CFO Service Finance & Accounting

Funding Alternatives for Start-ups and Small Businesses: Start-up Finance

An overview of Start-up finance

The term “start-up finance” deals with some kind of initial infusion of money needed to translate an idea (by starting a business) into reality. Apparently, while starting out a new business venture, it is quite difficult to obtain funds from big lenders such as banks, financial institutions, etc. as they are generally reluctant in extending finance in start-up businesses owing to risk concerns.

When a business or firm is at its initial stage and is still making strenuous efforts to mark its footprints in the market and gain goodwill among its stakeholders, it has not reached a point where a traditional lender or investor would be interested in it. Thus, such start-up businesses have no recourse left but to place reliance on options such as selling some assets, borrowings against one’s home, obtaining loans from close family and friends, etc. However, this too involves a lot of risks, including the risk of bankruptcy and strained relationships with friends and family. A strong business plan is needed to successfully launch a new business and get it to a level where large investors are interested in investing their money.

Moreover, to attain enduring success in the field of entrepreneurship, it is pertinent to speed up the initial set of business operations as quickly as possible so as to reach to a point where outside investors can see and feel the business venture. They must hold a sense of confidence in the firm and value the level of risk that is put into by the entrepreneur to reach up to such level.

Most common start-up finance options

Start-up finance is needed by every newly established business to gain access to capital, whether it is for funding of product development, acquisition of machinery and raw materials, or meeting administration costs such as paying salaries to its workers. As banks are less likely to give loans for start-up finance, most entrepreneurs go for innovative measures to fund their business needs. Also, in the case where small business’s capital needs do not qualify for a traditional bank loan, there are a number of alternative financing methods which can bridge the gap of funds in SMEs. Some of the most common sources used for funding a start-up or SME include the following:

1. Self-funding or Personal savings
2. Peer to peer lending and family and friends
3. Crowd-funding
4. Vendor financing, Purchase order financing and Trade credit
5. Factoring
6. Angel Investment
7. Venture Capitalist and Venture Debt
8. Loan from banks/NBFCs and CGTMSE loans
9. External Commercial Borrowings (ECBs)

Let us have a look at each of these financing options while addressing their peculiarities in brief:

1. Self-funding or Personal savings

Most budding entrepreneurs never thought of saving any money to start a business or to propel their small businesses in the right direction. However, personal financing can play a vital role. Some important points to note here are:

• Self-funding is all the more important because outside investors will not put money into a deal if they see that the owner himself has not contributed any money through personal sources.
• Personal credit lines, such as credit cards can also play a crucial role.
• But banks are quite cautious while offering personal credit lines to entrepreneurs, and they provide this facility only when the business has enough cash flow to repay the line of credit.  

Bootstrapping: An individual is said to be bootstrapping his business when he or she attempts to find, nurture and build a company from personal finances or from the operating revenues of the new company. A common mistake made by most new entrepreneurs 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 new business often leads to unwise and wasteful expenditure. On the other hand, investment by startups from their own savings leads to a cautious approach. It curbs wasteful expenditures and enables the promoters to follow a well-planned approach all the time.

2. Peer to peer lending and family and friends

People in close family and friends who generally believe in you would provide you help without even thinking that your business idea works or not. Similarly, peer to peer lending has also been there for many years. Some important points to note in this type of start-up finance are:

• The loan obligations to friends and close relatives must always be in writing as a promissory note or otherwise.
• Under peer to peer lending, a group of people come together and lend money to each other.
• Many small and ethnic business groups having similar faith or interest generally support each other in their start-up endeavours.
• Loans availed through peer to peer lending should also be strictly businesslike.

3. Crowd-funding

Lately, crowd-funding has emerged as one of the most popular start-up finance techniques through which small amounts of capital from a large number of individuals are raised to finance a new business initiative. It is a technique that makes use of the easy accessibility of vast networks of people through social media and crowd-funding websites to bring potential investors and budding entrepreneurs together. Some important points to note in this type of start-up finance are:

• Crowd-funding allows anyone with a clear vision and strong business plan, including entrepreneurs, to raise money for their project or venture.
• Crowd-funding platforms allow businesses to pool small investments from several investors instead of seeking out a single investment source.
• The entrepreneur is required to share his business plan and objectives with a large group of people hoping that enormous donations will eventually lead to the generation of desired funds.
• Some of the popular crowd-funding sites are Indiegogo, Wishberry, Ketto, Fundlined, Kickstarter, RocketHub, DreamFunded, and Catapooolt.
• Marketing benefits also reap in along with the raising of a start-up loan through crowd-funding. It provides validation of a business idea by many potential future customers for the new business.

4. Vendor financing, Purchase order financing and Trade credit

Vendor financing or trade credit takes place when many manufacturers and distributors are convinced to defer payment until the time the goods are sold. It is a form of credit allowed to businesses from their vendors or material suppliers so that they can make delayed payment to them. This means extending the payment terms to a longer period for e.g. 30 days to 45 days or 60 days. Trade credit is one of the most important ways to reduce the amount of working capital one needs.

