Financing Guide: Definition, Tips And Best Practices
In business circles, there are words or terms that are easily recognizable in the sense that, the moment they are spoken or raised in conversation, business people have instant recognition for them. Examples of such words are assets, liabilities, capital, equity, profits, losses, income, expenditures, loans, and net worth, to name a few.
There is another word that can never be separated from business, even for those who are only just starting out. That is financing.
In this in-depth guide 1) we will provide an introduction to financing and why it is important for businesses, 2) we define internal and external financing as well as as the advantages and disadvantages of each, 3) we discuss raising debt including pros and cons, debt investors and their investment criteria, and the process of raising debt, 4) we discuss raising equity including pros and cons, typical equity investors and their investment criteria, and the process of raising equity, 5) we discuss other ways to finance your business, and lastly 6) share some best-practices and tips related to financing.
Wow! We’ve got a lot to cover. So let’s get started.
AN INTRODUCTION TO FINANCING
“Financing” basically refers to the act of providing funds for business operations, activities or projects. It often involves asking another individual or a financial institution to lend you money, or invest money in your business or enterprise, with the promise or commitment that their money will be repaid, or that they will get a corresponding amount of their investment returned to them at a future date. Examples of financial institutions that can be approached for funding are banks, financing companies, credit unions and cooperatives.
Financing becomes an essential activity from the beginning. Entrepreneurs who have brilliant and promising business ideas will need to find sources of funds in order for them to bring their ideas to life. Sure, they may have their own money set aside to start the business, but more often than not, this money is not enough hence they will need assistance to finance the whole venture.
However, it’s not only new businesses that require financing. Even established companies may also seek funding from various sources, such as when they have plans for expansion, or they plan on launching a new product line. Basically, any business activity that requires infusion of money calls for financing. With this in mind, financing is an activity that businesses can never separate from.
Ordinary consumers, or those who are not engaged in commercial operations, may also turn to financing when they find themselves in need of additional money say, to purchase a piece of real estate, or a new car.
Importance of Financing
Finance is considered to be the lifeblood of industry and commerce. Without it, businesses won’t thrive, industries will not flourish, and economies will flounder. That is also most likely the reason why financing is referred to as the “lifeblood of growth”.
The purpose and importance of financing will depend on the reason why you are looking for funds. We will try to name some of the most common purposes.
- Financing helps budding entrepreneurs to start their own businesses. We have earlier mentioned how so many brilliant aspiring entrepreneurs are able to come up with great business ideas, if only they have the money to start the ball rolling. Every year, hundreds of thousands of businesses are started. Every year, hundreds of thousands of these businesses fail. One of the most common reasons for a business failing from the outset is lack of financing. The business owner or founder may not have been able to secure the amount of capital needed to start business operations.
- Financing helps existing business to operate and grow. Businesses that are already in operation will always seek for ways to grow and, in order to do that, they should be willing to spend money on it. Unfortunately, expanding operations – e.g. introducing new product lines, launching new marketing campaigns, entering other markets – requires money, which is why these businesses also need to have strong financing strategies in place.
- Financing helps a business become more competitive. How many times have you heard of businesses cowering away from competition with other, bigger, businesses for the simple reason that they do not have enough funding to go against them? With financing, these smaller businesses can become more competitive until they can gain a solid footing in the industry and the market.
- Financing aids in economic growth. Through financing, small- to medium-sized businesses are able to exist, thereby helping give the economy a boost. Since operations are funded, the business can create new jobs and offer value to the public or the community. From the point of view of the one that provides financing, making good financing decisions will result to returns on their investments, or repayments of funds they have provided, with interest. So it’s not just the recipient of financing that will get all the advantages, because the one providing the funds will also get something out of it.
Learn how business operations and financing are inter-connected.
INTERNAL VS. EXTERNAL FINANCING
We have already established that there are various sources of financing that businesses can turn to in times of need. Let us try to clarify things further by categorizing these sources of financing into two: internal and external.
When a company uses its own net income or profits in order to make a new investment, purchase new capital equipment, expand its operations, or some other business activity, we are talking about internal financing.
If a business opts to distribute its profits to the owners or shareholders of the company, that is not internal financing, since the end result would be the business seeking to obtain capital elsewhere, usually outside the company.
Another form of internal financing is selling idle or unutilized assets, or the identified non-core assets or businesses, and using the proceeds from the sale to fund its new projects or business activities.
For example, a company with a focus on construction may have business segments or ownership of companies related to real estate or bond investments. These are treated as non-core assets or businesses, as they do not really fall under the main function or category of industry that the business belongs to. If they are in need of financing and they refuse to take out loans or borrow from credit institutions, one quick recourse is to sell these non-core businesses.
Advantages of Internal Financing
Preference for internal financing is primarily due to the fact that it is, in general, less expensive than external financing, thanks to the following:
- No transaction costs incurred, since financing is obtained from within the business;
- No interest payments, since the company is not taking out a loan with any credit or finance institution;
- Credit line of the company is not affected, therefore, the business’ creditworthiness remains unaffected;
- More freedom and control are given to the business owners and management, since they are not bound or obligated to anyone;
- Freedom from the influence of third parties, as financing details are all taken care of internally, inside the company;
- Streamlining of the company’s business operations, in the case of the sale of non-core assets or businesses, since they can focus on the core activities instead.
