The startups should always be aware on their funding requirements, availability and accessibility of fundings. In this paper, funding options are explored and analyzed. In general, capital funding can be used for buying shares in equity or obtaining loans shown as liability to startups. Choosing the right funding options for startups, it depends on various factors, such as capital cost, exit criteria, management control, timelines, submission requirements, guarantees and securities and many others. From lending perspectives, investing in startups is a risky decision and it should be compensated with a higher return. The challenges facing startups to get fund are immensely severe due to the lack of track record and higher business and investment risks. The startups should come up with a funding plan showing actions and capital requirements during various business stages. Startup should also be aware of the funding obligations like interest rate, dividends, repayment schedule, ROI, exit arrangement, management control and others before they decide in any of the funding option. Nowadays online services have made funding easy to access and use; however, it is becoming more competitive and enable crowding users to enter this business arena.
What is Capital Funding?
Capital funding is the money that lenders and equity holders provide to a business. A company’s capital funding consists of both debt (bonds) and equity (stock). The business uses this money for operating capital. The bond and equity holders expect to earn a return on their investment in the form of interest, dividends, and stock appreciation.
- Equity Funding: To acquire capital or fixed assets, such as land, buildings, and machinery, businesses usually raise funds through capital funding programs to purchase these assets. There are two primary routes a business can take to access funding: raising capital through stock issuance and/or raising capital through debt.A company can issue common stock through an Initial Public Offering (IPO) or by issuing additional shares into the capital markets. Either way, the money that is provided by investors that purchase the shares are used to fund capital initiatives. In return for providing capital, investors demand a Return On Investment (ROI) which is a cost of equity to a business. The return on investment can usually be provided to stock investors by paying dividends or by effectively managing the company’s resources so as to increase the value of the shares held by these investors. One drawback for this source of capital funding is that issuing additional funds in the markets dilutes the holdings of existing shareholders as their proportional ownership and voting influence within the company will be reduced.
- Debt Funding: Capital funding can also be gotten by issuing corporate bonds to retail and institutional investors. When companies issue bonds, they are in effect, borrowing from investors who are compensated with semi-annual coupon payment (interest) until the bond matures. The coupon rate on a bond represents the cost of debt to the issuing company. Capital funding through debt can also be raised by taking out loans from banks or other commercial lending institutions. These loans are recorded as long-term liabilities on a company’s balance sheet, and decrease as the loan is gradually paid off. The cost of borrowing the loan is the interest rate that the bank charges the company. The interest payments that the company makes to its lenders is considered an expense in the income statement, which means pre-tax profit will be lower.
- Cost of Capital: Companies usually run extensive analysis on the cost of receiving capital through equity, bonds, bank loans, venture capitalist, sale of assets, retained earnings, etc. A business may assess its weighted average cost of capital (WACC) which weights each cost of capital funding to calculate a company’s average cost of capital. The WACC can be compared to the return on investment capital (ROIC), that is, the return that a company generates when its converts its capital into capital expenditures. If the ROIC is higher than the WACC, the company will move forward with its capital funding plan. If it’s lower, the business will have to re-evaluate its strategy and re-balance the proportion of needed funds from the various capital sources to decrease its WACC.
What are the purposes of financing?
Capital funding can be used to finance the following:
- Working capital
- Acquiring a new business
- Adding new infrastructure
- Selling a business
- Merging with a business
How to develop a finance action plan?
Every entrepreneurs and startup owners will need to work out the finance action plan as per the following headlines:
- What does your company need the finance for?
- When do you need it?
- How much do you need?
- Which type of finance do you think is appropriate?
What is the broad funding landscape?
Funding landscape demonstrates the funding needed at different business stages as per the following framework:
- Pre-startup stage: to finance the business concept and feasibility.
- Commercialization stage: to finance working capital.
- Growing stage: to finance growing activities, like staffing, production, marketing and sales.
What are the key types of finance?
- Internal finance:
- Sweat equity: Unpaid man-hours performed by the owner of the business.
