To understand where you can go to acquire the necessary capital to start, better manage, or expand your venture, you must first become acquainted with the various types of money available, how it is generated, and in what forms you’ll be able to obtain it.
There are two types of funding sources: internal and external. Internal funding is the most inexpensive way to generate capital because you are relying on your own operation to raise the necessary money.
External capital is just what it means – capital generated outside the company. Sources for external funding include banks, suppliers, commercial finance companies, investment bankers, and venture capital funds.
When planning to raise money, you should consider internal options before searching for an external source. Not only is it a logical way of proceeding, it lets you avoid the cost of borrowing as long as possible.
Even if you can’t generate all your capital requirements internally, at least you’ll offset the amount of money required so that only a portion has to be raised through external sources.
There is another plus to internal funding. Lenders are more apt to take a risk on you and your company if they know that you have an internal commitment to the venture.
They will also have more confidence in your management ability if you show them you can make the most out of internal resources. But there is also a danger to utilising internal funding.
You may end up investing a considerable portion of your assets into the business, making yourself unattractive to external funding because there is less opportunity for them.
Generally speaking though, those who utilise internal funding before they look externally will experience greater long-term success.
At some point during the growth of your business, you will need to raise capital through external sources. As you evaluate these sources, you should realise that there are several types of capital that can be generated through external funding.
Keep in mind that while there are different types of funding available, a combination of external sources is usually used.
In most cases, a business is borne out of the cash reserves of its owner. As stated, many lenders and investors frown upon risking any money for a proposed business unless the owner or owners have a vested interest in it.
This is especially true on the small-business level. If you are unwilling to accept the fact that you will have to commit some or all of the funds to start your business, perhaps you should rethink the idea of business ownership.
Many experts ask, “Why risk your own money when you can use someone else’s?” The reason is simply because you won’t find anyone else to fund 100% of the business unless you’re willing to give up ownership.
For a lender or investor to take substantial risk, they’re going to ask for something substantial in return.
Either the cost of the money is going to be extremely high in terms of interest, or you are going to relinquish the majority of equity within the company.
Sure, you won’t risk your money, but what you are risking is your place in the future of your business.
By utilising your own money, you will not relinquish control of your company. You will reduce your debt service, and you will look more attractive to external sources because of the confidence in the business you’ve exhibited by investing your own funds.
To determine just how much money you have to invest in a business, you have to create a personal balance sheet.To assist you in obtaining or regaining control of your personal finances, consider compiling cash-flow statements on a monthly basis.
To determine your cash flow, first enter your variable expenses and fixed expenses. Add these to arrive at total monthly expenses. Now write in your gross income, which should account for your payroll cheque total, your spouse’s pay, and any extra money you earn. Subtract any deductions that appear on the face of the payroll or other cheques to arrive at take-home pay.
Next, subtract expenses from gross income to get your net income. Finally, subtract appropriate living expenses from your net income. On the bottom line, enter what you are left with. This is your disposable or discretionary income. This is the amount of money that works for you. It can be used for anything from leisure activities to building a savings or money-market account.
By creating a cash-flow statement, you are charting your leverage. When the standard monthly expenses are deducted, what is left shows you how much more debt you can incur. If you incur any more than that, you are forced to borrow. That is why you must understand cash flow – your knowledge of it can keep you out of trouble, both before and after you start your business.
Debt financing offers the widest choice of possibilities for raising money. It is a form of external funding based on receiving a loan from an outside source, repayable over a specified period of time at a specific rate that is usually tied to the going cost of money in the financial markets.
Debt financing sources offer loans which are either secured or unsecured. With a secured loan, you offer some form of collateral as an assurance that the loan will be repaid.
If you default on the loan, that collateral is forfeited to satisfy the payment of the debt. Most lenders will ask for security of some sort on a loan. Very few will lend you money based on your name or idea alone.
What type of security can you offer a lender when seeking a loan from an outside source? Here are the more common types:
Guarantor – A guarantor signs an agreement with the bank that states they will guarantee the payment of the loan.
Endorsers – Same as a guarantor except an endorser may be asked to post some sort of collateral.
Co-maker – Acts as a principal in the loan.
