Small Business Funding.
Are you thinking a way to startup your own business? Are you worried about the cost of such finance will badly impact to you? Will my finance gives me a better return? Well financial management has answers to all of these. Let’s discuss small business funding in detail.
So If you are reading this article for the first time I would recommend you to read our first three articles which will give you a hindsight on financial management and from now on it will be a detailed discussion on how to fund your business.
To manage finance we need to have Finance. This is basically small business funding
One simple classification of Finance is,
We can obtain fund by owner’s capital (Self Funding) or issue of shares- Equity Finance or money got from your friends family members, That is called private equity and the next option you have is obtaining a short term loan from the bank, we can issue bonds/debentures Which we call Debt Financing.
First and easiest and safest way of funding your small business is putting your own funds. But there are few concerns. We now we put our money to get a good return. But when its come to business it cant assure you a guaranteed return, it may vary on the performance of the business and how it operates in the foreseeable future. But you could have invested that money in place where you can get a guaranteed return and earn more. So we cant say there is no cost when putting your own money to the business. We call it “Opportunity Cost”- the next best alternative forgone investing money in your business. Therefore, always compare the options and then select the best one. But even if there are no short term profits business can grow in the future. That’s the nature of this investment. If you are planning to start your own business. You must invest some part of your own money as capital. This is the first choice you have relation to small business funding
Private equity is another way of small business funding. It’s a form of finance that you could get from a bunch of investors (Private equity funds) they mainly focus on company’s equity, which means the fund providers will ask for an proportion of ownership in the business. Private equity funds (PE Funds) are mainly focused on financing Private Companies so first you have to incorporate your business as a company and then seek for private investors.
PE Funds prefer investing in specific types of target companies based on the Life cycle stage of this target.
Some PE funds are interested in young companies with high growth prospective and controlled by good management team. While other PE funds are focused on established companies with stable cash flows. Where some are preferred to invest in Distressed Companies through Hedge funds
So how are they going to invest in your company?
First, they invest in your company shares and they may own majority of share capital in the organization and they probably change the management as well. This is also called a management buy-in in financial management. They will improve your financial performance of the business. Then they wait till few years to see whats going on with the business and they find a way to exit from the business with a good return in their hand. This is actually a good way to improve your business.
For your information there are two types of private equity firms
- Limited Partnerships (Most popular in United States)
- Close-end funds (Most popular in European Countries)
This is another form of private equity and globally has been a growing source of small business funding. So who are venture capitalists?
“Venture Capitalist (VC) are the organizations that provide money in return for an equity stake of the organization”
Same as PE funds venture capitalist is also seeks an ownership in the company but not majority maybe 20%-30%. VC will then ask for dividends and capital gains from the business. Then VC will look into profitability and growth prospects. If VC believes company is not growing, VC might not invest. He is just a money lender although he owns a proportion of shares. Therefore VC asks short term profits as return this is sort of a disadvantage for original owners. So if your company has just started business and company may have losses in the initial stage of the business, then perhaps it could lead to an equity ratchet. Equity Ratchet occurs when VC cannot get proper returns VC would confront the owners and say
“Look I gave you money, but I haven’t got a proper return for past few years, therefore I need more shares”
Like this vc might increase his shareholding which dilutes the ownership from original owners. This is the main disadvantage of private equity. But you could obtain quick funds without having to pay dedicated interest payments.
The next option you have is obtaining a bank loan as a Source of Finance. That also depends on where your business stays in the business life cycle. If you have just started operations then it will be very difficult to obtain a bank loan.
This is because of the risk– Established companies could have a good history of making profits rather than small businesses. So bank think they have the ability to repay the debt. But still there are lot of banks where you can obtain a loan for smaller business but with bit higher interest rates and a good security (eg- Land Deed). So if you can afford these two things there are banks who will ready to grant you a loan.
There are both advantages and disadvantages using this method as a method of finance.
1.Money is available in the business for a certain period (Unless there are no breach of loan covenants)
2.No need of giving an ownership to the bank in return of the loan.
3.Since interest rate are available, we can predict future interest payments and see whether there’s an negative impact coming from the interest payments.
There are disadvantages as well,
1.You have dedicated interest payments for bank loans.
2.You balance sheet may stacked with debt (highly geared)
3.The bank will be secured with the property if your business fails to meet the payments. Then business has to transfer the assets and settle debts prior to shareholders.
4.Lack of flexibility- you can’t take loans customized to your nature of business & has to agree to standard terms and loan covenants.
The next method of finance is share issue, but before going to deep dive lets understand the concept of Financial Markets.
Money Markets and Capital Markets
So from where we obtain finance for business funding – There’s a concept called Market in Financial Management.
In traditional definition, a market is where the buyer and seller meets. But now along with the introduction of e-commerce concept of Market Space came into play instead of Market Place.
Market Space is where the buyer and seller interacts rather than meets. (through online,Phone,texts..etc).
Same thing is with Financial Markets,
Financial Market is where the person who needs money (Borrower) and the person who gives the money (lender) interact.
Financial Surplus – Financial Deficit
There are two classification of Financial Markets