Sourcing money may be done for a variety of reasons. Traditional areas of need may be for capital asset acquirement – new machinery or the construction of a new building or depot.
The development of new products can be enormously costly and here again, capital may be required. Normally, such developments are financed internally, whereas capital for the acquisition of machinery may come from external sources.
In this day and age of tight liquidity, many organizations have to look for short-term capital in the way of overdraft or loans in order to provide a cash flow cushion. Interest rates can vary from organization to organization and also according to purpose. However, whilst these may be “traditional” ways of raising funds, they are by no means the only ones. There are many more sources available to companies who do not wish to become “public” by means of share issues.
These alternatives include bank borrowing, government assistance, venture capital and franchising. All have their own advantages and disadvantages and degrees of risk attached. Finding the money to start their small businesses is usually one of the first problems that entrepreneurs face. For most people, this process can be hard and very frustrating.
What makes this process frustrating is a combination of wrong expectations and looking for money in all the wrong places. One has to remember that finding the money to start your small business is a game of endurance. You must work hard to overcome potential rejection if you want to succeed.
Sources of funds
Most entrepreneurs start their companies by investing their own savings. This source of financing can be ideal – if you can afford it. It puts you in full control of how much you are going to get. Furthermore, you never have to justify yourself to investors. This last point is an important benefit. You have the freedom to operate as you see best. There is a trade-off, though: this freedom usually comes at the expense of having little money.
Saving up to start a business takes determination and sacrifice. Save a portion of your income every month. Save as much as you can for as long as you can. You will need every cent you can get your hands on. Consequently, you may have to give up luxuries – such as vacations and new cars – for a while. The reward is the ability to launch your startup.
Family members and friends
One common way to finance a business is to ask friends and family members for an investment. The problem is that if things go wrong, your friend/family relationship is affected. And in any startup business, you are guaranteed that things will go wrong at one point or another.
If you start your small business using friends and family investors, decide whether to sell them equity or take a loan from them. Both have advantages and disadvantages. Investments from selling equity don’t have to be paid back. However, the person to whom you sold the equity becomes an owner and shares the profits. Loans, on the other hand, have to be paid back. However, once the loans are paid, the transaction concludes.
Regardless of which structure you use, have an attorney draft a formal agreement. Lastly, separate the personal relationship from the business relationship – treat all investors professionally.
Usually, the government does not provide grants to start or operate a business unless your business is in a specific industry or serves a very targeted cause.
Remember that the government is investing your tax rands and is very strict and careful when spending them. The government will not be able to help you if you need money to:
1. Start a business
2. Pay operational expenses
3. Settle business debts
Borrowings from banks are an important source of finance to companies. Bank lending is still mainly short term, although medium-term lending is quite common these days.
Short-term lending may be in the form of:
a) an overdraft, which a company should keep within a limit set by the bank. Interest is charged (at a variable rate) on the amount by which the company is overdrawn from day to day;
b) a short-term loan, for up to three years.
Medium-term loans are loans for a period of from three to ten years. The rate of interest charged on medium-term bank lending to large companies will be a set margin, with the size of the margin depending on the credit standing and riskiness of the borrower. A loan may have a fixed rate of interest or a variable interest rate so that the rate of interest charged will be adjusted every three, six, nine or twelve months in line with recent movements in the Base Lending Rate.
Lending to smaller companies will be at a margin above the bank’s base rate and at either a variable or fixed rate of interest. Lending on overdraft is always at a variable rate. A loan at a variable rate of interest is sometimes referred to as a floating rate loan. Longer-term bank loans will sometimes be available, usually for the purchase of property, where the loan takes the form of a mortgage. When a banker is asked by a business customer for a loan or overdraft facility, he will consider several factors, known commonly by the mnemonic PARTS.
P The purpose of the loan A loan request will be refused if the purpose of the loan is not acceptable to the bank.
A The amount of the loan. The customer must state exactly how much he wants to borrow. The banker must verify, as far as he is able to do so, that the amount required to make the proposed investment has been estimated correctly.
R How will the loan be repaid? Will the customer be able to obtain sufficient income to make the necessary repayments?
T What would be the duration of the loan? Traditionally, banks have offered short-term loans and overdrafts, although medium-term loans are now quite common.
S Does the loan require security? If so, is the proposed security adequate?
Venture capital is money put into an enterprise which may all be lost if the enterprise fails. A businessman starting up a new business will invest venture capital of his own, but he will probably need extra funding from a source other than his own pocket. However, the term ‘venture capital’ is more specifically associated with putting money, usually in return for an equity stake, into a new business, a management buy-out or a major expansion scheme.
The institution that puts in the money recognizes the gamble inherent in the funding. There is a serious risk of losing the entire investment, and it might take a long time before any profits and returns materialize. But there is also the prospect of very high profits and a substantial return on the investment. A venture capitalist will require a high expected rate of return on investments, to compensate for the high risk.
A venture capital organization will not want to retain its investment in a business indefinitely, and when it considers putting money into a business venture, it will also consider its “exit”, that is, how it will be able to pull out of the business eventually (after five to seven years, say) and realize its profits.
When a company’s directors look for help from a venture capital institution, they must recognize that:
• the institution will want an equity stake in the company
• it will need convincing that the company can be successful
• it may want to have a representative appointed to the company’s board, to look after its interests.
The directors of the company must then contact venture capital organizations, to try and find one or more which would be willing to offer finance. A venture capital organization will only give funds to a company that it believes can succeed, and before it will make any definite offer, it will want from the company management:
a) a business plan
b) details of how much finance is needed and how it will be used
c) the most recent trading figures of the company, a balance sheet, a cash flow forecast and a profit forecast
d) details of the management team, with evidence of a wide range of management skills
e) details of major shareholders
f) details of the company’s current banking arrangements and any other sources of finance
g) any sales literature or publicity material that the company has issued.
A high percentage of requests for venture capital are rejected on an initial screening, and only a small percentage of all requests survive both this screening and further investigation and result in actual investments.
Franchising is a method of expanding business on less capital than would otherwise be needed. For suitable businesses, it is an alternative to raising extra capital for growth. Franchisors include Wimpy, Nando’s Chicken and Chicken Inn.
Under a franchising arrangement, a franchisee pays a franchisor for the right to operate a local business, under the franchisor’s trade name. The franchisor must bear certain costs (possibly for architect’s work, establishment costs, legal costs, marketing costs and the cost of other support services) and will charge the franchisee an initial franchise fee to cover set-up costs, relying on the subsequent regular payments by the franchisee for an operating profit. These regular payments will usually be a percentage of the franchisee’s turnover.
Although the franchisor will probably pay a large part of the initial investment cost of a franchisee’s outlet, the franchisee will be expected to contribute a share of the investment himself. The franchisor may well help the franchisee to obtain loan capital to provide his-share of the investment cost.
The advantages of franchisees to the franchisor are as follows:
• The capital outlay needed to expand the business is reduced substantially.
• The image of the business is improved because the franchisees will be motivated to achieve good results and will have the authority to take whatever action they think fit to improve the results.
The advantage of a franchise to a franchisee is that he obtains ownership of a business for an agreed number of years (including stock and premises, although premises might be leased from the franchisor) together with the backing of a large organization’s marketing effort and experience. The franchisee is able to avoid some of the mistakes of many small businesses because the franchisor has already learned from its own past mistakes and developed a scheme that works.