How to obtain Finance for your business?

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.

Owner’s Capital

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

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

  1. Limited Partnerships (Most popular in United States)
  2. Close-end funds (Most popular in European Countries)

Venture Capital

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.

Bank Loans

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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.

Advantages

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.

Share Issue

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

Money Market

Short term capital requirements are fulfilled- If your requirement is short term

Capital Market

Long term capital requirements are fulfilled-If your requirement is long term.

What are Money Markets?

The money market is the field in which financial institutions make accessible to a wide range of borrowers and speculators the opportunity to purchase and offer various forms of short-term securities. There’s no physical “cash showcase.” Instead it is an casual arrange of banks and dealers connected by phones,  and computers using online mechanisms.

So basically money market is where short term instruments are traded and the instruments have maturities ranging from one day to one year and are liquid (can convert the instrument into cash quickly).

Normally for business purposes we don’t pay much attention to Money Market because of its inherent limitations and the business goals are long term and they have long term financial requirement instead of short term.

What are Capital Markets?

The money market is the field in which financial institutions make accessible to a wide range of borrowers and speculators the opportunity to purchase and offer various forms of long-term securities. 

The basic capital market that we all know Is Stock Market (Stock Exchange).

Stock Markets are accessible to the companies which are listed

Stock Markets are two types.                     

1.Primary Market

Where organizations can raise new funds through issue of fresh (new) share to the public.

If your company is planning for a listing in the stock exchange then at first you must place your offer in the Primary Market. So basically this is where you raise Funds to your business.

So investors can visit your prospectus issued and after critically evaluating your business they will buy shares.

What happen afterwards….?

2.Secondary Markets

Investors need a space to trade the shares that they have bought with other investors.

Why is secondary market important?

In the primary markets company issue new shares and for those new share company gets money, but in the secondary market they do not issue new shares, what has been previously issued is now sold by one the investor and bought by another investor further that does not add more funds to the company.

For a moment will think you as an investor. Assume you have bought some shares of company XYZ Inc. from the primary market. Time passes and you will now want to sell the bought shares. As a rational investor would always like to have a gain by way of receiving dividend or selling those share to a higher price keeping a margin with you. So if there’s no Secondary Market in place how would you sell the shares?? If I cant sell back what I’ve already bought will Primary Market works? Answer is NO.

So this is where the secondary markets comes into play and that is a big issue that secondary market addresses.

Image Source- marketbusinessnews.com

A public listed company is a company who has listed their shares in the stock Markets such as

  1. New York Stock Exchange (NYSE)
  2. NASDAQ -USA
  3. Japan Exchange Group (JPX)
  4. London Stock Exchange (LSE)
  5. Shanghai Stock Exchange (SSE)
  6. Hong Kong Stock Exchange (SEHK)

What are the advantages of a Stock Exchange

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A public listed company is a company who has listed their shares in the stock Markets such as

  1. New York Stock Exchange (NYSE)
  2. NASDAQ -USA
  3. Japan Exchange Group (JPX)
  4. London Stock Exchange (LSE)
  5. Shanghai Stock Exchange (SSE)
  6. Hong Kong Stock Exchange (SEHK)

Since we discuss about raising funds for an organization In this article, lets discuss how to gain a good income by investing in secondary market in a separate article.

So basically if your shares are listed in above stock markets you will enjoy following benefits

Advantages of Stock Market

  • Access to more funds– Not like in private equity we are able to access more investors to our business through listing in a stock exchange, also if you have a finance requirement for a new investment you can sell your shares to raise new funds. Its easier than taking a bank loan and waiting it to be approved and paying additional interest. Further its easy and convenient way to obtain finance.
  • Business can grow via acquisition.- every entrepreneur’s, Shareholder’s dream is to grow their business, So by listing in the stock exchange you can purchase other company’s shares through secondary market, so if you can purchase a higher Percentage gradually & can acquire that company & have controlling power as the parent company. (If more than 50% is acquired)
  • Enhance public image – A listed company is known with general public and if the company performs well they can find new shareholders to invest in the business because they wont go and invest in a private company where there’s no details available to the public. This further improves our brand name.
  • Marketability of Shares- As discussed above shares of a listed company can be traded in the secondary market. So if you’re listed then its more convenient for your business and you have a readily available market price for your business.

On the Other hand there are few drawbacks of being listed in a stock exchange that you should be aware of,

Disadvantages of Stock Market

  • Strict Regulations- There will be essentially more prominent public regulation, responsibility and scrutiny. The legitimate requirements the company faces will be more noteworthy, and the company will moreover be subject to the rules of the stock trade on which its shares are recorded.
  • A wider circle of investors with more exacting requirements will hold shares.

Shareholders will always be looking at the business performances, will they make profits in future, how much dividend they will declare what is the share price next month…etc.

  • Additional costs involved in making share issues, including brokerage commissions and underwriting fees.
Image Source- www.adityabirlacapital.com

Financial Intermediaries

Who are financial intermediaries?

So far we have discussed what are Capital Markets and how they work, So If you plan to obtain funds to your organization this concept is also very important. So in a market there should be a supply and a demand and it should be effectively managed in order to be a successful market. So apart from the stock exchange there are other options that you can seek to obtain finance. Therefore financial intermediaries are the institutions that will create a link between the Fund Provider-(Supply of Funds) and the Borrower (Demand of Funds) to meet financial objectives of both the parties.

Image Source- www.theinvestorbook.com

 

Well he had a brief understanding regarding the ways that you could obtain finance to your business. You have to evaluate the each method with your condition. If you need any help regarding specified scenarios feel free to contact us in the comments section.

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