THE BASICS OF STARTUP FINANCING
Startup financing means some initial infusion of money needed to turn an idea (by starting a business) into reality. While starting out, big lenders like banks etc. are not interested in a startup business. The reason is that when you are just starting out, you're not at the point yet where a traditional lender or investor would be interested in you. So that leaves one with the option of selling some assets, borrowing against one’s home, asking loved ones i.e. family and friends for loans etc. But that involves a lot of risk, including the risk of bankruptcy and strained relationships with friends and family.
So, the pertinent question is how to keep loans from family and friends strictly business like. This is the hard part behind starting a business -- putting so much at risk but doing so is essential. It's what sets entrepreneurs apart from people who collect regular salaries as employees.
A good way to get success in the field of entrepreneurship is to speed up initial operations as quickly as possible to get to the point where outside investors can see and feel the business venture, as well as understand that a person has taken some risk reaching it to that level.
Some businesses can also be bootstrapped (attempting to found and build a company from personal finances or from the operating revenues of the new company).They can be built up quickly enough to make money without any help from investors who might otherwise come in and start dictating the terms.
In order to successfully launch a business and get it to a level where large investors are interested in putting their money, requires a strong business plan. It also requires seeking advice from experienced entrepreneurs and experts -- people who might invest in the business sometime in the future.
SOME OF THE INNOVATIVE WAYS TO FINANCE A STARTUP
Every startup needs access to capital, whether for funding product development, acquiring machinery and inventory or paying salaries to its employee. Most entrepreneurs think first of bank loans as the primary source of money, only to find out that banks are really the least likely benefactors for startups. So, innovative measures include maximizing non-bank financing.
Here are some of the sources for funding a startup:
(i) Personal financing: It may not seem to be innovative but you may be surprised to note that most budding entrepreneurs never thought of saving any money to start a business. This is important because most of the investors will not put money into a deal if they see that you have not contributed any money from your personal sources.
(ii) Personal credit lines: One qualifies for personal credit line based on one’s personal credit efforts. Credit cards are a good example of this. However, banks are very cautious while granting personal credit lines. They provide this facility only when the business has enough cash flow to repay the line of credit.
(iii) Family and friends: These are the people who generally believe in you, without even thinking that your idea works or not. However, the loan obligations to friends and relatives should always be in writing as a promissory note or otherwise.
(iv) Peer-to-peer lending: In this process group of people come together and lend money to each other. Peer to peer lending has been there for many years. Many small and ethnic business groups having similar faith or interest generally support each other in their start up endeavors.
(v) Crowdfunding: Crowdfunding is the use of small amounts of capital from a large number of individuals to finance a new business initiative. Crowdfunding makes use of the easy accessibilityof vast networks of people through social media and crowdfunding websites to bring investors and entrepreneurs together.
(vi) Microloans: Microloans are small loans that are given by individuals at a lower interest to a new business ventures. These loans can be issued by a single individual or aggregated across a number of individuals who each contribute a portion of the total amount.
(vii) Vendor financing: Vendor financing is the form of financing in which a company lends money to one of its customers so that he can buy products from the company itself. Vendor financing also takes place when many manufacturers and distributors are convinced to defer payment until the goods are sold. This means extending the payment terms to a longer period for e.g. 30 days payment period can be extended to 45 days or 60 days. However, this depends on one’s credit worthiness and payment of more money.
(viii) Purchase order financing: The most common scaling problem faced by startups is the inability to find a large new order. The reason is that they don’t have the necessary cash to produce and deliver the product. Purchase order financing companies often advance the required funds directly to the supplier. This allows the completion of transaction and profit flows up to the new business.
(ix) Factoring accounts receivables: In this method, a facility is given to the seller who has sold the good on credit to fund his receivables till the amount is fully received. So, when the goods are sold on credit, and the credit period (i.e. the date upto which payment shall be made) is for example 6 months, factor will pay most of the sold amount up front and rest of the amount later.
Therefore, in this way, a startup can meet his day to day expenses.
