Starting A Business: Sources of Finance

In general, there are 3 sources when it comes to sourcing for funds for a new business. Yourself, lenders and investors.

Using Your Own Funds

Your own sources of funds include personal savings and proceeds from sale of investments or personal assets.

The good thing about using you’re your own money is that your business could earn a rate of return higher than the interests from your savings and investments.

Cash flow is also more flexible without worrying about the minimum repayments to your lenders. You also have no investors to answer to except yourself.

Borrowing from Lenders

Some general types of lenders are commercial banks, investment bankers and corporate finance companies. You could also borrow from your family and friends.

Above all else, lenders are interested to know if they will be able to recover the loan. Most lenders look at the 4Cs when assessing a loan application. Character, cash flow, collateral and contribution.

1. Character
   The lender looks at your talent, reliability, experience and honesty. He will also assess your credit history. The lender needs to feel confident that you are capable of running the business and repay the debt.
   
   
2. Cash flow
   Lenders will study your financial projections. They need to be satisfied that your business will generate enough cash flows to service the loan after paying for all the operating costs and keeping a cash buffer for uncertainties.
   
   
3. Collateral
   Loaning money to a new start-up with no previous history is considered to be high risk. Lenders will want to obtain collateral on the loan. The collateral could be the form of mortgages against tangible assets or equipment. Most lenders will also require your personal guarantee as additional security.
   
   
4. Contribution
   Lenders also look at how much equity you have in the business. If your business requires $100,000 funding and you invest $30,000 of your own money into it, then your contribution is 30%. The higher your contribution, the more convinced is the lender with your commitment towards the business.
   
   The more tied down you are to the business, the more effort you will commit to the business to ensure its success and hence, your own success. This increases the chances of the lender recovering the loan from you.
   
   

Apart from the 4Cs, lenders also look at the debt ratios, repayment period and the interest rates. Here is an article on financial ratios. It discusses about debt ratios that lenders are interested in, as well as other ratios such as investment ratios and profitability ratios.

The repayment period usually depends on the useful life of the asset financed. The longer the repayment period, the lower is your cash outflow but you will incur more interests. The shorter your repayment period, the less interest you pay but your cash outflow will be higher since you are repaying your debt faster. You have to find a balance in between.

Most business loans nowadays are provided at a variable rate. This is usually quoted at a prime rate plus x%.

One of the major advantages of financing your business with a loan is because lenders often make decisions faster than investors.

Funding from Investors

Some common sources of equity financing are venture capital funds, vendors, venture capitalists, your family and friends.

Venture capital funds are usually setup as a limited partnership. The investor is the limited partner whereas the entrepreneur is the general partner. The general partner normally puts up a very amount of capital (as little as 1%) and the rest is financed by the limited partner. The general partner controls and run the operation.

Sources of venture capital funds include financial institutions, pension funds and corporations. These investors look for high rates of return, from 25% to as high as 50% compounded annually. They are also interested in investments that will become liquid in a short period of time.

These investors also look at other qualities such as the quality of the individual entrepreneur, the quality of the management team, and whether the business has an edge over its competition.

Obtaining venture capital funds could take around 6 months or longer.

Vendors are also a source for funding a business. If an entrepreneur can convince the vendor to extend 30, 60 or even 90 days of credit to him, then this will ease the cash flows and reduce capital requirements.

Corporate venture capitalists are companies which fund start-ups that can contribute technology or are compatible in some ways to the company. Sometimes, the corporate venture capitalist will buy over the start-up.

The most popular source of funding for an entrepreneur during the initial stages is their family and friends. These people know you, and will surely support you if your business makes sense to them. After all, your family and friends are always looking for the next big stock to buy, or the next area with booming real estate prices.

For many small entrepreneurs, this look like the natural route since it is difficult to get commercial loan of less than $20,000 and even more difficult to get venture capital funding for less than $500,000.

You don’t need to go through strict screening and documentation hassles. This is crucial if you have bad credit history or you lack entrepreneur experience. This also shortens the time it takes for the funds to be injected into the business.

The disadvantages of having your family or friend as investors are they might want to control or have their ways in how the business is run. Their way might not fit into your overall strategy or style. Also, relationships could become sour if the business is losing money. You must consider these possibilities when deciding to get your family and friends to invest in your business.

In summary, there are various sources of capital funding. You have to weigh the pros and cons of each source. The source that you choose should fit into your overall long-term strategy of your business.

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