Disadvantages of Internal Financing
There is a gray area on the matter of taxation when it comes to tax obligation. On one hand, since the profits are not returned to owners or shareholders by way of dividends, the taxes associated with dividend payments are nonexistent. However, internal financing may also end up becoming more expensive because of the fact that it is not tax-deductible.
Other arguments against internal financing are:
- There is no increase in the company’s net worth. There is no increase in capital or assets, and there is no decrease in the company’s liabilities, either. Instead, the profits earned are retained and used for financing, which means the company’s capital remains unchanged.
- Internal financing may be limited. Unless the company is doing very well in the profits front, the amount of financing available is usually quite low. The amount of financing will depend on the amount of profits being earned by the company. In many cases, the profits may not be enough to meet the capital requirement that the business is looking for, so they will either end up seeking outside sources of financing or lowering the expansion plans.
When a business obtains funding by bringing in new money into the company from the outside, we refer to that as external financing.
Advantages of External Financing
Instead of internal financing, other businesses opt to look elsewhere – outside the company – for financing. Usually, they do so for the following reasons:
- External financing allows them to preserve the company’s current resources. In internal financing, it is the company’s internal financial resources that are used to fund a project or activity. If external financing is used, the company may use their internal financial resources on other operations or activities. These internal resources may even be used to pay off outstanding debts, which will inure to the benefit of the company’s credit rating, and improve its chances of securing external financing.
- External financing can help the company finance growth projects. Often, companies cannot finance or fund projects on their own, or solely using internal sources, which is why we often encounter companies using a combination of internal and external financing methods. For example, a company may use its internal financial resources to fund working capital requirements for a new business segment, but it may secure external financing to purchase the equipment and machinery that will be used in that segment’s operations.
- External financing can help the company become more competitive. Again, just as mentioned previously, the company’s internal financing efforts may not be enough to fund, say, major advertising campaigns. There is no way they can be competitive if they won’t invest on their marketing, and securing additional funds through external financing will enable them to gain a competitive edge in the market.
Disadvantages of External Financing
The main problem of businesses with external financing is that it usually costs more to obtain the funds, thanks to the transaction costs involved. When obtaining funding from banks, for example, there are fees and charges that must be shouldered by the company before they can get the funding that they are asking for.
Aside from this major disadvantage, external financing may also potentially:
- Affect the ownership of the business, in the case of external financing using equity. This type of financing essentially means investors or shareholders will be coming in, buying ownership shares of the company in exchange for their money. As a result, the ownership of the company will be diluted, and the current owners will have other new owners to share the pie with. They may also have a say in the decision-making processes of the company.
- Put company’s assets at risk, in the case of external financing using debt. In debt or loan agreements with banks and credit institutions, the fund providers would want to be protected as much as possible. In order to do that, they make sure that they have partial claim on the company’s assets in case the latter fails to meet its periodic principal and interest payments. In the event that the company fails to repay its debts, the creditors may go after these assets for liquidation.
- Pose more financial burden to the business. Earlier, we said that external financing may be more expensive due to transaction costs. But that is not the only thing that can make this option more expensive. Since investors and lenders alike are providing funding with the expectation of getting returns on their investment, they will add interest. Banks will add interest to a loan, while investors will set a specific ROI that the company must meet. These interests will definitely add to the expense on the part of the company.
- Put the company under more scrutiny. In the past, the financial reports and records of the company are only made available to the members and stakeholders of the organization. With external financing, there are external entities that are also entitled to these records. The company will be beholden to report to their investors and creditors periodically.
There are several types of external financing, but we can broadly classify them into two categories: with debt and with equity. That is what we will focus on next.
EXTERNAL FINANCING WITH DEBT
For purposes of simplicity, there are two identified main types of external financing for businesses or companies: they either use debt or equity financing. First, let us take a look at the first type, which is financing using debt.
What Is Debt Financing?
This is the type of financing that most people may be familiar with, because even individuals who are not involved in business or commerce avail of this type of financing. The most common examples you may have come across is a car loan and a mortgage on one’s house. Those are types of obtaining external financing through debt.
Usually, businesses – both new and old – resort to debt as a way to raise funds or seek financing for their business activities. In this type of financing, the company will seek out lenders from outside the company – so they are previously uninvolved with the company – who will be willing to let them use their money (in the form of short-term or long-term loans) in exchange for a rate of interest and the principal paid regularly, depending on the agreement that they two parties will arrive at consensually.
Pros and Cons of Raising Debt
First, let us take at the pros of using external financing using debt.
- Debt terms may be negotiated to the company’s advantage. When getting a loan, the company can negotiate for lower interest rates, or payment terms that will not be too much of a burden to the company. Of course, this would largely depend on whether the other party – the lender or creditor – will allow it. However, with proper and good negotiation, the two parties can reach an agreement that will be mutually beneficial.
- Debt financing is easier to obtain if the company needs only a small amount of funding. Maybe the company requires a small amount of cash to purchase some assets, or even to meet its working capital requirements. If the company borrows money to buy assets, they will also have an easier time, especially if the assets will be used as collaterals. Lenders will be more inclined to provide the funding you need if this is the case. It is also easier to obtain funding by borrowing the cash needed than it is to go through the process of selling shares of stock. And what if the company structure is anything other than a corporation and there are no shares of stock to be sold? Sole proprietorship and partnerships will definitely find debt financing to be the easier option.
