Business Funding Options: Debt Financing

Hello and welcome to FYI.

This week, we bring you the third installment of a five-part series on business finance. It’s about debt financing as an external source of funding and continues from our last post on bootstrapping.

So what is debt financing?

Simply put, it means the injection of borrowed money into a business with the promise of paying back at a predetermined future date. Depending on the source of debt, the repayment may also include an agreed interest component and the pledge of collateral for the duration of the loan. However, once repayment is completed, the business has no further commitment to the lender, and the collateral pledged must be returned.

And what are these sources?

For small businesses in 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 and usually 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. It is important to note though, that the absence of drawn agreements and a defined repayment plan has resulted in lots of problems with family loans, especially during future refinancing stages of the business.

The second and most popular source of debt finance is a bank loan. For starters, banks are sustained by the income they make from the money they lend. They therefore require proof of capacity to repay the principal and in most cases, an interest component. They may also require the pledge of collateral as a second way out and are likely to base lending decisions on the proven character and integrity of the principal officers. As such, business history or realistic and provable financial projections are necessary. It is for these reasons that bank loans are very difficult to obtain during the start-up phase but get progressively easier as the business grows. But that’s not a bad thing. These demands serve to make businesses better by exposing details of feasibility, profitability, and most importantly, cash flow; which ultimately determines if the business will succeed or not.

Another source of debt finance is private companies. These are usually unofficial, short-term and high-interest lenders that provide quick access to funds and do not demand some of the conditions provided by banks. They however require personal guarantees and are based on referrals from trusted existing or former customers.

So how do you decide on debt financing or the source to pick?

Any decision on debt finance must be based on what is to be financed, cash flow realities, interest rates offered, and the availability of collateral. Loans from family and friends are usually finite and one-off. As such, they finance the early stages. They also allow extra cash to run the business by eliminating interest payments and the need for collateral.

Bank loans on the other hand are dependent on an appraisal of cash flow, prevailing interest rates, and collateral. Cash flow depends on terms of payments between you, your supplies, and buyers. The most favorable terms of payment should allow you to get supplies and pay later while also collecting money from your buyers in advance; the least, being a situation where you pay suppliers in advance and sell on credit. These situations will determine your capacity to make timely loan repayments and will affect the bank’s decision to lend. Even if these are satisfactory, an understanding of the part of the business to be financed is critical to the successful repayment of loans.

Care must be taken to understand the difference between financing for fixed assets/costs and variable ones. For example, a loan to construct a warehouse, or factory or purchase furniture will not be the same as one to run daily activities such as shortfalls in fuelling costs, or raw materials. While the former will finance a process during which the business does not generate any extra money, the latter can start being recouped from daily operations. The basic rule of thumb is to finance fixed costs with long-term loans that allow moratoriums where possible, and finance variable costs with lines of credit. However other types of loans may even provide extra flexibility.

Okay, Okay! What is a moratorium? A moratorium is a period when loan repayments are suspended to allow for the construction or installation of an asset to be completed. In some cases, moratoriums are granted on principal only. For example, a loan of one million naira may still have a one million naira principal component after 6 months while interest on the one million is charged each month. In other cases, both principal and interest are capitalized for the period of the moratorium. In this case, a loan of one million naira will, based on a six-month moratorium, start charging repayments on a principal component of say one million and one hundred thousand naira (principal of one million plus six-month interest of one hundred thousand naira) in the seventh month.

A line of credit (e.g. an overdraft) is an amount that can be drawn on an account when it is unfunded but attracts interest on only the specific amount used. For example, if a business with a million naira line of credit uses two hundred thousand in March, repays, and then uses one hundred thousand in April, interest will only be charged on two hundred thousand in March and on one hundred thousand in April. Moratoriums and lines of credit allow for reduced burdens on repayment obligations while freeing cash to run the business, but an understanding of your cash flow and terms of payment is critical to the source of debt financing you choose.

Fundamentally, debt allows you to retain full ownership of the business and schedule expenses based on a defined repayment plan, with the added benefit that the lender’s claim expires once the loan is fully repaid. The key is however to remember that it has to be repaid, with interest, which may erode cash flow, and the ability to grow and result in the loss of assets pledged as collateral. But don’t fret! Even if these aren’t favorable to your business, other funding options exist and will be discussed in the next two posts. So just follow our social media page(s) and get notified.

Care to share how you have used debt to fund your business so far?

Editor’s Note: A version of this article first appeared in The Business Hub on 6th August 2014.

Business Funding Options: Bootstrapping

Hello and Welcome to FYI

This week, we bring you the second installment of a five-part series on business finance. It’s about bootstrapping as an internal source of funding.

So what is bootstrapping?

In the start-up phase, involves investing personal funds and, in some cases, funds from loans against personal assets into a business as capital. But while bootstrapping is usually referred to as a start-up process, in the latter stages, it may include the re-investment of profits, change of use, or outright disposal of existing assets to run a self-sustained business. Businesses that navigate this funding process require excellent financial management, creativity, and planning but successful entrepreneurs get to retain complete ownership and control while avoiding interest payments.

So how do you achieve this?

In the start-up phase, businesses that adopt bootstrap financing must keep their expenses low. This means money must only be spent on absolute necessities; including the number of employees (with founders undertaking responsibility for multiple roles), deferred payments, and mutual exchange of goods and services in place of cash (bartering). Other areas where costs must be minimized include office space, furniture, equipment, and utilities. As such, where these are essential to the business, bargains on used furniture and equipment are used to drive down costs. These businesses may sometimes also start as freelancing endeavors to cut staff costs, work out of a home or mobile office to save on office space, or adopt trade terms that allow for goods to be sold before suppliers are paid. Innovations in office solutions also allow flexible use of shared spaces, meeting rooms, and utilities such as electricity and internet connectivity.