- Personal savings
- Retained profit
Advantages: Easy to get, full control of management, no financing charges and obligations. Disadvantages: no external participation, weak team management, risk to fail.
The government agencies, development institutions and individuals may offer grants to encourage potential entrepreneurs and startups to build and grow successful businesses.
Advantages: The main advantages of such financing is that it is free of charges and has no control over the management of the business. Disadvantages: It is not usually available upon request but it requires certain conditions & prerequisites as well as it is available through competition and finally the time frame to acquiring such grant is out of control of claimers.
- Loan finance:
- Asset Based Lending: When an organization lends money to a company against all their assets including property, plant machinery, stock or sometimes against their brand name.
- Factoring Loan: You raise an invoice to your client for products and services provided and at the same time as you send the invoice to your client you apply to your factoring company to have the invoice discounted as per your agreed facilities. The factoring company will take over the factoring invoice and collect the payments. There are two types of factoring: recourse and non-recourse factoring. The key differences between the two types are the course factoring the factoring company doesn’t carry the risk or obligation on uncollected payment and it will remain the core obligation of the owner of the invoice.
Advantages: are easy to get cash based on receivable dues and you can raise invoices on a daily basis and discount them at certain percentage in agreement with the factoring company. The charges of factoring are usually competitive. Disadvantages: are bad debt will affect the cash in flows. Some clients may not want to be chased by other companies for cashment. For small amount invoices, it may be unworth to factoring them due to higher overhead cost associated with issuing and chasing cashment.
- Invoice Discounting: Invoice discounting releases money from the debtor book and can be up to 100% of total debt. Unlike factoring, the company retains complete control over the reporting and collection of debts. As a general rule, invoice discounting fees are slightly cheaper than factoring.
Advantages: are easy to get cash based on receivable dues. The charges of discounting is cheaper than factoring discounting. Invoice discounting is usually done between the business and its clients and thus it keeps certain level of confidentiality. Disadvantages: are bad debt will affect the cash in flows. For small amount invoices, it may be unworth to factoring them due to higher overhead cost associated with issuing and chasing cashment.
- Leasing and asset finance: leasing assets basically means that you rent or hire the asset over period of time but never own it. Sometimes the lessor may agree with leasee to buy the asset based on set of preagreed conditions and terms.
Advantages: are where technology is prone to change rapidly and the company will need to upgrade to more modern equipment with a relatively short period of time. They are usually cost effective and doesn’t require relatively huge cash to finance acquiring the wanted asset. Repayments will be extended over a period ranging from one year to 10 years depending on the nature and type of acquired asset. Disadvantages: It maybe resulted into paying leasing payments more than it is real market value.
- Commercial and corporate finance: Providing financial services to businesses including account management as well as providing loans and credit facilities. Itis known as a structured finance facilities and most recently as ‘ asset-based lending’. It ranges from the invoice factoring and discounting, stock financing, cash financing, plant and machinery financing, working capital financing and many others. The asset based lending will often present the company with indicative terms subject to due diligence, valuation and audit.
- Turnaround funding: it is usually associated with businesses seeking to restructure or ‘turn around’ a company’s financial position and replace existing funding and or obtain increased funding when in difficulty.
- Banking finance: A bank will offer a collective short, medium and long term loans. It includes overdraft (loan to finance cash flow requirements), bridging (finance transitional stage to acquire a capital assets like properties, businesses), receivable funding (invoice factoring and discounting), term loans, asset finance and leasing, commercial mortgages, fixed asset leans. Below is the banking finance services:
- Overdraft: It is mainly for financing short term financial obligations. It is normally low cost and more importantly highly flexible. Interest is counted and paid on daily basis. There is usually no cancellation fees and it is quick to arrange and can be easily extended to meet additional short-term requirements. Overdraft is normally secured against the business assets as well as personal guarantees from the directors including debenture charges over the director’s personal asset such as their house.