- Using debt enables the company to retain its ownership and control over its business operations. The only thing that the lenders or creditors will be concerned about is whether you will be able to repay your debt in time or not. They do not have a say on how you will run the business, and neither will they have an influence on the business decisions of management. The owners will remain as the owners.
- Often, the payments of the loan principal and the interest may be classified as business expenses and, therefore, are tax-deductible. This additional tax deduction will definitely be beneficial to the business, and it will also put you in a good light as an economic partner of the government.
- Financial planning is made easier. After all, you are already aware of the exact amount of principal and interest that you would have to pay regularly. In addition, you are also aware of the schedule or the exact times when the payments must be made. Thus, budgeting is made easier.
Debt financing, however, is not without its disadvantages.
- Aside from the principal of the loan, the business also has to pay the interest. In some cases, businesses find the interest to be more cumbersome than the principal. If negotiations do not fall to the company’s advantage, it is possible that they will be made to pay high interest rates.
- Usually, repayment of debt is in the form of cash. That means that a good portion of the company’s cash flow will go to the payment of debt. This could be a problem if cash flow of the company is poor to begin with, because cash that is supposedly for working capital allocation will go to loan repayment. In contrast, if cash is used for current operations instead of payment of the outstanding loans, the company is at risk of defaulting on its payments, resulting to penalties and surcharges, or worse.
- In debt financing, the company is basically borrowing against the earnings of the company in the future. Instead of using the earnings or profits of the company to expand operations, part of it will go to repaying the loan principal amount and the corresponding interest.
- Debt financing is usually accompanied by strict conditions. The company is entering into a legal agreement or a covenant with its lenders or creditors, and the terms put forth or agreed upon must be followed to the letter. Failure to meet the terms stated therein is definitely going to result to bigger problems and complications. Aside from terms on repayment and interest, the creditor may also add other terms in there that the borrower must comply with.
- The debt must be paid regularly, or as agreed upon, regardless of the current financial state of the company or the economy. Even if times are difficult, the debt must be paid back. In fact, even if the company is already failing (or even failed already), the debt must still be repaid. Otherwise, it would result to the company defaulting on its payments, and creating bigger problems.
- Obtaining debt increases the risks that the company is facing. It means the company will also be increasing its future borrowing costs. Come to think of it, having more debts, by itself, will have an impact on the company’s credit rating. Further, lenders may also require borrowers to provide collateral and, often, the business and its assets are the ones presented as collaterals. This also puts the company, and even the personal assets of the owners, at risk.
- There is bound to be some difficulties faces by companies looking to borrow funds, because creditors and lending facilities often have stringent requirements or qualifications that must be met before they can avail of the funding. One of them is the credit rating. If they have poor credit rating, their chances of obtaining debt financing is very low.
Typical Debt Investors and their Investment Criteria
Debt investors are individuals, companies and other entities that invest in a company, a business, or a project through:
- Lending money (in the form of loan) for a fixed rate of return, with the agreement that they will be paid regularly over a certain duration or time period, until such time that the loan has been fully paid.
- Purchase of bonds, debentures, or other debt instruments.
Now let’s take a look at the typical debt investors, or those that businesses can approach to secure external financing using debt.
Think “business loans” – or pretty much any type of loan – and the first source that comes to mind are banks. In North America alone, around 90% of small businesses turn to banks for their debt financing.
Banks, however, do not just readily provide financing to any small business or business enterprise that comes knocking on their door, asking for a business loan. There are similar factors, or investment parameters, that the loan applicants must meet before they can be considered for a loan grant.
Credit rating of the company.
There are third-party agencies that assess and keep records of credit histories and the corresponding credit ratings of businesses. An example is Dun & Bradstreet. When a bank is considering a loan application by a business, they will obtain a copy of the company’s commercial credit report from these agencies, to get information on the company’s payment histories, credit scores, and other data relevant to the credit rating and performance of the company.
Usually, a company that has a history of defaulting on payments, or incurring delays in paying its regular scheduled payments will be considered as a poor debt investment for banks. In some cases, the bank officer in charge of assessing a company’s creditworthiness would ask for explanations or justifications. In other cases, however, they would not bother asking because it would take too much time. Instead, they will turn down the loan application and move on to other companies that are also seeking a loan.
Financial position of the company.
Bank officers will require copies of the company’s latest financial reports to assess the current financial condition of the business. In many cases, they may also request the financial reports of previous years, for comparison purposes, and to establish trends or patterns that will enable them to forecast the future financial position and growth of the business.
The financial statements of the company (mainly the balance sheet or “statement of financial position”, income statement or “statement of financial performance”, and cash flow statement) are subjected to financial analysis in order to ascertain the ability of the company to pay its debts – both the principal and the interest.
Availability of collateral.
Banks, as much as possible, want to be protected in case the company fails to meet the payments as they fall due. As such, they would require the borrowing company to offer collateral, which is often in the form of business assets. Should the company default on its payment, and fail to repay the remaining balance, the bank will seize the collateral and sell them, using the proceeds as payment for the unpaid loan balance.
The suitability of the collateral will also be under scrutiny. Mainly, the bank will determine whether the collateral is salable readily to another party. If they are deemed to be unacceptable for selling, the bank will require the company to present other, more acceptable, collateral.
Presence of guarantees by management.
Often, banks will also require personal guarantees of all the owners of the company. By way of these personal guarantees, the owners will provide the bank assurance that they are most likely to remain with the business at least until the loan has been fully paid. This signifies the level of commitment of the owners to the business.
