The essentials of business funding; its many sources and how to pick the right one for you
We all rely on bank loans, credit cards and personal loans from friends and family to get us through life, and it can be much the same in business – with sources like venture funds and angel investors offering other possible routes for funding.
Whatever the source in these trying economic times, traditional lending sources like banks and venture finances have raised the bar to lend, and are now very particular about who they would lend to. Therefore, it is essential for the small business owner to know what criteria the finance houses use to determine whether they will sponsor a start-up or fund the expansion of an existing business.
The 12 essentials of business funding
Business plan – Have a coherent and robust business plan!
Credibility – Establish personal credibility and reputation in your community or social circle.
Credit – Maintain a good credit rating. Confidence – Be confident.
Perseverance – Be prepared for rejections. Don’t give up.
Passion – Show a sense of passion. After all, you are the Chief Believer!
Pitch – Have an elevator pitch: a summarized description of your business to be articulated to potential funders in no more than three minutes.
Professional – Dress appropriately for the business that you are in.
Punctual – Always be punctual for any meetings with potential funders.
Preparedness – Rehearse your business plan presentation.
Presentation – Have a professional-looking and polished presentation summary of your business plan, as well as a detailed version of your business plan to hand with figures and forecasts that are conservative and achievable.
Personal – You should personally articulate your vision, mission and commercial model. It is alright to have the consultants beside you, but you should make the critical part of the pitch yourself.
Have an elevator pitch: a summarized description of your business to be articulated to potential funders in no more than three minutes.”– unknown
Exploring the funding sources available to a start-up or expanding business
There are many funding sources available and some of them are obvious, others less so.
Funding a business with your personal savings is not the most prudent thing to do. As most start-ups fail, it is neither smart nor sensible to put all your ‘eggs in one basket’. However, if you can afford it, then using a portion of your personal savings is definitely a boost in your overall funding endeavour, as it will show commitment. Potential lenders and investors like to see that their clients have some ‘skin in the
game’, and so stand to win big with the success of their business.
Keep in mind that the journey is going to be very tough, and therefore any personal investment from you should best be sourced from the sale of an asset that you are not currently using – like an extra property or vehicle. If you do have a chunk of your own extra money sitting in a bank, by all means invest in your business of choice.
(A point to note is that, if you do have a chunk of money sitting idle in the bank, then you probably would not be reading an article on sources of funding!) A word of caution: Before investing your hard earned personal savings, take a step back and consider seriously the impact it will have on your family and yourself. If you still feel that you must, then you are probably on to something that is worth the effort and the risk.
Family and friends
Most start-ups get started with money from their immediate family or friends (this type of funding is commonly known as FFF for friends and family – and fools). If your bootstrapped company is in dire need of cash, and if you have a family member or friend willing to invest, it is a path that you should consider.
Unless you are in a bubble economy or have some unique technology patent, most friends and family are not investing in the business, but rather they are investing in you personally. A word of caution – the $10,000 that Cousin Tom dished out might come at a high price – like requests for employment for all kith and kin and/or unnecessary interference in your time and business!
Since most family and friends are investing in a person rather than a business, it is recommended that funding from friends and relatives be started off as a loan rather than equity participation in the business. This loan should, of course, be structured with a formal agreement and repayment plan. This way, you can mitigate future unwarranted interference in your business.
Funding a start-up or an on-going business with personal credit cards is more common than you think. About 30 years ago, it was considered “non-passé” or “not credit worthy” or imprudent to use a credit card to fund your business. Today, it is neither frowned upon nor considered risky.
Before you start on a credit card splurge for your business, be aware of the high-interest rates that credit cards charge. Also do keep in mind that cash advances on a credit card carries with it much higher interest rates. Credit cards should only be used to fund emergencies in your business. Do not use credit cards to fully fund and manage your business. Credit cards should only be used as a mezzanine or stop-gap measure for interim working capital or inventory management.
If you do use credit cards to fund your business, ensure that the pricing of your goods and services reflect the relatively higher interest rates that you are paying to fund your business, through the usage of credit cards. Also, ensure that you choose the credit cards from providers offering interest-free financing, for longer periods of time.
A word of caution – Do not max out your credit card limits by paying the minimum monthly payments. If you are prone to paying the minimum payment, then this important source of funding will just not be there when you need it most! It is also one of the most expensive forms of borrowing.
The term “angel investors” originated from Broadway where wealthy folks who funded theatrical productions were called “angels”. Today angel investors are generally a group of successful folks who have extra money at hand to invest. Angel investors understand the risks of start-up businesses and therefore expect a much higher return for the increased risks that they are taking. As most start-ups fail, the increased returns that they expect are fair because it is more likely than not for them to lose a good number of their investments completely.
Before you approach a group of angel investors, it is important for you to know the objective of the angel investor. Of course, most of them are taking part in this high stakes game for the expected high returns. But do keep in mind that since most of them are successful entrepreneurs or former business executives themselves, there are other reasons why they fund start-ups. These can range from their need to keep informed of the latest trends in technology, to networking, to opening an avenue to
share their business experience and networks. Therefore it is important that you position your company and yourself to match the angel investor’s objectives.