- Term loan facilities: They are usually utilized for the acquisition of assets or longer term capital requirements or even startup. The banking institution will advance a set amount of money over an agreed time frame either on a fixed or variable interest rate dependent upon the asset value and the prevailing base rate. The charges will be setting the loan contract and the loan ordinary interest rate. The term can be from one to ten years. Interest can be fixed or variable. In general there will be additional securities required in the form of personal guarantees or indeed debentures or charges. The bank may require cash flow projections and valuation of the acquired assets.
- Property finance: It is broken up into several sections including commercial, residential and sale and leaseback. Usually the lenders will advance between 60-70% of estimated value of the property. It is usually financed against the security of the property itself and maybe some personal guarantees.
- Trade finance: It included set of financial facilities related to trading. This included loans, LC, bank collection, factoring & discounting of invoices, cross border payment, foreign exchange. Trade finance by comparison refers to the provision of working capital to fund a transaction utilising the credit standing of the end-buyer’s order. This enables the funder to finance the purchase of the goods from the suppliers and obtain reimbursement from the end customer on delivery.
- Bridge Finance: short term finance for an individual or business until permanent or the nest stage of financing can be obtained. It is usually utilised for the property and land acquisition where funds are required for a very short period of time to bridge the gap between the placement of a deposit and securing a mortgage facilities. It is a fund for the term of up to 6 months and in very extreme circumstances up to one year. The charges are very expensive and it is normally charged for 1.5-3 % per a month plus facility charges. There are two types of bridge finance, one named ‘open bridge’ and the other ‘closed bridge’. The difference between the two finances is that with the closed bridge, repayments or the sale of a proportion have already been agreed though a third party thus guaranteeing the payment of the loan.
Advantages: No ownership of equity share, low level of management control. Disadvantages: Paid with interest, liability, expensive, required long period of time for deciding, required a long track of record, required securities, required promising business plan and growth.
- Equity Finance:
The process of raising capital through the sale of shares in an enterprise. It is a process of selling portion of the company’s ordinary shares. The shares offered up will be calculated on the perceived value of your company. For the new startup company, raising capital through equity share is a challengeable issue due to difficult valuation and lack of sufficient records. For the middle and larger size company. Issuing equity is well established practice. Stock market plays a significant role in raising equity share and liquidation. Private funds coming from individual investors. The most regular form of equity investment come from venture capital, investment trusts and angel investor networks. Venture capital and private investment has become much more widely available and the level of equity demanded has always been reflected in the perceived risk that the equity investor can expect. There various classes of equity share like prefered shares and ordinary shares. In the case of disruptive startups, venture capital and other individual investors will consider large amount of investment for relatively small portion of equity share, gambling on the fact that the product and the company will become extremely valuable over time. Equity financing can be obtained through the following financing sources:
- Family & friends: When your family members and friend decided to buy shares in your business.
Advantages: funders have personal connection with the owner of business and thus it is considered as an easy way of getting a business fund. Disadvantages: Funders are usually not getting involved in the management of the company. Funds are not made upon a thorough studying processes but instead it is due to personal connection and attractions.
- Business angels: high net-worth individuals who invest their own money in a business and require part-ownership in exchange for taking a high but measured risk. Since it is difficult to obtain capital fund for amounts less than £250,000 through banks and venture funds, it becomes an acceptable practice for individual investors to step over and invest in equity shares for small and startup companies. Business angles are wealthy and entrepreneurial individuals who provide capital in return for shares in a company. They take high personal risk in expectation of owning part of a growing business, and in return wish to have an active interest in that business or offer mentoring and advice which may protect their investment. There are factors to consider before you approach angel investor for equity funding:
- The amount will be between £25k- £750k and you are willing to part in your equity shares.
- You are happy to develop a personal relationship with the angel investor.
- Offer high return 20-30% and for the period 3-8 years.
- You have a strong understanding of your product and market and good business plan and actual market research.
- You have enthusiasm and commitment and a strong team.
- You have planned a time scale when the angel can exit either by buying back their shares at market rate or finding another investor to buy or selling the company.
Angel investor are members in angel networks. When angel has expressed an interest you need to check that they have the finance available and negotiate amounts, percentages, dividends, expenses, revenues, plans and all issues related to running the business. A solicitor accountant should preferably be involved in setting up of terms and any tax issues.