Accounts Receivable – The bank will usually advance a certain percentage of the value of the receivables.
Equipment – Lenders will usually accept a certain percentage of the value of the capital equipment as collateral for a loan.
Securities – If your company is publicly held, you can offer stocks and bonds within the company as security for the repayment of the loan.
Real Estate – Most lenders will lend a high percentage of the assessed value of the real estate, either commercial or private.
Savings Account – If you have a savings account, you can use it to secure a loan.
Insurance Policies – Usually loans can be made for a high percentage of the policy’s cash value.
You can also attempt to acquire debt financing through an unsecured loan. In this type of loan, your credit reputation is the only security a lender will accept. You may receive either a signature or personal loan for several thousand dollars – even more if you have a good relationship with the bank. But these loans are usually short-term and have very high interest rates.
Keep in mind that most outside lenders are very conservative and will probably not provide an unsecured loan unless you’ve done a tremendous amount of business with them in the past and have performed above expectations.
Even if you do have this type of relationship with a lender, you may still have to post collateral on a loan due to economic conditions or your present financial condition.
Considered by some to be an internal source because of its frequency of use and reliability, debt financing through friends and family is perhaps the best source of funds.
Most experienced business operators frown upon this type of financing for new start-ups or business expansion, but regardless of the lack of sophistication involved in raising money through this source, it remains one of the most popular ways to launch a business.
When borrowing money from relatives or friends, have a lawyer draw up legal papers spelling out rates, terms and amounts. Too many businesspeople borrow money on a very informal basis from people close to them. The terms of the loan have been dictated verbally and there is no written contract.
Even family and friends are sensitive on the issue of money. If they don’t feel you are running your business correctly, they may step in and try to interfere with your operational plans.
If you do decide to pursue this avenue of financing, make sure that everyone involved understands the implications of the project.
Approaching banks for finance
Banks are the best source of financing available. You should already have an association with a bank through personal or business accounts.
Your bank is the logical place to go in order to raise capital. Keep in mind that they are inclined to be conservative.
According to the Franchise Finance Manager at Citibank:
“Banks have traditionally had a tough time lending to anybody looking to start up in business, but recently we have become more accustomed to the franchise system and have placed more faith in the franchisor’s ability to select a reliable and trustworthy franchisee.
Franchising as a business opportunity is perceived by many banks to have a lower risk profile than independent businesses, but every franchisee is assessed on an individual basis all the same, and we still require a certain amount of assets or real estate as security.”
Banks will require both personal and business information from you before they will make any commitments. They need character references, a complete business plan outlining your objectives, collateral for security, and how much money you expect to make.
They need a plan on how the loan is going to be used to fund the business. Above all, they’re going to be looking at you as an individual because they’re investing in you.
Depending on the size of the loan you apply for, there are several possibilities. If you have a term deposit account at a bank, you can use this as collateral for a short-term loan.
Personal loans are a possibility if your credit rating is good. You can usually take out a loan of this type for several thousand dollars, even more if you have a good relationship with the bank. These loans are usually short term and attract a high interest rate.
Another short-term loan is a commercial loan. This type of loan is usually taken for a short period of 6 to 24 months and can be reduced by lump sum instalments paid during the term of the loan.
Shares, bonds, even your life insurance policy can be used as collateral. You can also use any real estate you own or have an equity in as collateral. Loans can be secured for up to 80 percent of the value of any real estate over periods ranging from 1 to 20 years.
The term of a loan varies according to the type of real estate security offered and the bank’s lending policy at the time of application.
When you first start in business, unless you’re unusually well capitalised, you will need to evaluate your personal expenses to see if there is any chance of reducing your living costs.
You want to show that you have positive cash flow. Banks want to be assured that the money generated by the business will cover your living expenses, so that you’re not going further into debt. From a financial point of view, they see you and your business as a single entity.
Be wary of the difference in interest rates between banks. Too often, the borrower is more concerned with finding a loan, rather than locking in the lowest interest rate. Being excited about your business is fine, but that doesn’t mean you should agree to pay ridiculous rates to the first bank that accepts your loan proposal.