The most common scaling problem faced by SMEs and startups is the inability to secure a large new order. The reason is that they don’t have the necessary cash required to produce and deliver the product. Here, purchase order financing companies play a role and often advance the required funds directly to the supplier. This allows the transaction between the start-up and its supplier to complete and profit to flow up to the new business.

Moreover, 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 present a well-crafted financial plan. 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.

5. Factoring

Factoring is a financing method where accounts receivables of a business organization are sold to a commercial finance company (called the ‘factor’) at a discount with a view to raising capital. The factor then gets a hold of the accounts receivables of the business organization and assumes the responsibility of collecting the receivables as well as doing the associated paperwork in receivables management. Some important points in factoring are:

• Factoring can be executed on a non-notification basis, which means that the customers may not be told that their accounts have been sold.
• The process of factoring may reduce the costs for a business organization, associated with maintaining accounts receivable such as bookkeeping, collections and credit verifications.
• In addition to reducing internal costs of a start-up business, factoring also frees up the money that would otherwise be tied in accounts receivables.
• Factoring can be used as a tool for raising money for start-ups and keeping their cash flowing.

6. Angel Investment

Also known as informal investors, angel funders, private investors, seed investors or business angels, angel investors aid in providing start-up finance. They are affluent individuals who inject capital for budding start-ups in exchange for ownership equity or convertible debt. Some of the important features of the angel investment are:

• Angel investors are more concerned with helping start-ups take their first steps, rather than the possible profit they may get from the business.
• Angel investors prefer to take more risks in investment for higher returns.
• Most often, angel investors are among an entrepreneur’s family and friends.
• Angel investors typically use their own money.
• They can also provide mentoring or advice alongside capital.
• They may represent individuals, a limited liability company, a business, a trust or an investment fund, among many other kinds of vehicles.

7. Venture Capitalists

Venture capital means professionally managed funds made available for 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. Some of the important features of venture capital are:

• Venture capitalists usually finance new and rapidly growing companies, purchase equity securities, assist in the development of new products or services, and add value to the company through active participation.
• The relationship one establishes with a VC can provide an abundance of knowledge, industry connections and a clear direction for the business.
• Venture capitalists take care of pooled money from many other investors and place them in a strategically managed fund.
• 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 exchange such as NASDAQ.

8. Loan from banks/NBFCs and CGTMSE loans

Some common loans available specifically for start-up finance include Growth Capital and Equity Assistance Scheme by SIDBI, microloans, equipment financing, MUDRA loan scheme, Bank Credit Facilitation Scheme, etc. Banks and Non-Banking Finance Companies (NBFCs} are different from angel investment and venture capital. They do not become the owner after granting the loan. They provide loans to fulfil various business needs, such as:

• Inventory and equipment purchase
• Arrange opening capital (working capital) to carry out functions smoothly
• Fulfil fund requirement for the expansion purpose

On the flip side, there are some drawbacks of the funding option also like there is a requirement of making payment of interest on loan periodically irrespective of the growth of your business venture.  Apart from this, bankers may also ask for substantial collateral money and good credit rating along with the fulfilment of prescribed terms & conditions.

CGTMSE Loans: In order to encourage entrepreneurs and start-ups, the Ministry of Micro, Small & Medium Enterprises (MSME), Government of India has launched the Credit Guarantee Trust for Micro & Small Enterprises.

Without collateral or surety, the loan can be availed up to Rs. 1 crore. Fresh as well as existing MSMEs can obtain a loan from all scheduled commercial banks and specified Regional Rural Banks and those authorities which entered into an agreement with the Credit Guarantee Trust. For choosing this option, you have to check the eligibility criteria first, however, under this scheme, both new and existing micro and small enterprises including service enterprises are eligible for a maximum credit cap of Rs. 200 lacs.

9. External Commercial Borrowings (ECBs)

The other main option for funding of start-up is External Commercial Borrowings (ECB). Under this, funds can also be raised from non-resident lenders in the form of External Commercial Borrowings. The minimum average maturity period for the ECBs raised by start-ups shall be 3 years. External Commercial Borrowings can be procured in the below-mentioned forms:

• Bank loans
• Buyers’/Suppliers’ credit
• Financial Lease
• Foreign Currency Convertible Bonds (FCCBs)
• Securitized instruments such as non-convertible, optionally convertible or partially convertible preference shares, floating rate notes and fixed rate bonds, etc.

In India, External Commercial Borrowings can be done from two routes, namely, Automatic Route and Approval Route. It may be noted that except FCEBs (permitted only under the approval route) all other forms of ECB can be availed of both under the automatic and approval routes. The ECB framework depends on factors like eligibility of borrower and recognized lender, amount of ECB availed, average maturity period, etc.

Takeaway

As most banks are not willing to offer loans for start-up finance, non-bank financing acts as the via media for start-ups and SMEs to restore capital and/or debt fund as well as boost their business operations. While bootstrapping your business can help in the short-run, however, remaining without external funding for too long may deprive the business to take advantage of external market opportunities.