Sources of finance for a start-up business
Introduction
Often
the hardest part of starting a business is raising the money to get going. The
entrepreneur might have a great idea and clear idea of how to turn it into a
successful business. However, if sufficient finance can’t be raised, it
is unlikely that the business will get off the ground.
Raising
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).
Some helpful topices are here:
Internal sources
The
main internal sources of 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. Note
that retained profits can generate cash the moment trading has begun.
For example, a start-up sells the first batch of stock for £5,000 cash which it
had bought for £2,000. That means that retained profits are £3,000 which
can be used to finance further expansion or to pay for other trading costs and
expenses.
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 – this is covered further below.
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.
Personal sources
As
mentioned earlier, most start-ups make use of the personal financial
arrangements of the founder. This can be personal savings or other cash
balances that have been accumulated. It can be personal debt facilities
which are made available to the business. It can also simply be the found
working for nothing! The following notes explain these in a little more
detail.
Savings
and other “nest-eggs” An entrepreneur will often invest
personal cash balances into a start-up. This is a cheap form of finance
and it is readily available. Often the decision to start a business is prompted
by a change in the personal circumstances of the entrepreneur – e.g. redundancy
or an inheritance. Investing personal savings maximises the control the
entrepreneur keeps over the business. It is also a strong signal of
commitment to outside investors or providers of finance. Re-mortgaging is
the most popular way of raising loan-related capital for a start-up. The
way this works is simple. The entrepreneur takes out a second or larger
mortgage on a private property and then invests some or all of this money into
the business. The use of mortgaging like this provides access to
relatively low-cost finance, although the risk is that, if the business fails,
then the property will be lost too. .
Borrowing
from friends and family This is also common.
Friends and family who are supportive of the business idea provide money either
directly to the entrepreneur or into the business. This can be quicker
and cheaper to arrange (certainly compared with a standard bank loan) and the
interest and repayment terms may be more flexible than a bank loan.
However, borrowing in this way can add to the stress faced by an entrepreneur,
particularly if the business gets into difficulties.
Credit
cards This
is a surprisingly popular way of financing a start-up. In fact, the use
of credit cards is the most common source of finance amongst small
businesses. It works like this. Each month, the entrepreneur pays
for various business-related expenses on a credit card. 15 days later the
credit card statement is sent in the post and the balance is paid by the
business within the credit-free period. The effect is that the business
gets access to a free credit period of aroudn30-45 days!
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