Relationship of the company with the bank.
Banks tend to act more favorably to business that they have previous positive relationships with. If the company has been a depositor in the bank for several years, and has proven to be in good standing, the bank is more likely to be inclined to grant a business loan to that company.
#2 Credit institutions
There are non-bank institutions that operate purposely for granting of loans to businesses and individuals. Like banks and banking institutions, they too have their own set of parameters to assess whether to lend money to a borrower or not.
These credit institutions are similar in some ways with banks, particularly when it comes to their investment criteria.
Credit rating of the company.
Credit and financial institutions will also take into consideration the credit history of the company, taking particular note of whether the company is able to pay its dues on time.
Personal credit information of owners.
Lending institutions may also be interested in the owners of the business, personally. Thus, they may look into the personal loans, credit card debt, and liquid assets of the company. There are even those who will request for copies of the owners’ personal financial statements and tax returns. Why would they be interested with your personal credit card debt? Because these will give them insight on your personal spending habits, which may impact how you make spending decisions for the business. These institutions are likely to refuse investing on a business if the owners show signs of being delinquent in their credit card and debt payments.
Financial position of the company.
Credit companies will also look into the business’ performance (gross revenues or sales), profitability (expenditures and net income), and cash account balances. Looking at the cash account balances will be an indicator of the company’s ability to meet its regular payments.
Length of time that the business has been in operation.
Businesses that can demonstrate longevity are attractive prospects for credit institutions. They were able to last for a long time, so there is a chance that they can still last long to pay their debts in full.
Now what about new businesses, or those that are applying for a loan in order to start one? In these cases, credit institutions ask for a copy of the business plan. Their team of analysts will go over the business plan to evaluate its feasibility and viability, and make their decision on whether the company is worth investing in or not.
Normally, credit institutions ask for business plans with financial projections that cover the first three years of operations of the business.
Availability of collateral.
Credit institutions are also concerned with whether you can offer suitable collateral or not. This is to protect them in case you default on your loan and interest payments.
Interested in what collaterals small businesses can use? Watch this explanatory video.
There are also credit institutions that may require information on the current debts and outstanding loan balances of the company, including the terms, payment schedules, maturity and other information.
#3 Private lenders
Private lenders may not be as institutionalized as banks or credit companies but they, too, have factors that they look into before deciding whether to lend money to a business or not.
Financial position of the company.
The private lenders will look at the overall financial position of the company, checking whether the latter can meet the payments as they fall due.
Availability of collateral.
Collateral is also important among private lenders, since it is their way of protecting themselves from delinquent debtors. If the borrower fails to pay their debt, the private lenders can just sell the collateral.
Credit rating of the company.
There are some private lenders that take the time to check on the borrower’s credit rating before deciding whether to invest or not.
Process of Raising Debt
When considering what to use to raise financing and you are looking at debt as an option, there is a process you should follow.
Step 1: Assess if debt financing is really the best option.
In your assessment, you have to consider the following:
- What stage is your business in? Businesses that are just starting out are generally advised against incurring debts from the beginning, even before business operations have begun. After all, it is natural for businesses to incur losses on their first or second year of business, and this means there is a possibility that the business may not meet payments of its loans. In contrast, businesses that are already earning profits and have respectable cash flow are in a better position to incur debts or take out loans.
- What will you use the funds for? Determining this will give you an idea whether you can immediately get cash inflows that you can use to repay your debt. Usually, funds that will be used for variable costs used in the products or services sold by the company will be likelier to increase cash inflow immediately, so using debt financing is acceptable.
- What is the outlook on your cash flow? If your business mainly sells on credit, do your customers pay on time? Will your business operations ensure a steady flow of cash into your company, enough for you to make repayments on the principal loan and interest?
Step 2: Develop a business plan.
A financial business plan is something that may be required by the debt investor, so make one that outlines the business’ plans and its capital or fund requirements.
Step 3: Approach the debt investor (bank or lender) and express your intent to apply for a loan.
Depending on the debt investor, there may be forms that need to be filled out, along with a list of requirements that you must submit in support of your application. The requirements may also vary, so take note of what these are, and provide what is being asked of you.
EXTERNAL FINANCING WITH EQUITY
We now come to the other type of external financing, which involves raising equity.
What Is Equity Financing?
In this type of external financing, capital or funds are raised through the sale of shares of stock or ownership of a business or enterprise. Perhaps the most recognizable form of equity financing is that of a company launching initial public offerings (IPOs) or getting the company listed on a stock exchange. But equity financing actually comes in several forms.
Take, for example, a business owner or entrepreneur selling ownership shares to members of his family, or even to his friends. That is equity financing. What about if the company approaches other private companies and offers that the latter buy some parts to own? That is also a form of equity financing.
Basically, what we are saying is that equity financing is not limited to the sale of common stocks or common shares of a company. It can also come with the sale of other equity instruments, including preferred stocks and warrants.
Watch a founders view on raising equity.
Pros and Cons of Raising Equity
Equity financing is common in most industries and businesses, and here are the reasons why:
- The company will not be bound to make periodic or regular payments, which is a feature of debt financing. It will not have to be watchful of dates and schedules to keep in order to avoid defaulting on interest and principal payments.
- The risks and liabilities that come part-and-parcel with ownership of the company will be shared by the new investors or owners. Although the ownership of existing shareholders or owners may decrease, so will the risks and liabilities that they face.
