Demystifying Funding – A Thought-out Business Funding Strategy
Businesses need funding at some point in the lifecycle, whether it is a Start-up requiring starting costs or an ongoing business requiring growth and working capital. Whilst funding is crucial, sourcing enough money can be difficult.
Funding commonly comes in form of debt or equity. Let’s attempt to look at understanding the options for funding and the approach.
Funding options depend on what kind of business you have. Its age, position, performance, market opportunities, team, and so forth are very important. And hence the need to tailor the funding search and approach to avoid disappointment and time wastage.
Understand the general realities of getting funded
Like so many things in business, a lot about business financing depends on your specific details. Realities go case by case, depending on the growth stage, resources, and other factors.
An ongoing business may have access to standard business loans from a traditional bank that would not be available to start-ups. Also, high-tech high-growth start-ups have access to investment funding that would not be available to stable, established businesses that show slow growth.
Before delving into viable funding options for start-ups and established businesses, it is important to highlight some funding realities. Not as discouragement, but rather to deal with realities that we can work with and not myths we can’t.
#1: Venture capital is NOT a growing opportunity for funding businesses
Venture capital financing is actually very rare. Very few high-growth companies with high-power management teams are venture opportunities.
#2: Bank loans are NOT the most likely option for funding a new business
Banks actually do not finance business start-ups. Banks are vested for their depositors’ interests and not supposed to invest depositors’ money in new businesses.
#3: Business Plans DO NOT sell investors
They actually don’t.
A well-written and convincing business plan (and pitch) presents a business to investors in detail; but investors invest in the business, not just a plan.
Emphasis is in the team in place, progress toward idea validation, or even better, traction (paying customers).
Investors don’t invest in ideas or plans. They may invest in the entrepreneur in the rare exception where investors know an entrepreneur well and are ready to invest in them at an early stage. But never the plan.
But STOP! What then is the role of a Business Plan? There is a role for the elusive Business plan.
Do understand, the business plan is key and an essential piece of the funding puzzle, among other details, explaining succinctly, exactly how much money you need, and where it’s going to go, and how long it will take to earn it back.
Investors will look first to a summary, and then a pitch; but if you get through that screening, they’ll want to see a business plan for the process of due diligence. And even before that, during the early stages, they’ll expect you to be running the business along a strategic business plan in the background.
Everyone you talk to is going to expect to have a business plan available. They may not start their discussions by looking at the plan, but do expect to see it at some point.
It is not possible to chalk out how you are going to spend the money without having a business plan. In fact, most investors will not fund your venture without a complete business plan.
Your business plan also needs to have a realistic financial forecast. You should forecast the expected cost the investment or loan will cover, and the returns it will generate in a certain time frame. The projected statistics, facts, and figures must have a justification.
Now that we have cleared that:
Let’s tackle the challenge of convincing others the business idea is a solid investment while seeking the funds.
1. Demonstrate a Scalable and Sustainable business model
Whether you are seeking Equity or Debt funding to expand, investors or lenders want scalability. Investors, in particular, fund scalable or ready to scale businesses. Your business model must show the potential to increase the revenue with minimal expenditure during the term of the plan.
This means being able to increase profits without increasing costs at an equal (or higher) rate. Sure, it should be unique. But without scalability, it is less likely to be investable.
Usually, scalable business models have higher profit margin and lower infrastructure and marketing costs. If your business model is likely to result in the overextension of time, money, and resources, investors will be hesitant to invest.
2. Determine how much money to ask for
Whether you are asking angel investors to fund your expansion or seeking a bank loan, you must know how much money you need. Be specific and concrete of the needs.
When investors invest, they expect to see how, when and where you plan to spend their money. They will expect you to spend the funds to grow the business to its next milestone.
In other words, they wouldn’t be impressed if you intend to use the funds on paying down debts, high leadership wages, fancy furniture, cars or unnecessary automation. Milestones need to be measurable achievements.
Every business will have a few rollercoaster moments. However, your business should be able to show consistent achievements.
Demonstrating and showing the company’s ability to stay cash flow positive through the expansion phase is key. Better cash flow increases the chances of receiving the desired funding.
