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This week, we look at funding options available to businesses. It’s the first installment of a five part series that focuses on business finance.
What funding options are available to your business?
While business finance has always been a tricky affair, the list of options is growing. These options depend on the nature of your business, its current stage in the growth process, the availability of collateral, and willingness to relinquish some control or share of the business. They can be classified into internal and external options.
Internal options include bootstrapping during the start-up process, and reinvestment of profits during the latter stages. Although external options were traditionally classified into two broad areas (debt and equity finance), new innovations are bringing customers into the funding process earlier than ever before.
Bootstrapping is the process of using personal savings to run a business. In some cases it is extended to include funds from loans against personal assets. While being the fastest and easiest way to start a business, it eliminates leverage or the ability to share business risk.
Debt financing can be accessible at different stages of the business life cycle. However, the source of funding depends on availability of collateral and current stage of the business. For small businesses at the start-up phase, the major external source of finance is family and friends. While being a one-time source, it is the cheapest form of leverage, requires no collateral and minimum agreements if any. And because of the personal relationship with the funding source, the appraisal is not always based on a convincing business plan or market realities. Rather, it is an investment in the business owner.
The second source of debt financing is Financial Institutions. This is considered expensive due to the requirement for payment of interests. It is extremely difficult to access, slow and cumbersome during the start-up phase, but gets progressively easier as the business grows. Minimum requirements generally include a defined repayment plan, justified cash flow projections or business history, alternative sources of repayment through provision of collateral and reasonable asset liquidity. It is however an inexhaustible financing source as long as these basic requirements are met at every stage of the business life cycle.
Equity Financing is a rapidly growing source of funding for owners who are willing to give up ownership of part of the business. These sources also depend on the stage of the business. During the start-up process, family and friends in some instances would want a share of the ownership as opposed to granting a loan. The fund received under these terms is classified as equity finance because they inevitably become shareholders in the business. While providing leverage without the weight of interests, traded equity may sometimes reduce control of the business and slow down the decision making process.
The second source of equity financing is Angel Investors. These are usually business-savvy, wealthy individuals that bring networking opportunities in addition to interest-free leverage in exchange for a part of the business. They are the most sought after type of investor and can come in at different stages of the business life cycle. They not only share business risk, but also increase the probability of success through their personal experiences and relationships. They are however some of the most difficult type of investor to find and demand considerably higher stakes in the business than family and friends.
A third source of equity financing is Venture Capitalists. These are the big money investors that fund extremely rapid growth businesses in a bid to sell off or go public. They also bring networking opportunities, interest-free leverage, and a wealth of industry knowledge in exchange for a part of the business. They however rarely invest during the start-up stage, base their decisions on the competitiveness of the management team and sometimes insist on installing theirs. They also usually require that the business is sold within a five year period or less.
This brings us to the latest trend in external business financing. The Customer. It is growing thanks to innovations in marketing and an all-time high in competition. Ever heard of Crowdfunding? It’s basically a process of raising funds through customers during the start-up phase. This can be as pre-sale on a defined item or a promise of discount on an innovative product. It is usually a cheap source of non-equity based leverage; sort of like family and friends. While platforms like kickstarter are leading the online revolution, innovations in real estate finance has promoted a rapid shift in the industry offline.
The second source of customer financing is Strategic Investors. These are businesses that combine elements of classic equity financing models to provide interest-free leverage in exchange for part of a business they buy from. They are usually driven by a potential for lower long term costs, and the need to enjoy significant advantages on competitors. They could however end the relationship at any point in time while usually also restricting your ability to sell to their competitors.
It’s a lot of words, but we’re just getting started. Over the next four posts we’ll help make sense of it all by matching business types to funding options. Just follow our social media page(s) and get notified of the next installments.
For now, how have you funded different stages of your business? And what other funding options did we miss?
Abubakar Abdullahi is Managing Principal at The Front Office NG. He tweets @ab_bakr
Editor’s Note: This post first appeared on The Business Hub on 23rd July 2014.