Angel investors appreciate there will be a need for additional funds to scale your business. Therefore, one thing to keep in mind when you negotiate the term sheet is that you should alert the angel investor of your anticipated future funding needs. You should offer the angel investor the option to invest in subsequent rounds, as well as alert them of the high potential for dilution of their equity.
An important note on angel investors: If you have found an angel investor interested in your start-up and one who does not want to invest his or her money due to other commitments – an option is to leverage the angel investor’s asset base and reputation to guarantee a bank loan for your business.
Bank term loans
There are many forms of bank loans available for the small business and these include everything from bank overdrafts to term loans. A bank overdraft is seldom given to start-ups with no established cash flows, however. Instead, term loans are the most common types of loans. They are very simple in that the lender provides a specific amount of money, usually at a fixed rate of interest, and there is a schedule for repaying the loan (usually in monthly or quarterly payments) over a certain amount of time.
The big question that a bank wants to be answered is whether you have the necessary collateral. In these trying times, an unsecured loan is a rarity and is only offered to folks or businesses with an exceptional credit history.
There is a big caveat on bank loans that you should be aware – most banks will seek full recourse to the individual owner or shareholders for a full recovery of the loan just in case things don’t turn out the way you expected it. It is imperative, therefore, that you ensure that the business risks are mitigated before committing to a bank loan, as the consequences of failure will affect you personally.
The requirements for a term loan are arduous and time-consuming. Banks normally require a significant amount of information before they approve the loan. These can range from:
• Your detailed business plan.
• A personal guarantee for short-term loans if the collateral is insufficient.
• Your credit report.
• The type of collateral you can provide.
• Company incorporation or trading licenses.
• Your personal and financial commitment to the business.
• Financial statements of the business, for at least three years.
• Tax returns (if and where applicable), for the past three years.
Term loans have both benefits and drawbacks – they bring an ability to leverage the term loan to preserve working capital but you need to watch out for those exorbitant
Venture Capital (VC)
Funding from venture capital companies (VCs) provides medium-term committed share capital to help companies grow and succeed.
The funding objectives from VCs are very different from funding sourced through bank loans. Banks charge interest for their loans and seek repayment of the capital, irrespective of whether the business succeeds or fails. VCs invest funds in exchange for an equity stake in your business and expect significant returns when they exit the business, taking a start-up to an IPO stage or selling it or their share to other equity owners.
VCs invest in businesses that have unique intellectual property or in businesses that have a unique and sustainable commercial model. VCs also generally invest in companies which are managed by experienced and capable teams that have the requisite experience to take the business to the next level.
If you are confident of the uniqueness of your IP or commercial model, then seeking funding through VCs might be a good option to take your business to the next level, as they have the breadth of contacts that are needed to find new funding, new customers or new employees for your business.
Many small businesses do not use leasing as a way to fund a portion of their capital requirement, yet most equipment leases rarely require down payments. If a business has or needs vehicles, machinery or equipment that needs to be purchased, leasing is an option that should seriously be considered as a way of preserving capital.
For many startups, the reality is that leasing may be your only real option for acquiring needed business assets. An advantage that is often overlooked is that leasing may improve certain financial indicators, such as your debt-to-equity and earnings-to fixed-assets ratios. This is so because you are able to exclude your leased assets and their corresponding monthly rental obligations from the balance sheet, and yet are able to include the revenue derived from the assets in the income statement.
Factoring is useful for companies suffering a cash-flow squeeze and/or facing slow payment cycles from their customers. Small businesses can sell their invoices or accounts receivable to funding companies called factors. The factor advances most of the invoiced amount ranging from 75% to 95%, after verifying the creditworthiness of each of the small business’ customers. The factor charges a factoring fee and remits
the balance back to the small business. The factoring firm handles the collections allowing the company to focus on running the business rather than chasing invoices and cash collection.
Once the creditworthiness of a small business customer is established, a small business is usually able to get the funds for invoices within 24 to 48 hours rather than waiting the usual 30 to 90 days for the customer to pay.
Traditional lenders normally look at the business creditworthiness when evaluating a loan application, whilst factors evaluate mainly the financial standing of the small business’s customers. This is a tremendous boost for a small business’s funding endeavours, as they are able to fund their working capital through factors, even if they have little or no credit history.
One important point to note about factoring is that it can be costly by several basis points above a traditional lender. One other important consideration is that it will not be economical for a small business that sends out thousands of small value invoices, like the service fees that a factor charges might depend on the number of invoices issued.
Goods or service sales – the source of all funding
Business owners and managers have many options when it comes to funding their working capital or long-term funding requirements. The key issue to note is that the funding expense varies vastly and that the resultant costs should be baked into the pricing of your goods or services.
Do not feel dejected when funding applications are turned down. As a small business owner and risk-taker, you are already special. Don’t let some high and mighty bureaucrat in some large corporation tell you that you stand no chance! For inspiration, remember what Dale Carnegie said: “Most of the important things in
the world has been accomplished by people who have kept on trying when there seemed to be no help at all.”
JohnLincoln.one The business growth hacker