Every entrepreneur understands how hard it is to finance a business. Financing a startup/ SME is even harder.
If you survey why people do not start businesses, 90% will cite a lack of capital as the major cause. This is certainly true especially amongst young people who are just fresh from school. Such do not have any source of income and therefore, no savings.
Similarly, if you survey why entrepreneurs do not scale their businesses, they will cite a lack of working capital as the challenge. Most of them do not have the necessary finances to fund operations and growth in their businesses.
Therefore, lack of adequate money is a major problem in the business world; especially in the startup world.
Big businesses like Google and Facebook have all the money they need to do anything they want. If they need more money, raising it cannot be a problem. Many people, banks, and even governments will volunteer to fund them.
The risk factor
As a small business, your risk factor is very high. Many financial institutions and investors do not trust your business. This is because your business does not have the relevant business systems and brand reputation to guarantee sustained existence.
Due to the high-risk factor, very few (If not none) financing sources will be ready to give you money as a startup.
Since the price of a loan (Interest rate) is dependent on the risk factor, very high risk means a very high interest rate. This is not feasible for any business.
Very high interest will eat away all the profit. For a business loan to be beneficial, the return on investment (R.O.I.) of the business activities has to be higher than the rate of interest.
For this reason, it is almost impossible for small businesses to get financing.
Types of business financing for startups
There are three types of business financing options available to businesses.
- Internal financing
- Debt financing
- Equity financing
In this article, we will look at the three in-depth.
1. Internal financing
Internal financing means financing a startup through the money the founder of the business already has. This is the best method of financing a startup.
As people start businesses, they may have saved some money over time for this purpose. They can then withdraw the savings and invest in the new business.
An existing business can finance growth by plowing back profits. This is the most common way of financing a startup.
Small businesses find it hard to plow back profits because many small business owners get their livelihood from the business. They take a big chunk of the profits to finance their day to day lives.
Similarly, many small businesses do not keep proper financial records. This is because many founders do not have bookkeeping knowledge and cannot afford to hire an accountant.
Without proper financial management systems, it is almost impossible to allocate profits optimally and efficiently.
Profits can be used in two ways. One, they can be paid to shareholders as dividends. Two, they can be plowed back to finance growth in the business.
Businesses have what is called a dividend policy. It dictates how much dividends should be given and how much should be plowed back.
The dividend policy is drafted depending on the stage of the business and its needs. A business in the growth phase needs to pay fewer dividends and plow back more profit.
A business in the mature or aging phase can pay more dividends since there is little room for growth. Such a business is called a cash cow.
Advantages of internal financing.
- There is no interest payable.
- The owner does not have to part with some shareholding like in the case of equity financing.
- There is no financial pressure on the business since the money is not repaid. It is a grant from the shareholder to the business.
- It is easily accessible.
- Personal savings and profits may be limited. Very few people and businesses can have the money needed to finance a business completely on their own.
Despite the disadvantage, financing a startup internally is the way to go. Other financing options should be considered after this option is exhausted.
2. Debt financing
Debt financing is the second option when it comes to financing a small business. After internal financing options are over, a manager should consider financing a startup through debt before giving away shareholding.
Entrepreneurs love debt. They understand that debt is a form of leverage for growth. However, too much debt can be a problem for any business.
When a company has too much debt, we say that it is over-levered. Over leverage is a cause of financial distress in firms. It has led to the failure of many businesses; both big and small.
Prudent debt management is critical if the business wishes to get a loan. If a loan is misused, that is a cause of financial disaster for the firm.
When debt is properly managed, it should pay for itself. This means that it should generate an ROI high enough to pay for interest and get some profit.
There are general rules when it comes to debt management:
- Only take debt because you need it. Do not take it impulsively.
- Allocate debt to income-generating projects only. Do not take debt to finance liabilities.
- Only invest debt money in projects that have been tested and known to generate profit. Do not test the profitability of a business using debt.
- The ROI of the project should be higher than the interest rate of the loan.
- Always negotiate the debt terms. The debt should be on reducing balance if possible. The interest rate and the repayment period should be favorable and sustainable.
When debt is used well, it can be a great factor of growth to a business. When it is mismanaged, it might as well bring the business to its knees.
Forms of debt financing
There are many forms of debt financing available to a business owner. Some are more favorable than others.
Loans from friends and relatives
This is the best form of debt entrepreneurs should look for. It is less costly since it is mostly not accompanied by interest demands.
Loans from relatives and friends are easily accessible and they do not require any collateral. The terms of repayment can be favorable since the transaction is informal and social.
If you default on repayment, a relative or friend is less likely to take legal action on you and your business. They will hardly auction your property.
However, many friends and family are not willing to give business loans, especially if they are not entrepreneurs. Some of them are jealous and envious and would rather not help.
Many government programs offer loans to small businesses. For example, SBA loans to small businesses in the US. As governments realize the increasing role of small businesses in economic growth, more policies favorable to small businesses are coming up regularly.
