Business Funding Options: Crowdfunding

Hello and welcome to FYI.

In the last four posts, we covered business funding options and delved into the worlds of bootstrapping, debt financing, and equity financing. This week brings the concluding installment of our five-part series. It’s about Crowdfunding as an innovative source that focuses on the customer.

So what is crowdfunding?

Simply put, crowdfunding is the process of raising money through small contributions from a large number of people during the startup process. In the past decade, it has been successful in funding sectors as diverse as music, politics, IT, scientific research, and journalism. And while platforms like Kickstarter and Indiegogo are leading the online revolution, innovations in real estate finance have promoted a rapid shift in the industry offline.

How does it work?

The entrepreneur sells his idea or project to the public via a neutral platform (usually a website) to prospective customers (the crowd) and receives donations towards meeting a funding target. Depending on the cause or project, the entrepreneur will also set contributory terms such as reward, debt, or equity and offer commensurate returns accordingly. It is this particular capability of being set up as debt or equity financing or even providing an avenue to escape the drawbacks of both that has made crowdfunding a game changer. Additional flexibility allows the entrepreneur to offer to return individual contributions if the funding target is not met and the project doesn’t go forward.

And how do you decide on a crowdfunding campaign?

The best campaigns offer donors the right incentives to attract investments. It is therefore your target donors and their interests that will determine how you design yours.

For innovations, reward-based campaigns will generally offer free products, discounts, or first-purchase options to contributors. Credit-based campaigns are used to finance projects that will generate enough money to pay back debt and remain sustainable, while equity-based campaigns are used to finance projects that will generate enough profits to be shared with donors. An additional charity-based campaign may be used to finance philanthropic causes where the donors do not even except anything personal in return. Such projects may include potable water supply in rural areas, disaster relief, or local drug research for epidemics.

Fundamentally, a decision on crowdfunding should be based on an understanding that it is fuelled by innovations in marketing and competition. Donors will only contribute to causes or projects that offer innovation or rewards, solve problems, or promise social identification. These qualities allow each donor to view himself as a customer, individually drive awareness, and help mobilize the funds needed for the project to succeed. As such, crowdfunding campaigns must be set up to trigger the right donor emotions. This usually means a touching storyline delivered with the right words and captivating visuals.

And here’s the good news for African entrepreneurs. An African crowdfunding solution called Funda Solva was launched this year. And according to its website, it has successfully raised close to twice the initial funding target for Solar Nigeria; a project that intends to source solar cells and wiring materials from Nigeria and build solar panels.

So what are you waiting for? With several options through bootstrapping, debt or equity finance and now crowdfunding, the last thing that should hold back your business is funding.

Editor’s Note: A version of this article first appeared in The Business Hub on 20th August 2014.

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

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.