CHAPTER 10
Getting Financing or Funding

The Importance of Getting Financing or Funding

The need to raise money surprises a number of entrepreneurs, in that many of them launch their firms with the intention of funding all their needs internally. Commonly, though, entrepreneurs discover that operating without investment capital or borrowed money is more difficult than they anticipated. Because of this, it is important for entrepreneurs to understand the role of investment capital in the survival and subsequent success of a new firm.

Why Most New Ventures Need Funding

There are three reasons that most entrepreneurial ventures need to raise money during their early life: cash flow challenges, capital investments, and lengthy product development cycles.

Sources of Personal Financing

Typically, the seed money that gets a company off the ground comes from the founders’ own pockets. There are three categories of sources of money in this area: personal funds, friends and family, and bootstrapping.

Preparing to Raise Debt or Equity Financing

Once a start-up’s financial needs exceed what personal funds, friends and family, and bootstrapping can provide, debt and equity are the two most common sources of funds. The most important thing an entrepreneur must do at this point is determine precisely what the company needs and the most appropriate source to use to obtain those funds. A carefully planned approach to raising money increases a firm’s chance of success and can save an entrepreneur considerable time.

Sources of Equity Funding

The primary disadvantage of equity funding is that the firm’s owners relinquish part of their ownership interest and may lose some control. The primary advantage is access to capital. In addition, because investors become partial owners of the firms in which they invest, they often try to help those firms by offering their expertise and assistance. Unlike a loan, the money received from an equity investor doesn’t have to be paid back. The investor receives a return on the investment through dividend payments and by selling the stock.

Business Angels

Business angels are individuals who invest their personal capital directly in start-ups. The prototypical business angel, who invests in entrepreneurial start-ups, is about 50 years old, has high income and wealth, is well educated, has succeeded as an entrepreneur, and invests in companies that are in the region where he or she lives.

Venture Capital

Venture capital is money that is invested by venture capital firms in start-ups and small businesses with exceptional growth potential. Venture capital firms are limited partnerships of money managers who raise money in “funds” to invest in start-ups and growing firms. The funds, or pools of money, are raised from high-net-worth individuals, pension plans, university endowments, foreign investors, and similar sources.

Initial Public Offering

Another source of equity funding is to sell stock to the public by staging an initial public offering (IPO). An IPO is the first sale of stock by a firm to the public. Any later public issuance of shares is referred to as a secondary market offering. When a company goes public, its stock is typically traded on one of the major stock exchanges.

Sources of Debt Financing

Debt financing involves getting a loan or selling corporate bonds. Because it is virtually impossible for a new venture to sell corporate bonds, we’ll focus on obtaining loans. There are two common types of loans. The first is a single-purpose loan, in which a specific amount of money is borrowed that must be repaid in a fixed amount of time with interest. The second is a line of credit, in which a borrowing “cap” is established and borrowers can use the credit at their discretion. Lines of credit require periodic interest payments.

Commercial Banks

Historically, commercial banks have not been viewed as practical sources of financing for start-up firms. This sentiment is not a knock against banks; it is just that banks are risk averse, and financing start-ups is risky business. There are two reasons that banks have historically been reluctant to lend money to start-ups. First, as mentioned previously, banks are risk averse. The second reason banks have historically been reluctant to lend money to start-ups is that lending to small firms is not as profitable as lending to large firms, which have been the staple clients of commercial banks.

SBA Guaranteed Loans

The loans are for small businesses that are unable to secure financing on reasonable terms through normal lending channels. The SBA does not currently have funding for direct loans, other than a program to fund direct loans for businesses in geographic areas that are hit by natural disasters. SBA guaranteed loans are utilized more heavily by existing small businesses than start-ups, they should not be dismissed as a possible source of funding.

Other Sources of Debt Financing

There are a variety of other avenues business owners can pursue to borrow money or obtain cash. Vendor credit (also known as trade credit) is when a vendor extends credit to a business in order to allow the business to buy its products and/or services up front but defer payment until later. Factoring is a financial transaction whereby a business sells its account receivable to a third party, called a factor, at a discount in exchange for cash. A common type of alternative lending is the merchant cash advance. In a merchant cash advance, the lender provides a business a lump sum of money in exchange for a share of future sales that covers the payment amount plus fees.

Creative Sources of Financing and Funding

Because financing and funding are difficult to obtain, particularly for start-ups, entrepreneurs often use creative ways to obtain financial resources. Even for firms that have financing or funding available, it is prudent to search for sources of capital that are less expensive than traditional ones.

Crowdfunding

A popular creative source of funding for new businesses is crowdfunding. Crowdfunding is the practice of funding a project or new venture by raising monetary contributions from a large number of people, typically via the Internet. There are two types of crowdfunding sites: rewards-based crowdfunding and equity-based crowdfunding. Reward-based crowdfunding allows entrepreneurs to raise money in exchange for some type of amenity or reward.  Equity-based crowdfunding helps businesses raise money by tapping individuals who provide funding in exchange for equity in the business.

Leasing

A lease is a written agreement in which the owner of a piece of property allows an individual or business to use the property for a specified period of time in exchange for payments. The major advantage of leasing is that it enables a company to acquire the use of assets with very little or no down payment. Leases for facilities and leases for equipment are the two most common types of leases that entrepreneurial ventures undertake.

Other Grant Programs

There are a limited number of other grant programs available to entrepreneurs. Obtaining a grant takes a little detective work. Granting agencies are, by nature, low-key, so they normally need to be sought out.

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