There is no single approach here. Calculate how much money you will need for the necessary production, training, hiring, marketing, and automation to create a viable financial model. Figure out where your cash flow bottoms out and add appropriate buffers or contingencies.
Make sure your funding request is in-line with your financial projections.
Most people would say you should raise as much money as you can. However, in many cases, more isn’t always better.
More funding can equate to increased pressure to scale up your business quickly. Although it can be helpful for healthy growth, sometimes it can prove detrimental—companies that have received huge amounts of investment have failed because they couldn’t manage the rapid expansion.
The bottom line is to ask for the amount of money your business needs and can handle.
3. Find the right funding option
To increase your chances of getting funded, you need to choose the most suitable funding alternative. You may need to consider and leverage more than one option to fund the business.
Each option comes with a distinct set of advantages and disadvantages. You will have to make your decision based on your particular situation.
The process of looking for money must match the needs of the company. Where to look for money, and how to look for money, depends on the company and the kind of money it requires. Research and be clear about it.
So, what type of funding is available to businesses?
A. Venture capital
Venture capital is frequently misunderstood. Many companies complain about venture capital companies for failing to invest in ventures.
People talk about venture capitalists as sharks, because of their supposedly predatory business practices, or sheep, because they supposedly think like a flock, all wanting the same kinds of deals.
Think of the venture capital business as a business in its own right. The people we call venture capitalists are business people who are charged with investing other people’s money. They have a professional responsibility to reduce risk as much as possible. They should not take more risk than is absolutely necessary to produce the risk/return ratios that the sources of their capital ask of them.
Venture capital should be thought of as a source of funding for very few exceptional businesses. Venture capital is usually afforded to businesses with an extraordinary combination of product opportunity, market opportunity, and proven management.
Venture capital professionals look for businesses that they believe could produce a huge increase in business value within short periods. They are acutely aware of failure rates of high-risk ventures, so the winners have to win big enough to pay for all the losers.
They focus on scalability by huge multiples over a short period of time and try to work only with proven management teams who have dealt with successful businesses in the past.
They tend to invest in business models that are designed for rapid growth and huge expansion. Being professional investors, they can provide guidance in growing the business, they’ll also probably be interested in having a say in how your business operates.
Keep in mind that venture capital firms will invest at a point when injecting more capital into your business will result in further growth and more profit.
If you are a potential venture capital investment, you probably know it already. You have management team members who have been through that already. You can convince yourself and a room full of intelligent people that your company can grow.
B. Angel investment
We started with venture capital first because the phrase is more common, and some people think of all outside investment as venture capital.
The reality, however, is that what we call angel investment is much more common than venture capital, and usually is much more available to start-ups, and at earlier growth stages too.
Although angel investment is a lot like venture capital (and is often confused with it), there are clear differences. First, angel investors are groups or individuals who invest their own money. Second, angel investors tend to invest in companies at earlier stages of growth, while venture capital typically waits until after a few years of growth.
Businesses that land venture capital typically do so as they grow and mature after having started with angel investment first.
Like venture capitalists, angel investors normally focus on high-growth companies at early stages of development. Don’t think of them for funding for established, stable, low-growth businesses.
Angel investors may offer more flexible investment terms compared to the venture capital firms. They typically tend to invest less than venture capital in exchange for equity.
The significant disadvantage of using angel investors is losing the ownership of a part of your company in exchange for the money. They will also have a say in how the business is run, and they’ll be highly interested in an exit strategy.
It is worth noting, in most jurisdictions’ angel investment is or was limited to individuals meeting some minimum wealth requirements, called “accredited investors” in the legal wording. Whilst still under debate in some jurisdictions, Crowdfunding is the accepted term for individual investment by people who don’t meet the legal wealth requirements.
Under certain conditions, small business can solicit investment from a wider range of investors. Details are still fuzzy on a lot of this, so, it is recommended to check with a good commercial lawyer first.
Again, depending on the jurisdiction you fall under, Crowdfunding can help you to reach a broad group of potential investors and possibly generate publicity for the business. However, crowdfunding campaigns require a significant amount of time and planning, and your ability to achieve funding often rests on whether you already have a wide network that you can access to ask for support. Plus, some platforms mandate that if your campaign fails to raise the target amount, you don’t receive any funding at all.