Advantages: Through accepting an angel investing, this will increase validity and open the doors for the business. Angel investors will be usually involved in the management of the business and assist to support success of the business. They require longer period to exit from the business. Disadvantages: Angel investors will usually require higher return (20-30% annually) and clear plan to exit. It is sometimes difficult to find and agree with angel investors.
- Venture funds: Venture capital funds are investment funds that manage the money of investors who seek private equity stakes in startup and small- to medium-sized enterprises with strong growth potential. These investments are generally characterized as high-risk/high-return opportunities. Venture capital is a type of equity financing that gives entrepreneurial or other small companies the ability to raise funding. Venture capital funds are private equity investment vehicles that seek to invest in firms that have high-risk/high-return profiles, based on a company’s size, assets and stage of product development. Venture capital investments are considered either seed capital, early-stage capital or expansion-stage financing depending on the maturity of the business at the time of the investment. However, regardless of the investment stage, all venture capital funds operate in much the same way. First, like all funds, venture capital funds must raise money prior to making any investments. A prospectus is given to potential investors of the fund who then commit money to that fund. All potential investors who make a commitment are called by the fund’s operators and individual investment amounts are finalized. From there, the venture capital fund seeks private equity investments that have the potential of generating positive returns for its investors. This normally means the fund’s manager or managers review hundreds of business plans in search of potentially high-growth companies. The fund managers make investment decisions based on the prospectus and the expectations of the fund’s investors. After an investment is made, the fund charges an annual fee of around 2%, and some funds may not charge a fee. The management fees help pay for the salaries and expenses of the general partner. Sometimes, fees for large funds may only be charged on invested capital or decline after a certain number of years. Investors of a venture capital fund make returns when a portfolio company exits, either in an IPO or a merge and acquisition. If a profit is made off the exit, the fund also keeps a percentage of the profits — typically around 20 percent — in addition to the annual management fee. Though the expected return varies based on industry and risk profile, venture capital funds typically aim for a gross internal rate of return around 30 percent.
Advantages: Through accepting an venture investing, this will open the doors for the business. Venture fund will be usually involved in the management of the business and assist to support success of the business. Disadvantages: It is available for a fund exceeding £250k. Venture fund will usually require higher return and more expensive than angel investor and clear plan to exit. It is sometimes difficult to find and agree with venture investors.
- Crowdfunding: A system in which many people invest very small amounts of capital into an SME, an individual or non-profit organization. This is always carried out on the internet and it a way of raising finance by tapping into a ‘crowd’ of like-mind individuals who are willing to invest small amounts of cash. There are three types of crowdfund: donation, equity and debt. If a project reaches its funding target it is considered successful. It is an internet platform linking borrowers with lenders in a modern, friendly and fast way of reaching a large audiences. Borrowers can get better terms and access to more capital than banks and lenders earn higher returns by investing in a number of companies. You will need to decide on your most suitable platform for crowdfunding. The platform is a middle-man organization matches business investors, funders and lenders with appropriate SMEs and entrepreneurs seeking funds. The platform usually offers advice, due diligence, promote the funding project, receive funds, distribute the fund on borrowers and contract ownership and terms. For such services, the platforms collect fees.
Advantages: It is an internet platform and it is easy to acquire fund. It is cheaper than other financing sources. It is granted and organized by the middleman platforms which administer and do the due diligent services. It is suitable for early stage and startups. Disadvantages: it is unregulated business and associated with higher risk of failing.
- Mezzanine finance: Convertible debt into equity. It is the process of loaning a company, which is in a development phase, for set of targets for selling out and the lender will have the right to step and convert the loan into equity especially if the company turns out successful.
Advantages: It provides funding that is normally not available to a commercial entity and provides a debt/equity solution. Disadvantages: Mezzanine financing is considered with a high interest rate due to high risk involved.
Written by: Munther Al Dawood
Enterprise Development Services
- Wooler, J. 2014. The Finance & Funding Directory, Harriman house, Great Britain.