Operating without investment capital or borrowed money is more difficult than they anticipated.
Why Most New Ventures Need Funding
Cash flow challenges, capital investments, and lengthy product development cycles are three reasons that most entrepreneurial ventures need to raise money during their early life.
A. Cash Flow Challenges
Inventory must be purchased, employees must be trained and paid, and advertising must be paid for before cash is generated from sales.
B. Capital Investments
The cost of buying real estate, building facilities, and purchasing equipment typically exceeds a firm's ability to provide funds for these needs on its own.
Some products are under development for years before they generate earnings. The up-front costs often exceed a firm's ability to fund these activities on its own.
Sources of Personal Financing
There are three categories of sources of money in this area: personal funds, friends and family, and bootstrapping.
A. Personal Funds
Involves both financial resources and sweat equity. Sweat equity represents the value of the time and effort that a founder puts into a firm.
B. Friends and Family
Often comes in the form of loans or investments, but can also involve outright gifts, foregone or delayed compensation, or reduced or free rent.
C. Bootstrapping
Finding ways to avoid the need for external financing through creativity, ingenuity, thriftiness, cost-cutting, obtaining grants, or any other means.
A carefully planned approach to raising money increases a firm’s chance of success and can save an entrepreneur considerable time. Here are the steps involved in properly preparing to raise debt or equity financing
- Determine precisely how much money the company needs.
- Determine the most appropriate type of financing or funding.
- Developing a strategy for engaging potential investors or bankers.
The primary disadvantage of equity funding is that the firm’s owners relinquish part of their ownership interest and may lose some control. The primary advantage is access to capital.
A. Business Angels
Business angels are individuals who invest their personal capital directly in start-ups.The prototypical business angel, who invests in entrepreneurial start-ups, is about 50 years old, has high income and wealth, is well educated, has succeeded as an entrepreneur, and invests in companies that are in the region where he or she lives.
B. Venture Capital
Venture capital is money that is invested by venture capital firms in start-ups and small businesses with exceptional growth potential. Venture capital firms are limited partnerships of money managers who raise money in “funds” to invest in start-ups and growing firms. The funds, or pools of money, are raised from high-net-worth individuals, pension plans, university endowments, foreign investors, and similar sources.
An IPO is the first sale of stock by a firm to the public. Any later public issuance of shares is referred to as a secondary market offering. When a company goes public, its stock is typically traded on one of the major stock exchanges.
Debt financing involves getting a loan or selling corporate bonds. Because it is virtually impossible for a new venture to sell corporate bonds, we’ll focus on obtaining loans.
There are two common types of loans. The first is a single-purpose loan, in which a specific amount of money is borrowed that must be repaid in a fixed amount of time with interest. The second is a line of credit, in which a borrowing “cap” is established and borrowers can use the credit at their discretion. Lines of credit require periodic interest payments.
Advantages are:
- None of the ownership of the firm is surrendered
- Interest payments on a loan are tax-deductible
- It must be repaid, which may be difficult in a start-up venture in which the entrepreneur is focused on getting the company off the ground.
- lenders often impose strict conditions on loans and insist on ample collateral to fully protect their investment.
A. Commercial Banks
Commercial banks have been reluctant to loan funds to entrepreneurial ventures, largely because they are risk-averse and because lending to smaller firms is less profitable for them compared to lending to large, established organizations.
7(A) loan guaranty program: The main Small Business Administration (SBA) program available to small businesses operating through private-sector lenders providing loans that are guaranteed by the SBA; loan guarantees reserved for small businesses that are unable to secure financing through normal lending channels.
C. Other Sources of Debt Financing
1. Vendor credit (also known as trade credit)
When a vendor extends credit to a business in order to allow the business to buy its products and/or services upfront but defer payment until later. The practice is especially common in retail, but it can be seen in other businesses as well.
A financial transaction whereby a business sells its account receivable to a third party, called a factor, at a discount in exchange for cash.
The lender provides a business a lump sum of money in exchange for a share of future sales (typically a set percentage of the business’s daily credit card sales) that covers the payment amount plus fees.
A financial transaction that occurs directly between individuals or “peers.”
Creative Sources of Financing and Funding
A. Crowdfunding
Crowdfunding is the practice of funding a project or new venture by raising monetary contributions from a large number of people, typically via the Internet.
B. Leasing
A lease is a written agreement in which the owner of a piece of the property allows an individual or business to use the property for a specified period of time in exchange for payments.
C. SBIR and STTR Grant Programs
The Small Business Innovation Research (SBIR) and the Small Business Technology Transfer (STTR) programs are two important sources of early-stage funding for technology firms.
D. Other Grant Programs
Granting agencies are, by nature, low-key, so they normally need to be sought out. One thing to be careful of is grant-related scams.
E. Strategic Partners
Strategic partners often play a critical role in helping young firms fund their operations and round out their business models.
A. Crowdfunding
Crowdfunding is the practice of funding a project or new venture by raising monetary contributions from a large number of people, typically via the Internet.
There are two types of crowdfunding sites: rewards-based crowdfunding and equity-based crowdfunding.
- Rewards-based crowdfunding allows entrepreneurs to raise money in exchange for some type of amenity or reward.
- Equity-based crowdfunding helps businesses raise money by tapping individuals who provide funding in exchange for equity in the business.
A lease is a written agreement in which the owner of a piece of the property allows an individual or business to use the property for a specified period of time in exchange for payments.
The Small Business Innovation Research (SBIR) and the Small Business Technology Transfer (STTR) programs are two important sources of early-stage funding for technology firms.
Small Business Innovation Research (SBIR) competitive grant program that provides over $1 billion per year to small businesses for early-stage and development projects.
The STTR Program is a variation of the SBIR for collaborative research projects that involve small businesses and research organizations, such as universities or federal laboratories.
Granting agencies are, by nature, low-key, so they normally need to be sought out. One thing to be careful of is grant-related scams.
E. Strategic Partners
Strategic partners often play a critical role in helping young firms fund their operations and round out their business models.
