Fund Raising Options for Startups – An Overview
Funding is always a hot topic of discussion in the startup world but more often than not, it gets restricted to Angel/VC funding. Here, we talk about other means of raising funds...Internal sources of Finance:
Personal Source of the Founder- This can be personal savings or other cash balances, it can also be personal debt facilities connected to the founder himself.
a) Personal Savings- An entrepreneur will often invest personal cash balances into a start-up. This is a cheap form of finance investing personal savings maximizes the control the entrepreneur keeps over the business.
b) 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; however, it can be a risky proposition.
c) Borrowing from family and Friends- Friends and family who are supportive of the business idea provides money either directly to the entrepreneur or into the business. This can be quicker and cheaper to arrange 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, also socio-relations come in the picture.
d) 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, 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 around 30-45 days
External Sources of Finance
a) Business Loan from Banks- Business loan are generally for a longer period of time, with pre-determined fixed period over which the loan is provided, the rate of interest and the timing and amount of repayments. The bank will usually require that the start-up to 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. Also, it’s not easy to get business loans for startups, especially in India. It’s very interesting to note that you can get personal loan any day, but getting a business loan can be cumbersome.
b) Bank Overdraft Facility- An overdraft facility is a form of 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.
c) Equity Participation – outside investors – This as a source of fund raising has become very popular and effective. The best thing about this, participation investors are also ready to take the risks of the business, however you have to share ownership and control of the business. Some of these are:
Angel Investors/ Seed Funds - Seed money also known as seed funding or angel funding, is a form of equity offering in which an investor purchases part of a business. It’s basically a very early investment, meant to support the business until it can generate cash of its own, or until it is ready for further investments. Seed money options include friends and family funding, angel funding and – recently, crowd or group investing. Investment mostly made for the business idea, and funding is done to actually try and test the idea for future scale up.
Venture capital funding or commonly known as VC funding - is a type of financing by private equity capitalist or private funds to early-stage high-potential, growth companies and comprises of various funding rounds/ stages. These are (i) The Start-up stage, (ii) The Second stage, (iii) The Third stage and (iv) The Bridge/Pre-public stage. It’s also called IPO preparation funding schema, the ultimate aim of which to have clear exit policy and prepare the business to be sold-off attractively.
d) Special Financial Institutions- these have been established in India for providing long-term financial assistance to industrial enterprises. There are many all-India institutions like Industrial Finance Corporation of India (IFCI); Industrial Credit and Investment Corporation of India (ICICI); Industrial Development Bank of India (IDBI) and others.
At the State level, there are State Financial Corporation’s and State Industrial Development Corporations. These national and state level institutions are known as 'Development Banks'. Besides the development banks, there are several other institutions called as 'Investment Companies' or 'Investment Trusts' which subscribe to the shares and debentures offered to the public by companies. These include the Life Insurance Corporation of India (LIC); General Insurance Corporation of India (GIC); Unit Trust of India (UTI).
These come with lot of paper work, persuasion and also hitched with enormous amount of bureaucratic follow-ups. The government needs to simplify the way these institutions really work.
e) Leasing Companies- Manufacturing startups can secure long-term funds from leasing companies. For this purpose a lease agreement is made whereby plant, machinery and fixed assets may be purchased by the leasing company and allowed to be used by the manufacturing concern for a specified period on payment of an annual rental. At the end of the period the manufacturing company may have the option of purchasing the asset at a reduced price. The lease rent includes an element of interest besides expenses and profits of the leasing company.
To conclude, there is no absolute rule that makes one way of fund raising better than the other. The selection of same should be purely a case specific based on factors such as the objectivity of the founder, business rationale, funding requirement, ownership and management control and such other factors.