in companies, flying over the vast space in-between.

Recognizing the need for more venture capital funding in Ohio, the Ohio General Assembly created a “fund of funds,” the Ohio Capital Fund, in 2005. The Ohio Capital Fund raised cash by issuing bonds to private companies; the fund of funds invested its cash in venture capital funds. The twist on this setup was that the Ohio Capital Fund by statute had to provide 75 percent of its capital to venture funds that operated from Ohio and invested in Ohio companies.

The Ohio Capital Fund was not without controversy; some people object to the idea of government involvement in the venture capital industry, regardless of intent or results. Questions didn’t diminish when the state needed to issue tax credits in 2017 so the Ohio Capital Fund could make its debt payment.

Even so, the Ohio Capital Fund has helped numerous funds make the decision to put an office in the state, and this helped early stage companies access venture capital. In fact, a dozen or more venture capital funds set up shop in Ohio—funds that had not previously had a physical presence in the state. Private companies needed an incentive to invest in the possibility of lower returns that Ohio venture investments generate. The Ohio Capital Fund served as a motivating and differentiated source of capital to the venture capital funds at a time when they were sorely needed.

(Last Updated on February 26, 2024).

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