- The company’s cash flow can be diverted to business operations and even for expansion and diversification projects. Cash flow of the company will not be negatively affected, since they won’t be used to pay off debts on a regular basis.
- The company’s credit rating will be positive, increasing its chances of getting loans in the future, in case the need arises. By using equity instead of debt, the company’s debt-to-equity ratio will put it in a strong position.
When talking about the cons of raising equity for financing, we have to look not only from the point of view of the business in general, but also from that of the existing owners or shareholders of the company.
- Equity financing means ownership will be diluted with the entrance of new investors. This also means that the decision-making authority of the business will be diluted. The new investors, who are now owners, will also have some say in how the company will be run. In cases where the new investors will invest large amounts of money into the company and end up owning larger portions of the pie, they may even assign their own people on the board of directors of the company.
- The company may end up spending more than they expected, especially if the business succeeds in a big way. There is a possibility that, in the long run, the total amount of profits that were distributed to the new investors will far exceed the amount of interest that you would have paid had you decided to use debt financing instead.
- On the part of the existing shareholders, their percentage of ownership will be reduced. In the process of raising funding, the company will have to issue more common stocks to outside investors, increasing the number of shares issued and outstanding. As a result, the share of the existing stockholders will decrease.
Typical Equity Investors and their Investment Criteria
Equity investors are those that invest money in a company, business or a project, in exchange for a percentage of the profits that you will earn in the future, as well as involvement in other aspects of the enterprise.
Institutional and retail investors
The usual picture of investors that come to mind when we hear “equity investors” are those who purchase securities or shares of stock from a stock exchange. They can either be institutional investors or retail investors.
As the name implies, institutional investors are those who buy in large quantities, often for other companies, organizations or entities. This is in contrast to retail investors, who are also referred to as “small investors” or “individual investors”. These small investors buy and sell securities for their personal account, which is why they are usually in much smaller quantities.
Investors are often advised to do their research before investing in a company. After all, if they are going to provide funding and be part owners of a company, they have to make sure they will earn high returns from them. What do these investors look at in a potential equity investment?
- Market position and competitive advantage. These equity investors would prefer to put their money on companies that have strong market positions, enough for them to be labeled as leaders in the market. Their business models should also be sustainable, even in the face of strong competition.
- Growth opportunities. If a company is able to demonstrate having multiple avenues or opportunities for growth, they will be more attractive to investors. Companies that have the potential to introduce new products, advance to new markets or geographical locations, and utilize more distribution channels will have greater chances of availing external financing with equity.
- Stability of cash flows. Sufficiency of cash flow means that a company will be able to meet all its debt requirements and manage working capital smoothly. Investors will prefer to provide funding to a company that can demonstrate stable and recurring cash flows.
- Industry trends. Companies are also affected by trends in the industry, so investors also tend to keep their eye on how the market and the industry are behaving at certain points in time. If industry trends are favorable, they will look more kindly to a company in that industry as an investment prospect.
- Management team. Investors also put stock on the team that manages the company. After all, they want to be owners of a company that they know will be run smoothly, effectively and efficiently.
For startups or entrepreneurs looking for capital for businesses that they plan to establish, they should look for early-stage investors, and one of their options are angel investors, also known as informal investors, private investors or seed investors. These angels are called such because they are basically making a gamble, providing funding for businesses that may or may not earn in the future. There is also the fact that they invest their own money or personal resources, that’s why you normally find them in the persons of affluent individuals or entities.
Typically, angel investors provide funding on a one-time basis. However, there are times when angel investors provide funding continuously or on an ongoing basis during the early stages of the business, at least until it has gained solid footing and is making steady profit.
Compared to your usual definition of a lender or an investor, the angel investor invests on the entrepreneur or the businessman rather than on the business. He cares about the entrepreneur more than on whether the business is viable or not. Their focus is on aiding the entrepreneur get the company off the ground and take its first steps in business. They do not really pay much attention on the possible profit that the business may be able to give them afterwards.
According to the Center for Venture Research, in 2014, the total investments made by angel investors in the United States reached $24.1 billion, with 316,000 angel investors funding more than 73,000 startups or businesses.
Angel investors will look into the following:
- Information on the entrepreneur and his management team. Angels whose interest is piqued by the initial pitch are likely to want to spend more time getting to know the entrepreneur and the team behind the prospective business.
- A concrete business plan. Angels will want to know the details of your business plan, especially the financials, the market strategy, and what will make your business or offering stand out.
There is no fixed mold for angels, because some may be more interested in the team and their performance and less on the landscape that the business will operate in, or vice versa.
Venture capitalists are mistaken to be the same as angel investors, but, these days, VCs see angel investors as their direct competitors. While angels invest their own money in startups and companies in their very early stages, VCs invest money that they have pooled and raised from others to businesses during their later stages, primarily for growth.
The investment decisions of VCs depend on the following:
- Management of the business. VCs will take a look at who compose the management team of the business – their qualifications, their skills, and generally what they have to offer in running the company. They will want an assurance that the management team in place has the ability to execute what is mapped out on the business plan. Usually, VCs look favorably on management team members who have experience in building businesses that have successfully earned profits and enabled its investors to get high returns on their investments.
- Market size. VCs are more attracted to businesses that target large markets, or the markets that can generate large amounts in revenues and, consequently, net earnings. After all, large earnings will translate to high returns on their investments. Details of the market and its analysis should be presented in the business plan, along with third-party market researches and relevant reports. These will aid in the company’s efforts to raise funding through equity from VCs.
