Demystifying Capital Raising Basics for Local Small Business

How do local small businesses raise capital? Originally appeared on Quora: the place to gain and share knowledge, empowering people to learn from others and better understand the world.

Undercapitalization is a primary cause of small business failure. i.e. not having sufficient funds to build a business that can work. It’s a bit like a building a plane really, you might have 95% of what you need to build a plane but without the 5% extra needed to build the small tail flaps, the plane will crash – the same with a small business. You need sufficient capital to both build the infrastructure of the business plus have the funds you need to support the business until it breaks-even.

There are three primary sources of capital available to small business:

• Equity finance – from people who give you money in return for both a share of the profits and say in your business operations
• Debt finance – from people who give you money in return for getting that money plus interest repaid within a fixed period of time and
• Grant funds – that can be obtained from government agencies and statutory authorities if your business aligns with current government initiatives.

Equity finance is not repaid but the provider does get a share of the profits and gets a say in your business decisions. Debt finance is repaid with interest and mostly requires security (a guarantee of the debt repayment that is supported by another asset like property). Grant funds are provided from time to time by governments keen to promote business development in certain key area of policy (i.e. environment, tourism). Grant funds require significant work in the application process but it does not generally mean that you share your profits or that the grant funds need to be repaid.

Sufficient capital raising is of critical importance to the ultimate success of a small business and you will most probably need to access all means possible to achieve it. As we have already seen with the plane metaphor, you should never attempt to build a business without a high probability of securing the necessary capital to build and support the business until it breaks-even. If necessary, you should modify your business model rather than try and stretch your capital beyond its capacity.

Here is a capital raising process to follow, listed from what I think is the easiest to access to the hardest:

Founder – (Equity)

The founder can and should provide capital from savings, from selling personal assets or from personal credit cards or loans raised against an existing stable corporate employment history. Every person that contributes to the capital of a small business first wants to know how much ‘hurt money’ you as the founder has advanced. So make sure it’s significant, otherwise forget about approaching the rest of the people on this list.

3Fs – (Equity/Debt)

Friends, family and fools (3Fs) is the next port of call for a founder looking to raise capital for their small business. Just remember “Before you borrow funds from a friend, first decide which you need the most”. This is generally easy money because it is emotionally driven and whatever integrity you have built in your life to-date, this is the time to cash it in. This is easy money to raise, but if it all goes bad, remember you will need to live with that shame for the rest of your life with funders from this particular funding source.

Working Partner – (Equity)

Many people are attracted to someone ‘having a go’ at starting a business and you will soon find people offering to provide funds to secure a financial share and a job in the new venture. For me, this is ‘last resort’ funding even though it is one of the easiest places to get capital for a small business. See, partnerships don’t work … FULLSTOP. If you do need to enter a working partner funding arrangement, make sure it’s short term with some well thought out exit strategies at the outset.

Suppliers – (Debt)

Suppliers are your real commercial partners in a venture. See, your success is also directly linked to theirs. They can’t sell their products without you. So leverage their need and look to secure 30-day credit terms from statement date which can give you up to 60 days of free finance. Then, if you can sell their products within 60 days, you personally never have to finance your inventory. You may need to support your supplier by carrying their full range of products to get the favorable credit terms, but it’s worth it, because it is one form of debt finance that is both interest free and typically unsecured.

Customers – (Debt/Equity/Grant)

Customers are an often forgotten source of finance for a small business. Crowdfunding (i.e. Kickstarter) has opened up a whole new form of raising funds if you can tell a good story that goes viral and attracts the typical $25 donations (grant/equity) or pre-sales (debt) from a hungry customer base keen for the product that you are planning to supply. Deposits are the more traditional way of raising capital from customers. These days it’s quite acceptable to ask for a 50% deposit prior to commencement which should cover your out-of-pocket expenses leaving only your profit at risk of customer default. Either way, it’s a great funding source.

Leasing Finance – (Debt)

Banks typically also own a finance company as a subsidiary. Finance companies are prepared to take greater risks for a greater interest rate reward than the banks, so they are usually a good source of finance for the riskier small business financing. The main items that finance companies are prepared to fund are moveable (i.e. able to be easily repossessed) like equipment and vehicles, provided it is purchased new. This form of finance can be used to fund some of your ‘big ticket’ items in your fit out or business establishment leaving your remaining capital for items that are not easy to funds from financiers (i.e. intangibles like fees, licenses, trademarks, formation costs).

Angel Investor – (Equity)

Angel investors have grown in significance lately due to the now retiring, affluent and numerous ‘baby-boomer’ generation who are asset rich but cashflow poor. They are also living longer than any previous generation and are looking to stay involved in the businesses they know much about, but don’t want the stress of the day to day responsibilities … that’s your job. They are looking to take a share in your business, provide mentor support and maintain their interest in business through you.

Bank Overdraft – (Debt)

Bank overdraft provides a finance facility that covers the ebbs and flows of the cash needed in your business. Banks usually will consider this finance option for small business because it attracts a high interest rate and it is payable on demand. The bank may take a fixed and floating charge over the entire assets of your business but you will at least get the finance needed to pay your bills as they fall due during the month. The interest rate is expensive, but at least you have access to money when you need it.

Term Loan – (Debt)

Term loans are almost impossible to raise from banks unless you have property to the equivalent value of the loan that you are looking to raise. The quote “To get money from a bank you must first prove that you don’t need it” holds true for most applications. You will normally need an experienced accountant to help you with this application, that will also include your 3-5 year profit, balance sheet and cashflow forecasts. The interest is competitive but remember the repayment begin on day one of your business and will remain a constant source of stress least one default by you triggers the counter action by the bank on your security (typically the family home).

Grant Funds – (Grant)

The best funds to raise by far … if you can get it: no interest, no repayment, no profit share. Trouble is, your likelihood of getting the windfall of grant funds is about as high as getting struck by lightning. But it happens, which is why I have included it in the list. So look for current government policy initiatives that have grant funds attached and find a way of aligning your business with these policy initiatives. You will need to allow lots of time and be prepared to provide copious amounts of paperwork and planning documents, but if you do it right the rewards can be huge.

Venture Capital – (Equity)

Some startups with huge potential (in the billions) can approach venture capitalists with just a proof of concept, and get their funding. Small businesses usually need a long track record of growth and success to get the attention of venture capitalists. Still, it’s a funding source that you should know about and explored particularly if your idea is likely to be scalable via a franchising scheme.

There you have it – the list of funding sources for a small business. I wish you good luck in your quest to raise sufficient capital to make your business a success … but the key is to develop a business model that you can fully fund in both infrastructure and the working capital that you need to fund the business until it breaks-even. Remember: To avoid being another statistic of an undercapitalized small business failure – It’s always best to modify your business model rather than try and stretch your capital beyond its capacity.

Contributed by Peter Baskerville, Started owned & managed over 30 small business retail & hospitality for 30+ yr