Starting a new business usually requires money for activities related to business activities, such as product or service development, feasibility studies, market research, building prototypes, market and customer identification, purchase / lease facilities, hiring employees, etc. The illustrative graph included in related article Why, how, where and when entrepreneurs make money demonstrates the money requirements in the initial phase of the company.
Despite multiple financing options, obtaining financing is not easy and business owners and entrepreneurs may have a limited understanding of the pros and cons of available funding sources. Let us look at two common types of start-up financing: debt and equity.
Existing business versus startups
Existing companies have different financing requirements, backgrounds, perspectives and track records than startups. Existing companies have the advantage of established track records with detailed numbers. They can easily justify their financial needs and better qualify for financing on the basis of concrete plans for expansion into new areas or business sectors, supported by previous experience.
Startups are usually new companies that are still taking shape or are entrepreneurial companies based on a new product or service offering. Background information is not available, success is doubtful and sustainability can be risky. As a result, only a limited number of investors are willing to financially support startups.
In the simplest terms, a loan is money that has been received today to be repaid in the future together with interest (based on predetermined criteria).
Multiple sources are available for loans. A person (family member, friend) or a company (bank, investors, venture capitalists, etc.) can act as a lender, based on the trust between the lender and borrower or a convincing business plan. Loans can be easily secured (from friends or family) with little paperwork, but can be quite complicated if they come from external sources, because a lot of persuasiveness and formalities are needed.
The benefits of loan financing include:
- Loans are easier to understand and apply if the financing amount is relatively small to moderate.
- Lenders usually have no control over business decisions as long as the repayments are on time.
- The involvement of the lender ends as soon as the borrower repays the loan (with interest).
- Few countries offer tax breaks on interest paid on business loans.
- Term-based loan repayments provide easy-to-project numbers for future business operations, enabling a robust track record and meeting the accounting needs for future business / financing requirements.
- Governments often offer subsidized loans for small businesses. For example, the US Small Business Administration (SBA) offers SBA loan programs.
Financing amounts can vary depending on the different loan providers (and the relevant regulations), and can sometimes be a challenge:
- A family member who is willing to offer an interest-free loan may need to consider grant limits. The lender may be forced to charge a minimum IRS interest rate, even for other family members.
- An individual lender may have to comply with fixed rules and the necessary paperwork.
- A loan from an angel investor may have set a limit on both sides. Your startup financing requirement of $ 100,000 may be too small for consideration by a venture capital fund that only needs loans to companies with a minimum of $ 5 million.
In addition, lenders can directly or indirectly ask a part of the start-up company to request a mortgage (s) or guarantee (s) to secure their borrowed money and to avoid risks.
With equity financing, business owners offer part of their business to investors in exchange for a desired amount of financing.
Benefits of financing with equity:
- The risk is taken indirectly by the investor (s) who provides the financing.
- There is no requirement to repay the funds if the company goes bankrupt.
- It offers a recognizable appreciation for a starting company.
Challenges for financing with equity:
- It can be complicated to understand this.
- Business owners pay part of their business share to investor (s).
- Important decision-making requires approval from the investor (s).
- There are high costs associated with legal, administrative and procedural formalities.
- The financing period can be very long.
- A limited number of investors are willing to help start-ups.
- Maintaining relationships with investors is of the utmost importance, despite their positive / negative impact on a company, as the overall reputation of the starting owner may be at risk within the small pool of equity investors.
Debt or assets?
Securing all types of money is not just about the ‘x’ amount of money and applying for it. A well-considered assessment with a systematic approach can help someone make the right selection. Debts enforce obligations of future payments whether the company is a success or a failure. While shares take away part of the ownership, limiting the freedom of an entrepreneur to work as he or she wants. (Think of Apple, Inc. [AAPL AAPLApple Inc174. 81 + 0 32% Made with Highstock 4. 2.6] founder Steve Jobs was once fired because of his own company due to differences with management and investors.)
- Choose a duration for your company (eg, number of months before the rollout). Be prepared with an exit strategy if things don’t work in the set time period. Your financing needs can decrease drastically if you complete the time horizon of your business venture.
- Determine your capital requirements over a suitable operating period (three months, six months, one / two / three years).
- Collect all your personal Summerson-rich savings. Add to this the expected income from your existing job or alternative sources of income (such as rent) over the desired duration of the start-up phase.
- Add to this the zero / low cost financing available from willing family members and friends (after tax and interest considerations).
- Arrive at the deficit amount, which will now be an accurate indicator of your realistic financing requirement.
- If your required financing amount is moderate, you go for the relatively simpler debt financing, provided that you can pay the interest payments and conditions of the lender.
- Moderate to large financing requirements can make the financing of shares more attractive (taking into account the complex nature of the deal and partial loss of ownership of the company). Fast-growing companies often opt for equity financing and predict higher future returns based on large investments.
- Larger financing requirements may mean that an entrepreneur wants a mix of both debt and equity financing.
- Explore a time-bound mix. Start with a small to medium-sized loan, and if your startup shows signs of success at the end of the debt, go for larger equity financing.
The bottom line
No lender finances a company unless there are certain signs of success and an observed return guarantee. Startup owners must approach lenders with concrete business plans, clear business models, growth paths and projected returns. Finally, convertible and convertible bonds are other possible financing options that can be considered.