Many businesses need funding at some stage, whether it is a startup wanting to purchase its first assets or an established company looking to expand. Claude Harding explains the basics of fund raising.
Companies requiring funding usually find themselves in one of the following four scenarios.
Seed capital: Such funding is usually for businesses still in the idea or conceptual stage. Funding is often required to cover initial operating expenses until a product or service can start generating revenue.
Startup funding: Once a business model or product has been finalised, funding is required to set up the company, e.g., purchasing assets and setting up infrastructure.
Working capital: At startup phase to cover initial running costs until break-even is reached or to bridge the cash flow cycle of an existing business.
Expansion funding: Usually in the growth phase to acquire additional assets to increase capacity and sales.
Methods of raising funding
Debt: Taking on debt involves the borrowing of funds at a pre-agreed interest rate and repayment terms. Money can be borrowed from banks or other financial institutions, as well as from family or friends.
Equity: Equity involves an investment in a company where the investor becomes a shareholder in the business. Equity typically does not require the company to repay the investor, but as a part-owner of the company, the investor will share in the profits. Sources of equity include private investors, private equity firms and venture capital firms.
Grant funding: Another option is grant funding – funding programmes by government divisions or non-profit organisations. Usually funding is made available for businesses within a specific industry such as tourism, film, textiles, technology, or companies that are involved in manufacturing, which is labour intensive. There are usually specific qualifying criteria for funding under these programmes, such as number of employees, markets, product, historical performance, and ownership. Funding is provided with the express purpose of developing trade/industry/job creation within certain focus areas.
Debt vs. Equity
The decision on whether to borrow money from a bank (debt) or to sell a stake in your company to an investor (equity), can be complex, with each option having its pros and cons.
The right decision will depend on a number of factors, including your own financial capacity, potential investors, your credit history/record, your business plan, tax implications, the type of business you plan to start, etc. You need to evaluate all aspects and obtain expert advice before making a final decision. It is also important to remember that how you raise funds, affects the cost of capital (how much it costs you to finance your business).
Advantages of debt compared to equity
Because the lender does not have a claim to equity in the business, debt does not dilute the owner’s interest in the company. A lender is entitled only to repayment of the agreed-upon loan plus interest, and has no direct claim on future profits of the business.
If the company is successful, the owners reap a larger portion of the rewards than they would if they had sold stock to investors in order to finance the growth.
Principal and interest obligations are known amounts, which can be forecasted and planned for. Interest on the debt can be deducted on the company’s tax return, lowering the actual cost of the loan to the company.
Disadvantages of debt compared to equity
Unlike equity, debt must, at some point, be repaid. Interest is a fixed cost, which raises the company’s break-even point. High interest costs during difficult financial periods can increase the risk of insolvency. Companies that are too highly leveraged (that have large amounts of debt as compared to equity) often find it difficult to grow because of the high cost of servicing the debt.
Cash flow is required for both principal and interest payments and must be budgeted for. Most loans are not repayable in varying amounts over time based on the business cycles of the company.
Debt instruments often contain restrictions on the company’s activities, such as preventing management from pursuing alternative financing options or taking advantage of non-core business opportunities.
The larger a company’s debt-equity ratio, the more risky the company is considered by lenders and investors. Accordingly, a business is limited as to the amount of debt it can carry.
The company is usually required to pledge assets of the company to the lender as collateral, and owners of the company are in some cases required to personally guarantee repayment of the loan.
Types of financiers
Bank: Banks would generally provide startup and expansion funding – no seed capital. A company must have a solid business model before a bank will extend a loan.
Venture capital company: Venture capital firms will normally invest money as seed capital, startup funding, or early stage funding.
Private equity firm: Usually gets involved with expansion/growth funding. Due to the nature of the risk, and the expected returns, PE firms look for companies with a proven track record.
Government programmes and NGOs: These programmes and initiatives cover all the business development stages. Funding is dependent on each organisation’s particular goal.
Core principles of financial management
Every decision you make has a financial implication. There are three fundamental principles when it comes to business finance/financial management. They are:
Investment: Invest in assets/projects with the intent to earn returns. Think about why you are borrowing money/raising capital – the goal should be to grow the business and increase profits.
Financing: Choose a finance option/mix which makes the most of the value of the investment. Consider the cost of the funding versus the return on the project – it must be profitable.
Dividend/reward principles: Many businesses are run for the express purpose of providing the owner with an income – all profits are disbursed as owner’s remuneration, without any consideration for the long term sustainability and growth of the business. Profits (after owner’s remuneration) should be invested back into the business.