Starting a Business

Sources of Financing

Financing SourcesMost ventures start off on a low budget – with little or no external financing. Nevertheless, starting a business might require financial resources beyond your means, or beyond what you’re willing to risk personally. Needless to say, whoever participates in the financing of your venture will expect to get something in return. How much return they expect will depend on the perceived riskiness of your venture. A higher return is demanded the riskier the business is perceived.

Your job, is to obtain financing at the lowest possible cost. In this article, we’ll go over some typical sources of financing.

1) Start-Up Financing – Personal Equity Capital

To get your business off the ground, you’ll almost certainly going to start off with equity capital – rather than debt to be repaid to the entrepreneur by the business. If you’re looking for external sources of finance, equity capital is required to show commitment on your part. Investors feel that the entrepreneur will be more committed to the venture if he or she has a significant personal stake in the venture. You don’t necessarily have to put down equity capital in the form of cash. Your equity in the venture can include mortgaging personal assets like a house or car, as long as what you put down is perceived as equity by potential investors.

A more practical reason as to why your startup phase will usually be financed by your own funds is because to raise money, you will usually need more than an idea. You’ll have to invest some resources in the idea, to build a prototype or do a market study for example.

There are some specialized firms that provide this kind of seed financing but most venture-capital firms require your business be beyond the concept phase to qualify for their funding.

2) External Equity Capital

Often, entrepreneurs run out of their own funds before business can take off on its own. At this point, it’s usually still too early to get enough debt financing, which leaves outside sources of equity capital.

Angel Investors

A common source of equity capital is private investors, also known as “angels” or “wealthy individuals”.  These investors can range from family and friends with a few extra dollars to spare, to tycoons who manage their own money.

One of the best ways to find wealthy investors is to use your social networks. For example, a lawyer or accountant you’ve used may be able to put you in touch with a potential match. Angels can be a good fit for equity financing requirements that are too small for the typical venture capital firm to consider. At the very least, you’ll need a business plan when approaching a wealthy individual. 

An advantage of angels over venture capital firms is that they are often a  less expensive source of financing. There are downsides as well as we note below.

Wealthy investors:

  • Are far less likely to come up with additional funds if needed
  • Don’t have the expertise or time to support your business operations
  • Can bring you lots of frustration, especially if there are a lot of them. Complaining or phoning frequently when things aren’t going exactly as plan, angels can be a source of headaches despite your well intentioned nature.

Venture Capital

Venture capital is a pool of money that is professionally managed. Wealthy individuals invest in the fund which is managed by individuals who are compensated by fees and a percentage on gain.

Venture firms seek a high rate of return on their investments, 50-60% is not uncommon. This high rate compensates for the riskiness of their investments and services provided. Many entrepreneurs find this rate too high and consider venture capitalists “sharks”, but don’t discount venture capital prematurely. In exchange for the high return, venture firms will often provide valuable advice. They have seem many times before what the entrepreneur might be experiencing for the first time. Venture capital firms can provide useful counsel to help solve your company’s start-up problems.

Venture capital firms differ in which industries they invest in, and how “hands-on” they are with the day-to-day operations of their portfolio companies. When approaching a venture firm, the goal of your business plan is to capture their interest rather than to go into exhaustive detail. Most venture firms spend a great deal of effort sifting through and investigating potential investments.

Don’t propose the actual terms of the investment in the initial document. While you should write out how much financing you’re looking for, the details of the terms (such as “for 30% of the stock) should be left for later as it’s premature for an initial presentation.

Public markets

The largest source of equity capital are the public stock markets. Usually you’ll have to have a successful operation before you can raise money this way but in some “hot” industries, smaller start-ups are sometimes able to raise public equity.

Cover Yourself

At some point or another, the thought that a potential investor might steal your ideas will probably cross your mind. On the one hand, want to sell investors on your good ideas, on the other hand, you don’t want anyone to use them as their own. Venture capitalists are professionals who will guard your confidential information. Angels, on the other hand, should be dealt with more carefully. Only approach reputable and trustworthy private individuals.

Regardless of which group of investors you’re targeting, don’t disclose truly proprietary information or sensitive intellectual property in a business plan. For example, you can and should describe the functions of your new product, bud don’t include materials like engineering drawings, circuit designs and the like.

3) Debt Financing

Debt capital is the other main source of financing. Debt is generally thought of as less risky than equity capital because it is repaid to a predetermined schedule of interest and principal. Creditors will lend against the cash flow and/or assets of a firm. If you and your company have neither, you’re chances of getting debt financing are low. 

Cash Flow Financing

Cash flow financing is generally of the following types:

Short-term debt – Is often available to cover cash needs for periods of less than a year.

Line-of-credit financing – Once set up with a line of credit, you can draw from it as required. Interest and fees apply and you’ll generally have to pay it down to an agreed upon level at some point during the year.

Long-term debt – May be available for up to 10 years and is usually available to established and “secure” companies.  It is repaid via a predetermined schedule of interest and principal.

Most commercial banks make cash flow financing available and other institutions (such as finance companies, insurance companies) may as well. Lenders will often try to reduce their risk through placing restrictions on your business if you are to keep your credit. For example, you may be required to, limit your debt or keep a minimum cash balance.

Asset based financing

Many business assets such as accounts receivable, inventory, equipment and real estate can be financed. New ventures generally find it easier to get asset based financing because cash flow financing generally requires an earnings history. In asset based financing, the company pledges certain assets and in case of default, the lender can take possession of the asset.

Asset based financing is available from various financial institutions including banks, pension funds and insurance companies.

The following are commonly used for asset based financing:

Inventory – But only if your inventory consists of merchandise that can easily be sold. However, you won’t be able to finance the full value of your inventory, roughly half is a good rule of thumb.

Accounts receivable – Often up to 90% of your accounts receivable from solid customers can be financed. The bank will almost certainly do a check to see which accounts are eligible.

Real estate – If your company has a plant or buildings, mortgage financing is usually available for usually between 75-85% of your real estate’s value.

Equipment – If you have equipment, depending on how “sellable” it is, you might be able to get financing for up to 80% of its value.

Government secured loans – Certain government agencies might provide guaranteed loans designed to help businesses obtain financing. It’s well worth taking a look to see if you can get help this way.

Personally guaranteed loans – If an individual is willing to pledge his or her assets to guarantee a loan, the business can secure financing in this way. Of course, the risk is then borne by the individual.

4) Internally Generated Financing

Some careful “juggling” can help generate considerable financing without using the sources listed above. Financing generated from within the company includes:

  • Collecting outstanding bills more quickly.
  • Obtaining credit from suppliers so that bills can be paid less quickly. Some suppliers charge interest on late payments. Beware of taking this too far and frustrating key suppliers, they may simply stop serving you.
  • Reducing inventory and cash can help as well, but be ware of running the business too “lean”. You may end up being unable to properly serve customers or pay suppliers.
  • Selling off assets, this may be a more drastic approach but in a pinch, it might pull you through.