MODES OF FINANCING FOR STARTUPS
(i) Bootstrapping : An individual is said to be boot strapping when he or she attempts to found and build a company from personal finances or from the operating revenues of the new company.
A common mistake made by most founders is that they make unnecessary expenses towards marketing, offices and equipment they cannot really afford. So, it is true that more money at the inception of a business leads to complacency and wasteful expenditure. On the other hand,investment by startups from their own savings leads to cautious approach. It curbs wasteful expenditures and enable the promoter to be on their toes all the time.
Here are some of the methods in which a startup firm can bootstrap:
(a) Trade Credit: When a person is starting his business, suppliers are reluctant to give trade credit. They will insist on payment of their goods supplied either by cash or by credit card.
However, a way out in this situation is to prepare a well-crafted financial plan. The next step is to pay a visit to the supplier’s office. If the business organization is small, the owner can be directly contacted. On the other hand, if it is a big firm, the Chief Financial Officer can be contacted and convinced about the financial plan.Communication skills are important here. The financial plan has to be shown. The owner or the financial officer has to be explained about the business and the need to get the first order on credit in order to launch the venture. The owner or financial officer may give half the order on credit and balance on delivery. The trick here is to get the goods shipped and sell them before paying to them. One can also borrow to pay for the good sold but there is interest cost also. So trade credit is one of the most important way to reduce the amount of working capital one needs. This is especially true in retail operationsthe financial plan that you have prepared. Tell the owner or financial officer about your business,and explain that you need to get your first orders on credit in order to launch your venture.
The owner or financial officer may give half the order on credit, with the balance due upon delivery.Of course, the trick here is to get the goods shipped, and sell them before one has to pay for them.One could borrow money to pay for the inventory, but you have to pay interest on that money. So trade credit is one of the most important ways to reduce the amount of working capital one needs.
This is especially true in retail operations.
(b) Factoring: This is a financing method where accounts receivable of a business organization is sold to a commercial finance company to raise capital. The factor then got hold of the accounts receivable of a business organization and assumes the task of collecting the receivables as well as doing what would've been the paperwork. Factoring can be performed on a non-notification basis.
It means customers may not be told that their accounts have been sold.However, there are merits and demerits to factoring. The process of factoring may actually reduce costs for a business organization. It can actually reduce costs associated with maintaining accounts receivable such as bookkeeping, collections and credit verifications. If comparison can be made between these costs and fee payable to the factor, in many cases it has been observed that it even proved fruitful to utilize this financing method.
In addition to reducing internal costs of a business, factoring also frees up money that would otherwise be tied to receivables. This is especially true for businesses that sell to other businesses or to government; there are often long delays in payment that this would offset. This money can be used to generate profit through other avenues of the company. Factoring can be a very useful toolfor raising money and keeping cash flowthe financial plan that you have prepared. Tell the owner or financial officer about your business, and explain that you need to get your first orders on credit in order to launch your venture.
The owner or financial officer may give half the order on credit, with the balance due upon delivery.
Of course, the trick here is to get the goods shipped, and sell them before one has to pay for them.
One could borrow money to pay for the inventory, but you have to pay interest on that money. So trade credit is one of the most important ways to reduce the amount of working capital one needs.
(c) Leasing: Another popular method of bootstrapping is to take the equipment on lease rather than purchasing it. It will reduce the capital cost and also help lessee (person who take the asseton lease) to claim tax exemption. So, it is better to a take a photocopy machine, an automobile or a van on lease to avoid paying out lump sum money which is not at all feasible for a startup organization.
Further, if you are able to shop around and get the best kind of leasing arrangement when you're starting up a new business, it's much better to lease. It's better, for example, to lease a photocopier say at ` 5,000 per month , rather than pay ` 1,00,000 for it; or lease your automobile or van to avoid paying out ` 5,00,000 or more.There are advantages for both the startup businessman using the property or equipment (i.e. the lessee) and the owner of that property or equipment (i.e. the lessor.) The lessor enjoys tax benefits in the form of depreciation on the fixed asset leased and may gain from capital appreciation on the property, as well as making a profit from the lease. The lessee benefits by making smaller payments retain the ability to walk away from the equipment at the end of the lease term. The lessee may also claim tax benefit in the form of lease rentals paid by him.ing.