Entrepreneurs running small businesses should take advantage of these programs. Some of the characteristics of this small business government support programs include:
- They charge very low interest on the loan. The interest rates are lower than bank interest rates because the aim of the government is not to make a profit but to support small businesses and stimulate economic growth.
- They require the fulfillment of several bare minimum qualifications. Businesses are required to have been in existence for a certain period, say one year, to qualify. They should also have relevant business licenses and permits.
- They give favorable repayment periods.
- The loan request review process is bureaucratic and thus, slow.
After exhausting the option of getting a loan from friends and family, it is important to consider this option. Government loans are better than bank loans.
This is the third option available to business owners when it comes to debt financing. It is very stringent and the terms of repayment have to be followed to the letter.
A bank loan should be a solution of last resort when it comes to debt financing. To get considered for a bank loan, you need the following.
- A good credit rating. If you have a history of defaulting on loans, you may have a hard time accessing a bank loan.
- Good bank statements. Your account must be very active. You should deposit and withdraw money often.
- You should have collateral. This can be a car or a piece of real estate. Collateral acts as a security to the bank in case you default.
- Proper business financial statements are required. Your statements of financial accounts and balance sheets will be needed.
- A solid plan of how you intend to invest the money.
If you do not meet the above minimum requirements, you will never access a bank loan. Banks are very careful of who they lend to to reduce bad loans in their books.
To an established reputable business, this is an option. A corporate bond is given by the business (Borrower) as evidence of long term debt. Anyone can buy a corporate bond. In this case, you will be lending money to the business.
The business will then be obliged to pay interest when due and repay the principal when the bond matures, as specified on the face of the bond certificate.
The rights of the holder are specified in a bond indenture which holds the legal terms and conditions under which the bond was issued.
This option, as we have said, is only available to big reputable businesses and not startups.
Advantages of debt financing
- No control is lost by giving away shareholding.
- There are no limitations to the amount of money a business can access. Banks have trillions to lend and this is their main business.
Disadvantages of debt financing
- Most of them are accompanied by strict terms and conditions and legal repercussions upon default.
- Most need collateral that most small businesses do not have.
- The interest associated with formal debts can eat into profits if not well managed.
- Debt causes financial unrest in business because of the repayment obligations.
- If mismanaged, the business can be auctioned. During an auction, businesses lose more than the value of the debt.
Even though debt financing is still an option of financing a business, it should be well managed. Remember, mismanaged debt can bring financial disaster in the firm.
3. Equity financing
Equity financing is not common among startups. This is where you give away some shareholding in the business in exchange for money to fund the growth of the business.
Since equity financing brings loss of control and ownership, it should be the last option in your list. It should only be considered if all other options are exhausted.
However, equity financing can be useful in bringing new complementary skills to the business. These skills and experience can be invaluable to a new business.
There are many forms of equity financing:
An angel investor is a person who funds high growth business ideas with the intent of making a profit.
They will buy some shares in businesses whose prospects of growth are high and hold them.
Such investors may want short term profits after selling the shares or long term value when the business grows.
To be considered by angel investors, your business idea has to be innovative and the business model promising. You also need to have high management skills.
Venture capitalists are firms that fund high growth business ideas in exchange for shares in the business. These firms are constantly looking for such businesses to invest in.
Venture capitalists bring valuable business experience and skills to a new business. They work hand in hand with the founders/ managers to grow the business. They mostly buy a minority stake.
To be considered by venture capitalists, you need the following:
- A highly scalable business idea and model.
- Demonstrate great business management skills.
- A sound team with great qualifications.
- A good business plan.
- Proper business structures and systems.
Approach the nearest reputable venture capital firm in your area if you feel that you meet the above-mentioned qualifications. Who knows? They might fund your business and help you scale your business.
Initial public offering (IPO)
If your business is generating enough sustainable profits, you can list it in a securities exchange. A securities exchange is a shares market.
When a company is listed, the public can buy shares over the counter or on the trading floor. In this case, you lose some control in your business.
As a manager, you will be answerable to the shareholders. An annual general meeting (AGM) will be held to deliberate on issues affecting the business.
After a company is listed, it ceases to be a private company and becomes a public one. Governments regulate such companies closely to safeguard the interests of the general public.
A public company has to declare its financial results every year. This is for purposes of accountability.
If you are ready to lose control of your business, you can consider listing it. It is a great way to get all the funds you need to fund growth.
Other sources of financing
If your business has some visible social impact, you can apply for grants. Grants are given by governments, international bodies, and non-governmental organizations to help bring an impact in society.
You do not repay a grant and thus, it is a great way of financing your business.
As the name suggests, it is getting money to fund your business from the crowd. People, through various crowdfunding platforms, are ready to give money to businesses that they feel have a high potential for growth and profitability.
Some of the platforms include Kickstarter and IndieGogo.
Final words on financing a startup
Starting is easy but financing a startup to growth is not. This is the elephant in the room. If you can manage to get financing for your business, you are many steps closer to success.
Utilize internal financing options first. You can then consider debt financing and lastly equity financing. If your business is eligible, you can apply for a grant.