Often the hardest part of starting a business is raising sufficient finance to get going
By: Hitesh Khan/
The entrepreneur might have a great idea and clear idea of how to turn it into a successful business. However, if you cannot raise sufficient finance, it is unlikely that the business will get off the ground.
Raising sufficient finance for start-up requires careful planning.
The entrepreneur needs to decide:
- How much finance is required?
- When and how long the finance is needed for?
- What security (if any) can be provided?
- Whether the entrepreneur is prepared to give up some control (ownership) of the start-up in return for investment?
The finance needs of a start-up should take account of these key areas:
- Set-up costs (the costs that are incurred before the business starts to trade)
- Starting investment in capacity (the fixed assets that the business needs before it can begin to trade)
- Working capital (the stocks needed by the business –e.g. r raw materials + allowance for amounts that will be owed by customers once sales begin)
- Growth and development (e.g. extra investment in capacity)
One way of categorising the sources of finance for a start-up is to divide them into sources which are from within the business (internal) and from outside providers (external).
Internal sources are a great avenue in raising sufficient finance
The main internal sources of raising sufficient finance for a start-up are as follows:
Personal sources These are the most important sources of finance for a start-up, and we deal with them in more detail in a later section.
Retained profits This is the cash that is generated by the business when it trades profitably – another important source of finance for any business, large or small. N
Share capital – invested by the founder The founding entrepreneur (/s) may decide to invest in the share capital of a company, founded for the purpose of forming the start-up. This is a common method of financing a start-up. The founder provides all the share capital of the company, retaining 100% control over the business.
The advantages of investing in share capital are covered in the section on business structure. The key point to note here is that the entrepreneur may be using a variety of personal sources to invest in the shares. Once the investment has been made, it is the company that owns the money provided. The shareholder obtains a return on this investment through dividends (payments out of profits) and/or the value of the business when it is eventually sold.
A start-up company can also raise finance by selling shares to external investors.
Raising sufficient finance requires the exploration of external sources
Loan capital This can take several forms, but the most common are a bank loan or bank overdraft.
A bank loan provides a longer-term kind of finance for a start-up, with the bank stating the fixed period over which the loan is provided (e.g. 5 years), the rate of interest and the timing and amount of repayments. The bank will usually require that the start-up provide some security for the loan, although this security normally comes in the form of personal guarantees provided by the entrepreneur. Bank loans are good for financing investment in fixed assets and are generally at a lower rate of interest that a bank overdraft. However, they don’t provide much flexibility.
A bank overdraft is a more short-term kind of finance which is also widely used by start-ups and small businesses. An overdraft is really a loan facility – the bank lets the business “owe it money” when the bank balance goes below zero, in return for charging a high rate of interest. As a result, an overdraft is a flexible source of finance, in the sense that it is only used when needed. Bank overdrafts are excellent for helping a business handle seasonal fluctuations in cash flow or when the business runs into short-term cash flow problems (e.g. a major customer fails to pay on time). Two further loan-related sources of finance are worth knowing about:
Share capital – outside investors For a start-up, the main source of outside (external) investor in the share capital of a company is friends and family of the entrepreneur. Opinions differ on whether friends and family should be encouraged to invest in a start-up company. They may be prepared to invest substantial amounts for a longer period of time; they may not want to get too involved in the day-to-day operation of the business. Both of these are positives for the entrepreneur. However, there are pitfalls. Almost inevitably, tensions develop with family and friends as fellow shareholders.
Business angels are the other main kind of external investor in a start-up company. Business angels are professional investors who typically invest $10k – $750k. They prefer to invest in businesses with high growth prospects. Angels tend to have made their money by setting up and selling their own business – in other words they have proven entrepreneurial expertise. In addition to their money, Angels often make their own skills, experience and contacts available to the company. Getting the backing of an Angel can be a significant advantage to a start-up, although the entrepreneur needs to accept a loss of control over the business.
You will also see Venture Capital mentioned as a source of finance for start-ups. You need to be careful here. Venture capital is a specific kind of share investment that is made by funds managed by professional investors. Venture capitalists rarely invest in genuine start-ups or small businesses (their minimum investment is usually over $1m, often much more). They prefer to invest in businesses which have established themselves. Another term you may here is “private equity” – this is just another term for venture capital.
A start-up is much more likely to receive investment from a business angel than a venture capitalist.