To succeed, you must keep the campaign visible, measurable, and understandable. Having a well-established network of friends and professional contacts can increase the chances of a successful campaign.
D. Commercial lenders
Banks are even less likely than venture capitalists to invest in, or loan money to, start-up businesses. They are, however, the most likely source of financing for established small businesses.
Start-up entrepreneurs and small business owners are too quick to criticize banks and financial institutions for failing to finance new businesses. Banks are not supposed to invest in businesses, and are strictly limited in this respect by banking laws.
The government in most jurisdictions prevents banks from investment in businesses because society, in general, doesn’t want banks taking savings from depositors and investing in risky business ventures; obviously when (and if) those business ventures fail, bank depositors’ money is at risk.
Would you want your bank to invest in new businesses (other than your own, of course)?
Furthermore, banks should not loan money to start-up companies either, for many of the same reasons. Regulators want banks to keep money safe, in very conservative loans backed by solid collateral. Start-up businesses are not safe enough for bank regulators and they don’t have enough collateral.
Why then do I say that banks are the most likely source of small business financing?
Because small business owners borrow from banks. A business that has been around for a few years generates enough stability and assets to serve as collateral. Banks commonly make loans to small businesses backed by the company’s inventory or accounts receivable. Normally there are formulas that determine how much can be loaned, depending on how much is in inventory and in accounts receivable.
A great deal of small business financing is accomplished through bank loans based on the business owner’s personal collateral, such as home ownership. Some would say that home equity is the greatest source of small business financing.
Most bank loans require at least two years of tax returns showing good gross and net profits. In other words, you need a good credit history. Banks will also ask for collateral such as equipment or real estate. They will always ask you for a full traditional business plan. Make sure it includes financial statements or projections, personal and business credit reports, tax returns, bank statements, and growth projections.
E. Other Lenders
Aside from standard bank loans, an established small business can also turn to accounts receivable specialists to borrow against its accounts receivables.
The most common accounts receivable financing is used to support cash flow when working capital is hung up in accounts receivable.
For example, if your business sells to distributors that take 60 days to pay, and the outstanding invoices waiting for payment (but not late) come to $100,000, your company can probably borrow more than $50,000.
Interest rates and fees can be relatively high, and in most cases, the lender doesn’t take the risk of payment—if your customer doesn’t pay you, you have to pay the money back anyhow. These lenders will often review your debtors, and choose to finance some or all of the invoices outstanding.
Another related business funding practice is called factoring. So-called factors actually purchase obligations, so if a customer owes you $100,000 you can sell the related paperwork to the factor for some percentage of the total amount. In this case, the factor takes the risk of payment, so discounts are obviously quite steep.
This sort of funding, however, is only recommended where the margins can accommodate the interest, discount, establishment and other related costs. I have noticed businesses overburdened and irreparably paralysed due to the ease and wide availability of acquiring this type of funding. Read the fine print!
More importantly, attempt to fix “Leakage” in the business to ease cashflow before turning to this type of funding. Get a good Business Advisor or a Management Consultant to help FIRST.
F. Friends and family funding
If I could make only one point, it would be that you should know what money you need and understand that it is at risk.
If you take money from friends and family, then you can never get out – Businesses sometimes fail.
Most jurisdictions discourage getting business investments from people who aren’t accredited or sophisticated investors. They don’t fully understand how much risk there is.
If your parents, siblings, good friends, cousins, and in-laws will invest in your business, they have paid you an enormous compliment. Please, in that case, make sure that you understand how easily this money can be lost, and that you make them understand as well.
Although you don’t want to rule out starting your company with investments from friends and family, don’t ignore some of the disadvantages. Go into this relationship with your eyes wide open.
Asking your family and friends to invest in your business comes with considerable risks. You are not only risking their financial future but also potentially jeopardizing personal relationships.
You can, however, readily overcome these risks by writing a formal business plan just like the one you would use to attract professional investors. Then, handle the funds with professionalism. Document the terms (particularly what will happen if you can’t pay back the money) and stick to your agreement.