Examples of ideal bootstrap-financed start-ups in Nigeria include tailoring and fashion design, IT, Business solutions, and wholesale-retail. In tailoring and fashion design, savvy entrepreneurs typically bootstrap with home offices, negotiate trade terms that ensure the supply of materials on deferred payment agreements, and share the cost of utilities by partnering with other freelancers. It is also why you shouldn’t be surprised to find tailors offering to pay for a service by making new clothes. In IT and business solutions, home, mobile, and shared offices ensure cost reductions while upfront terms of payment are usually preferred to bridge financing limitations. In wholesale retail, distributors make their bootstrap investments in the form of minimum deposits that ensure the supply of fast-moving consumer goods (FMCG) such as cement, brewed products, and household equipment at favorable after-sale terms.

In the latter stages, businesses use bootstrapping to finance growth. In the first instance, sacrifices are made by shareholders to reinvest profit towards completing projects over a specified period. This may include office expansions or relocation, acquisition of vehicles and equipment, or even bigger staff strength if it is deemed to be profitable in the long run. In the second instance, unused assets such as office buildings, vehicles, and equipment are leased to external businesses to raise the funds needed to drive the daily operations of bootstrapped businesses during slow or recessionary periods. And in extreme situations, redundant assets are sold to finance growth in other profitable areas of the business. Cases where businesses completely sell off their business offices are also common in recent years due to stretched finances or technological advances that mean the business does not require that amount of space. For businesses with stretched finances, those offices can then be leased from the buyer under what is termed a “Sale and Lease Back Clause”.

So what are the drawbacks to bootstrapping?

In all of these instances, business owners retain total control, but also a complete share of the risk. As such, when anything goes wrong, it usually translates to a loss of the business including all personal savings and assets. Moreover, growth can only be achieved by reinvesting profits. So during the period before profits are generated, funding might gradually be exhausted, resulting in liquidation. In fast-growing sectors or industries where economies of scale are crucial, the business may also lose out to competitors because of a failure to grow at the right pace. And finally, some of the strategies used to ensure bootstrapping success are not fail-safe. For example, terms of trade may become unfavorable thanks to new suppliers offering lower prices, superior products, or quicker delivery.  Still, your primary supplier’s terms may change to exclude you or their business may even get liquidated.

That brings us to the need for leverage. And it’s covered in the next three posts. So just follow our social media page(s) and get notified of the next installments.

Care to share your bootstrapping stories?

Editor’s Note: This post first appeared on The Business Hub on 30th July 2014.

Business Funding Options

Hello and welcome to FYI

This week, we look at funding options available to businesses. It’s the first installment of a five-part series focusing on business finance.

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 the 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), 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 the availability of collateral and the current stage of the business. For small businesses in 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 and 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 interest. It is 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 the 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 who 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 risks but also increase the probability of success through their personal experiences and relationships. They are however some of the most difficult types of investors 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 be sold within five years 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 a process of raising funds through customers during the start-up phase. This can be as a pre-sale on a defined item or a promise of a 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 have 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 over 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. Follow our social media page(s) and get notified of the next installments.

For now, how have you funded different stages of your business so far? And what other funding options did we miss?

Editor’s Note: This post first appeared on The Business Hub on 23rd July 2014.

How to Multiply Investments in African Startups

Hello and welcome to FYI

In our very first post, we present an answer to the central theme of the Global Entrepreneurship Week (GEW) of November 2014.

The GEW meetups were organized as part of VC4Africa’s celebration of African entrepreneurship. Hailed as Africa’s largest start-up event, the networking meetings were held in 40 cities across the world; from Abidjan, Dar es Salaam and Nairobi, to Helsinki, Nuremberg, and Seattle. In Abuja, the conversation focused on the importance of collaboration, the pursuit of early traction, and the encouragement of sustainable networks of entrepreneurs and investors.

Collaboration remains one of the most important buzzwords of the 21st Century. Across fields as diverse as construction, conflict resolution, and international aid, it’s changing how we find solutions to emerging problems. It is no surprise then, that African entrepreneurs are finding theirs through easily identifiable clusters that allow the early exchange of knowledge, skills, and ideas. The rapid growth of incubation centers and shared working spaces across the continent, and the fact that our meetup held in one, can only continue to encourage investments.

Traction is gained through early testing of a minimum viable product or service. Simply put, it presents a picture of what or who your customer is, how many potential ones currently exist, what they think of your product, and whether or not they’re willing to pay for it. Its role as proof of product acceptance and viability in the decisions of equity investors has been critical to the success or failure of many an African start-up to secure investments. The pursuit of early traction can therefore only encourage greater investments.

The role of networks of entrepreneurs and investors in driving investments in African start-ups cannot be over-emphasized. If the success of VC4Africa is anything to go by, an important space exists. However, we believe these spaces can be more effectively filled through sustainable, local networks. Talk of a proposed Abuja Angel Investor Network (to be unveiled this year) generated excitement among the entrepreneurs. Investisseurs & Partenaires (I&P) is already providing these options in Niger and Burkina Faso and has challenged investment teams across Africa to join their expansion project.

Finally, the importance of the knowledge of funding options to African entrepreneurs cannot be neglected. 21st-century business owners, regardless of company size or demography, face a constant battle to find the right balance between debt and equity. And if African start-ups want to attract and retain the right kind of investments, this knowledge can only be beneficial.

Your thoughts?

Editor’s Note: A version of this article first appeared in the Business Hub on 14th January 2015.