Whether it’s money up front or money charged in increments so you don’t feel it, paying too much is never wise. Based on what you can qualify for, find a loan with a low interest rate and monthly payments you can afford. If your neighbourhood business bank isn’t competitive, look elsewhere until you find what you want. It’s your money after all.
Borrowing from the franchisor
Traditionally, the first place franchisees turn to for financing, once they’ve tapped their personal resources, is the franchisor.
When they offer financial assistance, nearly all franchisors in the country provide debt financing only. Some carry the entire loan or a fraction thereof through their own finance company, or they appoint a third-party finance company to whom they send franchisees for financing arrangements.
Loans made by the franchisor can be structured a number of ways. Some offer loans based on simple interest, no principal, and a balloon payment five or 10 years down the track. Others offer loans with no payment due until after the first year.
Instead of financing the entire start-up cost, franchisors may have financing for portions of the total cost. They may have financing plans for equipment, the franchise fee, operational costs, or any combination of these elements.
Franchisors are usually going to offer financing for all or a portion of:
The franchise fee
Purchase of supplies and products
Facility lease or purchase.
Generally, the larger the franchise fee, the smaller the portion of it the franchisor will fund. Recognise that some of these start-up expenses become ongoing expenses once operations are underway, depending on the nature of the business and the franchise arrangement.
Like other monthly or periodic expenses such as royalty payments and advertising fees, they are your responsibility.
In a lot of cases, franchisors have arrangements with leasing companies to lease you the necessary equipment. This can be a significant area for financing since equipment often makes up a considerable percent of a your total start-up costs.
If the franchise you’re considering doesn’t offer equipment leasing, look into non-franchise, non-bank companies that specialise in equipment leasing for franchises.
These types of financing companies will often provide asset-based lending to finance your furniture, equipment, signs and fixtures, and allow you to purchase the equipment at the end of the lease period.
Remember that a business is franchised for two reasons: to expand the business and to raise capital. If you have a reasonably good credit record and pass all the financial requirements, most franchisors will bend over backwards to get you on their team.
As stated earlier, franchisors usually assist with business plans, applications and introduction to lending sources. In many cases they serve as loan guarantor.
Equity financing & finance companies
Equity financing means you sell off a portion of your business to investors who may or may not actively participate in its management.
The main variable involved in equity financing is how much control to give up. This is the primary reason why equity financing is not popular in Australia.
It goes without saying that 9 out of 10 people would prefer to borrow money without having to hand over a piece of their dream venture to the lenders as a trade off.
Finance companies are geared towards active investors, and will generally loan money for more risky ventures than a bank will.
The trade off is that they will charge significantly higher interest rates. Finance companies will also be interested in collateral, your track record, and the potential of your new business.
Using venture capital
Like equity financing, obtaining money from venture capitalists is a very difficult and potentially detrimental avenue to take.
Although professional venture capitalists invest many millions of dollars annually in new and growing businesses, this is only a small percentage of the deals they are offered every year.
Venture capitalists like to invest in relatively new businesses that, whilst they might appear marginal, have the potential for relatively high profit and growth.
Venture capitalists are a diverse group of investors with different investment interests, skills and objectives. They specialise in financing particular industries or stages of development of an industry.
Some prefer to provide “seed” money for start up, while others are only interested in financing buy-outs. Some may favour particular geographical areas, others choose to specialise in financing certain industries.
They also have rules on the minimum amount of money they will invest. Some may operate on $50,000 to $100,000 minimums, while others will not invest in less than $200,000 to $500,000 projects.
Venture capitalists expect two things from the companies they finance – high returns and a method of exit.
Since venture capitalists are only successful with a small percentage of the businesses they fund, they must go into each deal with the possibility of a return of five to 10 times their investment in three to five years.
This may mean that they own anywhere from 20 to 70 percent or more of your company.
Each situation is different and the amount of equity the venture capitalist holds depends on the stage of the company’s development at the time of the investment, the perceived risk, the amount of capital required, and the current owner’s background.
Essentially, if you pursue this avenue of financing, you are looking to take on a partner, which means that you are willing to give up more of your business than just a slice of your creative skills. Consider the alternatives very carefully, and proceed with caution if you decide to go ahead with a scheme such as this.