G. Bootstrapping or Self-funding
The best (and the cheapest) option for funding your business is using your own savings. Flexible investment terms and quick availability makes it an attractive funding source.
However, if things don’t pan out, you lose your business and also your nest egg. Maybe choose to both run the business and work a day job until it is profitable.
Credit cards from a bank you have already got a relationship with maybe a simple option depending on where in the growth phase you are in.
It is also the most expensive option, as credit card debt comes with high interest rates.
Most credit cards are also personal, meaning that if your business goes bankrupt, you are still personally liable for any debt. Plus, your credit score will take a hit the moment you miss a payment—this can affect your ability to secure funding in the future.
Know how much you are betting, and don’t bet money you can’t afford to lose.
H. Government and Industry Grants and Awards
Whilst, we have left this last on the list; this type of funding can be beneficial in a number of ways if successful.
They help create awareness, validation and recognition in a very short span, which if used correctly can catapult the business in to its next phase very quickly.
The preparation, however, to qualify for these grants and awards can be just as arduous as pitching for other forms of funding, if not more.
More often than not, there may be a need to source outside funding to qualify, which can help diversify the risk and allow pre-qualification for other sources of funding at later stages, if required.
4. Stick to the spending plan and Communicate with your Investors once you’re funded
If you took investment, you’re accountable to your investors to do what you said you would do with their funds and to be transparent if you’re thinking of changing course.
Avoid going on a spending spree. Don’t spend the money on high leadership wages, paying down debt, overly expensive furniture, unnecessary automation, technology, workspace, infrastructure, equipment, business trips, and lunches. Save the splurge for when you’re bringing in more revenue.
Keep your investors in the loop showing them that their money is being put to good use – this will help forge a bond of trust.
Words of warning
Sadly, financing and investment involves money; and money breeds some predatory business practices, scams and such. So here are some reminders to help you avoid the pitfalls.
- Don’t take private placement, angels, friends, and family as good sources of investment capital just because they are described here or taken seriously in some other source of information. Some investors are a good source of capital, and some aren’t. These less established sources of investment should be handled with extreme caution.
- Never, spend somebody else’s money without first doing the legal work properly. Have the papers done by professionals, and make sure they’re signed.
- Never, spend money that has been promised but not delivered. Often companies get investment commitments and contract for expenses, and then the investment falls through.
- Be aware that turning to friends and family for investment is not always a good idea. The worst possible time to not have the support of friends and family is when your business is in trouble. You risk losing friends, family, and your business at the same time.
Most businesses are financed by home equity or savings as they start—bootstrapping. Only a few businesses can attract outside investment. Venture capital deals are extremely rare. Borrowing will always depend on collateral and guarantees, not on business plans or ideas. And business borrowing is normal for ongoing businesses with an established history, but not a normal option for start-ups.
What might be the next steps to take depends a lot on your specific business. Generally, most businesses might explore angel investment or friends and family first, while steady ongoing businesses should start by asking their small business banker. But always remember, your business is unique.
Funding is a tough nut to crack. Whether you are approaching a venture capital firm or trying your luck on a crowdfunding site, you will come across multiple hurdles while in search of funds.
Highlighting these general dynamics and the most common funding challenges should steer the funding quest in the direction of least resistance to secure appropriate capital for the business.
Let us know how you manage to secure funds for your business.
If you need an external eye to look at your quest for funding, Pick up the phone and call us for an obligation free assessment.
I am keen to understand the challenges businesses are facing in raising appropriate funding as we drill further in the technical aspects of preparing for pitches and looking for funding.
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Ketan Shah is a Business Advisor, Management Consultant and Entrepreneur with over 15 years of experience in Strategy Planning, Portfolio Management, Performance Measurement/Management, Project Management and Business Process Improvement. He is especially passionate about Business Strategy, Structure, Management, Operational Planning & Implementation for Growth, Turnaround and Commercialization initiatives.
Moksh Pty Ltd is a Strategic Business Advisory, Management Consulting, Investment & Funding Partner Supporting Turn Around, Growth, Commercialisation Initiatives.