7.02 – Reviewing Your Finance Options
Determining the amount of money needed to start your business is just the first step. Various funding sources are available, each with different obligations, responsibilities, and opportunities. Understanding these differences will help you make an informed choice.
Most small businesses tend to rely on long-term or short-term bank loans, often overlooking other financing methods due to perceived complexity or risk. However, many alternative finance sources can share the business risks to some extent.
You have three main options for raising money: borrowing with interest, finding investors to share ownership, and obtaining grants or awards.
Deciding Between Debt Capital And Equity Capital
At one end of the financing spectrum are shareholders, including individual business angels and corporate venture capitalists (VCs). These investors provide equity capital, taking on business risks and expecting a share of the rewards if the business succeeds. They are less interested in dividends and more focused on significant increases in the value of their investment, often realized through selling their stake to other investors during the firm’s growth stages. Investors prioritize the founder’s vision and the management team’s ability to deliver results over tangible asset security.
On the other end are debt financiers, primarily banks, who prefer minimal risk and expect returns regardless of business performance. Banks provide loans with interest, usually starting from day one, and they seek asset security to recover their money if the business fails. Banks are more like intermediaries helping turn illiquid assets into cash, but at a cost.
Understanding the difference between lenders, who provide debt capital, and investors, who provide equity capital, is crucial for sound financial management.
Between these extremes are various financing options with mixed lending and investing criteria. Regularly reviewing your business finances and choosing the appropriate mix of funds based on the risks and economic climate is essential. A general rule is to use debt and equity in equal amounts, adjusting towards more equity if the future looks particularly risky.
Comparing Lenders and Investors
Lenders (Debt Financing):
- Require regular interest payments regardless of business performance.
- Seek asset security for loans.
- Offer less flexibility in repayment terms.
- May force repayment if business performance falters.
Investors (Equity Financing):
- Share business risks and rewards.
- Do not require regular payments.
- Look for significant long-term returns.
- Focus on business growth and management capability.
Examining Your Own Finances
Start by assessing your assets and liabilities. Your most valuable assets are likely your house, car, and any insurance or pension policies. Subtract your liabilities from your assets to determine your net worth, which represents the maximum security you can offer for external funding.
Consider your risk tolerance and confidence in your business’s success. The more of your own money you invest, the more control you retain. The need for external funding means sharing power and possibly equity with others.
Calculate the total amount needed for your business start-up, then determine how much of your own money you can and are willing to invest. The difference is the amount you need from external financiers. If this amount exceeds your net worth, you are looking for investors. If it’s less, bankers may be the appropriate choice.
Be prepared to put your own money into the business to demonstrate commitment. Potential financiers will expect you to have invested personally before seeking external funds.
Leveraging Internal Resources
If you are already trading, maximize your cash flow by collecting from customers, negotiating credit terms with suppliers, and managing your inventory efficiently. These measures help free up cash without needing to borrow.
Consider your personal expenses during the start-up phase. Essential expenses like food, utilities, and housing are necessary, but luxuries such as vacations, a second car, or club memberships might be postponed until the business stabilizes.
By carefully reviewing and managing your finances, you can position your business for successful funding and growth.