- Viability of the product. Not only should the business have a great product to offer, the product should also be competitive when fielded in the market. VCs put priority on products and services that are expected to have a competitive edge or advantage in the market for a long time. They should offer real value and must be of actual use to consumers or end users.
- Risks that come with the business. VCs are all about mitigating risks while earning high returns on their investments. Therefore, they are going to be intent on being aware of the risks that they are potentially going to face if they do invest in a company. These include legal or regulatory issues, product risks, financial risks, and even the risk of the VC exiting or withdrawing its investment in the company.
Learn more about venture capital in this fantastic presentation.
Process of Raising Equity
If this is the route that the business has decided to follow in order to secure financing, then the company should expect to go through several hoops and loops to complete it. Equity financing is subject to several laws and legislation, since it is regulated by both local and national securities authorities, depending on the jurisdiction or area where the businesses operate in.
Step 1: Assess if equity financing is really the best option.
In your assessment, you have to consider the following: How important is ownership to you?
More specifically, how important is it for you, and the other owners of the business, to retain full control and ownership of the company? If there is a consensus on maintaining the current percentage of ownership, equity financing may not be the best choice.
Step 2: Choose the most suitable type of equity investor for your business.
Depending on your needs and the current state of your business, you will easily identify whether you should look for an angel investor or venture capitalist, or stick to retail investors.
Step 3: Nale your pitch.
Basically, you will be selling yourself, convincing the investors to grant more than a passing glance to your business and your proposal. You have to convince them that your business is worth investing on. When making your pitch, go through the due diligence process, in order to increase your chances of being looked on favorably by potential investors.
Step 4: Comply with the requirements of the equity investor.
And there will be quite a lot of them, so make sure all the requirements are met or complied with duly.
OTHER WAYS OF FINANCING YOUR BUSINESS EXTERNALLY
These are not the only options available for companies seeking financing. Let us look into the other external financing sources available.
#1 Personal Loan
In the past, the general perception of personal loans is that they are for consumer purposes, so they are mostly used to finance small projects, such as a car or a vehicle, home renovations and improvement projects, vacations or trips, and other similar activities. But personal loans may also be used in business.
This usually takes place in the form of entrepreneurs who are just starting their own businesses. These entrepreneurs take out a personal loan, in their individual capacity, and use the proceeds of the loan in financing their business startup or venture.
The amount is not large, usually not exceeding $50,000, and has an average term of 5 years. It may be a small amount, but small businesses that usually do not need much will benefit greatly from this type of loan.
- It is less expensive to avail of a personal loan than it is to take out a business loan since, normally, the interest rates are lower.
- Banks do not require financials of a business, so it is ideal for personal loan applicants that have limited or no business history or background.
- The loanable amount is limited up to a certain amount only, regardless of the capital requirement of your business.
- The loan will reflect on your personal credit history, which may also have a bearing on your company’s credit history (and rating) in the future.
- Some people may have difficulty separating their business loans from personal loans, since there is a possibility that the entrepreneur may avail of other personal loans, such as a car loan or a mortgage.
- Bank. Aside from business loans, personal loans are also granted by banks. However, banks may require specific purposes to be stated, and some may not accept “starting a business” as a valid reason for a personal loan. They may advice you to avail of a business loan instead. The main criterion is when the entrepreneur meets character and background checks, as well as their finance checks.
- Private individuals. The entrepreneur may have friends, family members or acquaintances who are interested to lend money to aid them in starting their business. This is a bit more flexible, since these individuals are mostly concerned on the ability of the borrower to pay. The terms of the loan may be negotiated freely and, if they have prior relationships before – whether personal or professional – these will be taken into consideration when deciding whether to lend the money or not.
- Lending companies or institutions. Similarly, private companies that extend personal loans are primarily concerned with the personal credit score and history of the borrower. Some of these companies may also be accessible online, since they now have their own websites where they can easily apply for a loan and get approval quickly.
Mark Cuban is totally right, if he says “Only Morons start a business with a loan”.
#2 Royalty Financing
Royalty financing became popular as technology became a thriving industry, with technology products and services being introduced at a rapid pace. Investors are aware of how the technology industry is lucrative, which is why they are willing to invest their money on viable products and services.
In this scenario, an investor catches wind of a great product idea of an entrepreneur, or a potential high-return project of a business. He will then invest on that project, in return for a specific percentage of the proceeds. Unlike your straightforward equity financing deal, there is no transfer of ownership in this type of financing.
The investor may opt to give money in advance against the future profits of a product or asset. In return, they will get part of these profits. In effect, this is an indirect way of saying that the investor has a percentage of equity in the business, considering this entitlement.
Or, the business may decide to sell the product or the asset to the investor once it has been completed. Therefore, the profits earned by the product or asset will be owned by the investor.
- Since this is not a business loan, and no debt is incurred, there is no repayment (and corresponding repayment terms) to be concerned about. The company is not bound to pay a certain sum of money at specific deadlines.
- Although it is a debt, it does not appear on the balance sheet as one. It may only appear on the Notes to Financial Statements as a contingent liability, since it is contingent to the ability of the business to earn money.
- The business remains intact, and owned by its current owners or stakeholders. After all, the investor does not dilute the ownership pool of the company even when he provides the needed funds.