(ii) Angel Investors: Despite being a country of many cultures and communities traditionally inclined to business and entrepreneurship, India still ranks low on comparative ratings across entrepreneurship, innovation and ease of doing business. The reasons are obvious . These include our old and outdated draconian rules and regulations which provides a hindrance to our business environment for a long time. Other reasons are red tapism, our time consuming procedures, and lack of general support for entrepreneurship. Off course, things are changing in recent times.As per Investopedia, Angel investors invest in small startups or entrepreneurs. Often, angel investors are among an entrepreneur's family and friends. The capital angel investors provide maybe a one-time investment to help the business propel or an ongoing injection of money to support and carry the company through its difficult early stages.Angel investors provide more favorable terms compared to other lenders, since they usually invest in the entrepreneur starting the business rather than the viability of the business. Angel investors are focused on helping startups take their first steps, rather than the possible profit they may get from the business. Essentially, angel investors are the opposite of venture capitalists.Angel investors are also called informal investors, angel funders, private investors, seed investorsor business angels. These are affluent individuals who inject capital for startups in exchange for ownership equity or convertible debt. Some angel investors invest through crowdfunding platforms online or build angel investor networks to pool in capital.Angel investors typically use their own money, unlike venture capitalists who take care of pooled money from many other investors and place them in a strategically managed fund.Though angel investors usually represent individuals, the entity that actually provides the fund maybe a limited liability company, a business, a trust or an investment fund, among many other kinds of vehicles.
Angel investors who seed startups that fail during their early stages lose their investments completely. This is why professional angel investors look for opportunities for a defined exit strategy, acquisitions or initial public offerings (IPOs).
(iii) Venture Capital Fund: Venture Capital Fund means investment vehicle that manage funds of investors seeking to invest in startup firms and small businesses with exceptional growth potential. Venture capital is money provided by professionals who alongside management invest in young, rapidly growing companies that have the potential to develop into significant economic contributors
• Finance new and rapidly growing companies
• Purchase equity securities
• Assist in the development of new products or services
• Add value to the company through active participation.
Characteristics of Venture Capital Financing
(i) Long time horizon: The fund would invest with a long time horizon in mind. Minimum period of investment would be 3 years and maximum period can be 10 years.
(ii) Lack of liquidity: When VC invests, it takes into account the liquidity factor. It assumes that there would be less liquidity on the equity it gets and accordingly it would be investing in that format. They adjust this liquidity premium against the price and required return.
(iii) High Risk: VC would not hesitate to take risk. It works on principle of high risk and high return. So, high risk would not eliminate the investment choice for a venture capital.
(iv) Equity Participation: Most of the time, VC would be investing in the form of equity of a company. This would help the VC participate in the management and help the company grow. Besides, a lot of board decisions can be supervised by the VC if they participate in the equity of a company.
Advantages of bringing VC in the company
• It injects long- term equity finance which provides a solid capital base for future growth.
• The venture capitalist is a business partner, sharing both the risks and rewards. Venture capitalists are rewarded with business success and capital gain.
• The venture capitalist is able to provide practical advice and assistance to the company based on past experience with other companies which were in similar situations.
• The venture capitalist also has a network of contacts in many areas that can add value to the company.
• The venture capitalist may be capable of providing additional rounds of funding should it be required to finance growth.
• Venture capitalists are experienced in the process of preparing a company for an Initial
Public Offering (IPO) of its shares onto the stock exchanges or overseas stock exchangeSuch as NASDAQ.
• They can also facilitate a trade sale.
Stages of funding for VC
1. Seed Money: Low level financing needed to prove a new idea.
2. Start-up: Early stage firms that need funding for expenses associated with marketing and product development.
3. First-Round: Early sales and manufacturing funds.
4. Second-Round: Working capital for early stage companies that are selling product, but not yet turning in a profit