The New Entrepreneur: Alternative Sources of Funding

As I stated in the previous post on funding your business, it may be that the banks are unwilling or unable to offer you the funding options that you need. Don’t lose hope, because they are other options available, and I will outline those here. Now, not every one of them will be suitable for your particular business idea, so it is important to consider the needs of your venture before deciding to proceed with any of them.

As a quick addendum for overdrafts, which I mentioned in the last post, I would just like to emphasise that while they are useful in covering day-to-day fluctuations in cash-flow, you need to be careful that they don’t form the bulk of your financing. Overdrafts are “on demand” facilities, meaning that the bank can rescind them at any time. If your account is constantly in the red, the bank is likely to parcel up your “core borrowing” into a short-term loan and impose a repayment schedule on you. Not only will this disrupt your financial planning in the short term, but it might also make it more difficult to obtain such credit in the future.

Term Loans
Term loans do actually come from banks, but they differ from business loans and overdrafts in that the bank will want personal guarantees from you as a business owner, as well as a charge against any physical assets as security. They are generally used for the purchase of specific assets such as machinery or computers that have a mid- to long-term life expectancy. The term of the loan will reflect the value of the assets and their expected working life. Interest can be fixed or floating, with interest payments made monthly or quarterly. Again, this will depend on both the nature of the assets, and also the terms offered by a particular bank, so it pays to shop around to see what is on offer.

Leasing
Leasing is the most common-form of asset-based format and takes the value of the asset being leased rather than your overall balance sheet, which is useful for startups or young companies that don’t have a long track record to which lenders can refer. It is also a good strategy for businesses that have asset-intensive needs, such as haulage companies or manufacturing plants. Generally, finance leases will show up on your balance sheet, while operating leases can be kept off. Depending on your business structure and tax regulations in your region, there may be advantages in choosing one over the other. It may even be more tax-efficient to lease rather than to buy particular assets. While many banks do have leasing departments, it is also sometimes possible to arrange leases with the manufacturers of the assets you hope to acquire. In addition, there are also specialist leasing firms who may be able to offer better terms than either of the former.

Invoice Discounting
Also known as factoring, invoice discounting looks at the debts and outstanding invoices owed to your business rather than your balance sheet. This is particularly useful once your business is up and running and you are experiencing rapid growth. The bank, or specialist credit firm will advance you a certain percentage of the money you are owed, taking their own cut in the form of a service charge for providing the service. While it is a flexible and quick way of raising funds, especially when compared to applying for an additional loan, it is expensive, and you need to be careful not too make too much use of this facility if it is available to you. It may seem counterintuitive, but you don’t want your business to grow too quickly unless this is something your business plan is banking on.

Private Equity
Equity basically involves handing a share of your business over to another individual or company in exchange for their investment. Now, this is why many budding entrepreneurs feel slightly anxious about private equity: your business is your baby, your came up with the idea, you’re the one who is going to take it forward, it’s only natural to feel conflicted about someone else owning a proportion of it. But ownership does not translate into control; it is not very difficult to have a shareholder’s agreement drawn up separating majority ownership from day-to-day control of a company. Shareholders who want to protect their investment, such as venture capitalists, may want certain concessions, such as a seat on the board, or preferential shares, but that is not to say that they will be hovering over your shoulder scrutinising every decision you make.

Venture Capitalists
It may not seem to be the case, given the hype that has surrounded a number of internet startups, but many equity investors are not actually interested in brand new businesses. The irony with equity financing is that it is far easier to raise large sumes than more modest amounts. Venture capitalists may not rate the possible returns from a smaller investment as worth bothering with, as the costs of conducting due diligence remain the same regardless of the sums involved, and smaller firms may therefore seem less appealing than a megabucks investment. There are some who may consider investing in smaller companies, but they are few and far between. Unless your business is likely to need a huge cash injection, searching for venture capital is probably a waste of your time.

Business Angels
Business angels are like the white rhino of funding options: it is rare to find one, they’re unpredictable, and your experience with one could be life-changing. Business angels are private investors, usually individuals who have made their fortune and are willing to invest in other ventures. They tend to have a more personal approach to the businesses they invest in, bringing both their expertise and their money to the table. As such, they generally tend to cluster in industry sectors where they are more comfortable, and as such are fairly difficult to track down. While their personal approach makes them more flexible than banks or venture capitalists when considering investment in your business, they can also be incredibly flighty, often changing their minds after initially being willing to invest. This is just another reason why you should get everything in writing, regardless of how straightforward something may seem.

Grants and Development Schemes
This is where I have to leave you on your own, I’m afraid. Depending on where you live and where you are going to start your business, there may be government or regional grants available to you. Given the international nature of the readership of this blog, it is impossible to outline the various options available. Nevertheless, it is a good idea to go to your local chamber of commerce, small business clinic, or regional development agency to see if there is anything available. Not every industry sector may be covered, but an additional port of call may also be the offices of the trade body for whichever sector you’re going to enter, as they may also have information about any funding or grants available to new entrants.

Generally, while equity finance will be the most expensive funding option for a new business, one of its advantages is that you do not have the burden of monthly interest payments to meet as you would do with debt financing such as a loan. After all, dividends are only expected when profits have been made. In addition, there is also no need to put up security, either in the form of assets or a personal guarantee. Nevertheless, be wary if you do choose equity as an option, as having too little equity could prevent you from accessing other funding, as owning a smaller proportion of your business means your creditors will have less to seize should you fail to repay your debts. When choosing the funding package for your business, you need to choose what is good for your business now, while you are starting up, in addition to considering what the options you choose mean for future growth.

[Image by KM & G-Morris]