- It may end up being expensive for the business, since the investor may ask for a high return on the money they provided to finance the product or asset.
Institutional, retail and private equity investors are the usual types of investors you will find engaging in royalty financing. Their attention would first be on the idea or the product of the entrepreneur, specifically its viability and potential or future profitability. After that, they may set some terms on the royalty agreement that both parties must consent to in order for the financing contract to be perfected.
If you are watching Shark Tank, this financing method was used a lot in this TV show.
What differentiates a grant from a debt? Debt requires repayment of the full amount of money given by the lender, including the interest. Grant, on the other hand, does not require any repayment. In short, the business can get money that it does not have to repay.
- Obviously, the fact that the borrower does not have to repay anything is an advantage. It is like being given funds for free, without a corresponding monetary obligation to give it back.
- In the case of government grants which are funded by taxes, there are strict rules that apply to its provision, all the way to the time when the money actually changes hands.
- Unfortunately, government grants are not given for the purpose of starting a business, paying off debts or obligations, and covering costs of operations. The granting agency makes the grant only to specific industries and targeted causes. The most common examples are for scientific researches, medical studies, and, in some cases, research & development (R&D)
- It may be difficult to find grants that you will qualify for, and even if you do, there tends to be a lot of requirements that must be complied with. The processing is likely to take a long time.
If you do not know where to start looking for grant providers, a popular method used by businesses is through online searches. The typical providers of grants include:
- Government agencies. Businesses may avail of small business government grants provided they meet the special circumstances or criteria set by federal grant-making agencies. One source of information for possible available grants is the United States Small Business Administration.
- Educational institutions. Some educational institutions are generous about providing grants, usually for R&D and studies that will also benefit their institution in the long run.
- Non-profit, non-government organizations and foundations. Some organization and foundations with targeted causes allocate funds as grants to those who will conduct special projects in relation to these causes or advocacies. For example, a foundation concerned with environmental issues may willingly finance a researcher on his study on, say, climate change and greenhouse gases. Similarly, organizations advocating women entrepreneurs may also provide grants to women who are looking to set up their own small businesses.
- Corporations. Large businesses and corporations, as part of their corporate social responsibility, set aside funds to offer as grants or assistance to small businesses.
- Private individuals. Sometimes, there are also individuals with deep pockets who provide these grants.
#4 Mezzanine Financing
In this type of financing, it starts out with financing obtained using debt, with the condition that the lender is given rights to convert to an equity interest in the company in the event that the company fails to repay the loan in full, or on time. Technically, this is a combination of debt and equity financing.
Mezzanine financing is available to businesses that are already in existence and in operation, but are looking to expand or grow, and needing funding to accomplish that. The usual setup is that there will be a senior debt provided by senior lenders (banks, credit institutions or VCs), and the mezzanine debt will only be subordinate to this senior debt.
- Availment of funds through mezzanine financing is usually very quick, so the borrower can immediately gain access to the money he needs.
- It usually requires very little to no collateral, which means that the assets of the business are safe from seizure in case of failure to meet loan payments.
- Since this is presented as equity on the balance sheet of the company, financial position is improved and will put the company in a favorable light in case it tries to apply for bank loans in the future.
- Since this is not secured by any asset, the interest rate is often set very high. This is why it is considered to be more expensive than a regular debt. On average, the cost of mezzanine financing is at 20%.
The typical investor in this type of financing is known as the “mezzanine provider” or “mezzanine lender”. What does the mezzanine provider look at in consideration of whether to provide mezzanine funds or not?
- Established reputation and product in the industry. The provider will look into the track record of the company. What are the products or services that it offers to the market? What is its standing in the market and in the industry as a whole?
- Profitability of the company. The provider will also consider whether the company is earning positive profits.
- Potential for growth. The business must also demonstrate a viable growth plan, such as for expansions, future acquisitions, and even entry to new markets.
- Stability of cash flow. Businesses that have stable and free cash flow are in a better position to avail of mezzanine debt.
BEST PRACTICES IN FINANCING A BUSINESS
Establish yourself first
If you are an existing business, or a business in the very early stages, you should try, as much as possible, to establish your company’s position first. This is so that your business will appear as an appealing prospect to the potential lender or investor.
- Maintain a healthy cash position. Debt investors would like to be assured that the money they lent to the company will be repaid in time, along with the interests attached. Equity investors, on the other hand, would like to get assurance that they will be paid the returns due them when the time for profit distribution arrives. Therefore, they will be inclined to take note of the cash position of the company, as well as the movement or flow of cash in and out of the business.
- Maintain good credit rating. Debt investors and equity investors will definitely avoid dealing or transacting with a company that has a history of being unable to make its loan payments. They would not be blamed for being afraid that they, too, will not be able to collect on the money that they invested.
Find out about all possible sources of financing and identify those that are feasible in your case
Do not immediately assume that the only way you can obtain money to fund your brilliant product idea is to go to the bank and take out a loan. The discussion above would have already clued you in that there are several more options available to you.
Once you have decided that debt financing is the most suitable avenue for you, or that equity financing is your best option, you should not just jump on the first debt or equity investor that you find. Learn to “shop” around. You may regret choosing a debt investor, only to realize later on that there is another investor that may offer more reasonable terms.
Explore all the options and avenues available to you. It is also possible that your analysis will lead you to realize that a single financing option is not going to be enough, and you’d have to employ two or three financing options. This can happen, and it is actually happening. Don’t worry; there is no rule that says you can only acquire debt financing or equity financing, but not both at the same time.
Know who you are seeking financing from, and probe the details
Study these investors, because you also would want to make sure you are dealing with legitimate and above-board institutions or individuals. Just because someone came forward offering money outright does not mean you should also accept it outright. You also have to make sure that they have a good reputation as investors.
You should also take note of the fees involved, or the costs that will be incurred in securing funding. Transaction fees, interest rates, and other charges are bound to come up, and it is vital that you know what they are, and what they are for. This will also give you enough knowledge to know whether you can negotiate terms or not.
Provide reliable, verifiable, and realistic cost estimates
Do not be greedy and overstate or understate figures in your financials and estimates, just so your company will be reflected in a good light. Bloating sales, revenues and assets, reducing expenditures and hiding obligations will not help you, since investors usually have their own teams in place specifically to verify the facts and figures that you will provide them. In case they find you out for tampering with these amounts, this may ruin your chances of securing financing at any time in the future.
You may obtain the help of consultants and professionals when coming up with early cost estimates of your project or business.
Proposal or plan must include both needs and constraints
Follow the instructions on how to prepare a business plan. Depending on the purpose, a business plan may be tailored to fit certain circumstances, so you may include parts that will be required by equity investors or debt investors, as the case may be. It is not enough that you state how much you will need. You also have to provide justification on why you need that specific amount: what you will use it for, and how you will spend it.
Once financing is obtained, follow the plan
One of the reasons that business fail, even with the provision of funding from debt or equity investors, is their failure to stick to the plan. Straying from what was originally stated in the business plan, more often than not, can cause problems. The investors specifically agreed to provide funding because of what was stated in the plan, and not following it is like saying you are not keeping your end of the bargain. This will no doubt create trust issues between you and the investors, and may hurt your future bids for financing.
If making changes or steering slightly from the plan is unavoidable, however, what you should do is to consult with the investors, making them understand the need for changes, and the benefits that will be derived from doing so. Proving that adapting these changes would be more beneficial will strengthen your case for not strictly adhering to the plan, and will also reassure investors of how much you respect and value their position.
Track your spending, and document it
It is very important that you keep track of how you spent the funding that you were able to acquire, and document everything accurately and completely. Aside from the fact that you will require these for your own records and evaluation of the project afterwards, some investors may request progress reports in the form of your spending reports.
Keep your personal and business finances separate
Entrepreneurs often make the mistake of lumping their personal and business finances together. As a result, they have a difficult time separating them, especially when they have to seek funding, and the potential investors require business financial records as opposed to the personal financials of the owner or entrepreneur. By keeping them separate, tracking of finances will be easier when financing has been secured.
Obtain the services of professionals
Face it: you may be an expert in your business and in your product, but there may be areas where you will need a lot of help. When seeking financing, you will probably need the help of an accountant to sort out your financial reports. A consultant or legal adviser may also be needed to take care of the legal side of things. Admit that you cannot do everything, and seek the help that you need.
Cultivate and nurture good relationships with potential investors
Take banks, for example. As mentioned earlier, banks tend to be more lenient in granting business loans to businesses or firms that they already know, by way of previous transactions. If a company has been a depositor or account holder in good standing with a bank, they are likely to have an easier time applying for a business loan with that bank.
Another example is when a business or an entrepreneur does not default on its tax payments. Once it applies for a government grant, they won’t have a problem in that area because they have been faithful in paying their taxes.
Companies that are currently operating should also make sure to distribute profits due to the shareholders. Otherwise, potential equity investors may not be too keen to invest in a company that fails to pay the shareholders what is due them.
Jason Calacanis dsicusses how to network with angel investors effectively.
OTHER TIPS WHEN SEEKING FINANCING FOR YOUR BUSINESS
Do not use scare tactics.
Investors will not be impressed with businesses that employ threats and other scare tactics to convince them to invest money on them. In the first place, these businesses are not in any position to be threatening or giving out ultimatums, no matter how much of a potential success their product or business idea will be. They are the ones in need of financing, so they should not be the one to make the demands.
Back up your claims with verifiable facts and figures.
With every piece of information or data you submit, make sure they are verifiable and can be backed up by legitimate sources. While it is true that the investors have the responsibility of checking whether your claims are correct or feasible, you should also make it easy for them to do their job, if only to facilitate evaluation of your proposal and speed up the process. Giving them a hard time will only prolong the wait for funding to be released to your disposal.
Keep business documents and financial records updated.
Records and documents that are not updated are of little relevance, especially in the eyes of investors. True, they may look at past records for comparative evaluation purposes, but their main focus would be on updated information.
Always keep business documents and records up to date, and make sure they are readily accessible when the investors ask for them.
Provide constant feedback.
Your relationship with investors does not begin and end when they have provided the money and you have fully repaid your debts or distributed profits to them periodically. You should also make it a point to provide constant feedback regularly, especially every time something important takes place. Investors will always want to be kept updated on the progress of their investments, and they will also tend to trust you more if you make an effort to keep them informed.
Despite the many options and requirements, this is one area where there is something for everyone. Look at the needs that you have in the business and weigh them against the advantages and disadvantages of each of the above methods of obtaining financing and you will be sure to find something that works for you.
In San Jose (CA), we meet Founder & CEO of Zoom, Eric Yuan. Eric talks about his story how he came …