Financing Your Business
November 29, 2017
All business owners, at one time or another, have needed an influx of capital. And for many businesses, securing the necessary capital to invest and grow can be challenging. Relatively new businesses often lack the track record necessary for funding sources to feel comfortable with making an investment. Lending processes can be burdensome which dissuades some business owners. Locating funding sources that meets the needs of the business without giving too much in return is also problematic. And while these factors will likely persist, advances in technology have diversified the speed and means by which business owners can connect with money. Summarized here are a variety of options for raising capital. Each has their advantages and disadvantages and the specific use will often help define the best capital source.
Friends, Relatives, and Business Associates
While not likely the foremost resource for business owners, friends, relatives, and business associates represent a large potential capital pool. This type of investor is probably familiar with your business, and in fact may even already be involved. And while you may know the potential investor well and have already established a degree of trust, this does not alleviate the need to formalize the investment relationship through some sort of written investor agreement.
In researching this subject, I was introduced to a new term for capital sourcing…Angels. The term Angel usually refers to a financially savvy individual with a high-net-worth who is seeking high return investment opportunities. Think the ever-popular ABC show Shark Tank. Angels are like venture capital investors except they are represented by an individual instead of a group. Due to the risk Angels take, the investment terms may include additional perks for the investor above those of traditional financing sources. The Center for Venture Research at the University of New Haven reported that the total Angel investment for 2016 was $21.3 billion dollars with 64,380 investment opportunities receiving funding (https://paulcollege.unh.edu/sites/paulcollege.unh.edu/files/cvr-reports/2016AnalysisReportFinal_0.pdf). These two resources offer business owners a wealth of information on Angel investing. The Angel Resource Institute (www.angelresourceinstitute.org) and the Angel Capital Association (www.angelcapitalassociation.org).
Probably the largest source of small business funding comes from Government agencies—federal, state, and local. These programs can be entirely government funded or made available through private resources with government support. Eligibility requirements vary by industry and the purpose for the funding. The U.S. Small Business Administration provides resources on Federal funding programs (www.sba.gov/).
In the most basic sense, a venture capital investor is a private company that secures money from a variety of sources that in turn is used to invest in businesses. Venture capital investors often operate on a scale much larger that Angels. To understand the scale of venture capital investors, one only needs to look at a recent investment in Uber, which received a $3.5 billion investment from a venture capital group in Saudi Arabia (www.wsj.com/articles/uber-raises-3-5-billion-from-saudi-fund-1464816529). And since the goal of venture capital investors is to make money, not unlike nearly all other investors, venture capital investors are looking for opportunities in a growing market space served by a talented and motivated management team. Venture capital investors routinely seek opportunities that will quickly and reliably achieve a return on investment.
The term “corporate partnering” encompasses a number of commercial relationships between two or more companies that may involve both a financing transaction and a business relationship. The goal in a corporate partnership is for each entity to derive some benefit that they may not necessarily be able to achieve on their own. One entity may have name recognition, while another entity has capital. The well-capitalized entity may help finance the recognized entity in turn for that recognition. One such example that you may have personally encountered is Pottery Barn and Sherwin-Williams paint. Pottery Barn pairs their ever-popular items with complementary paint colors from Sherwin-Williams. While I am not 100% certain, it’s very likely that there was some investment by one of the two entities in the other’s business. While this may not be a popular means of capitalizing a small business, it is a lesson in how unlikely partners can derive mutual benefit by combining resources.
Probably the most familiar funding source for small businesses is private institutions such as commercial banks and finance companies. Funding usually comes in the form of direct loans for which interest rate, maturity and prepayment can vary. Each institution will also have its own eligibility and application requirements.
Incubators and Accelerators
Underscoring incubators and accelerators is mentorship and training. This may be coupled with a nominal financial investment in the small business by the incubator or accelerator in return for an equity interest in the business. And while these programs can provide seed money for a new owner, their greatest value is in structuring the earliest stages of the business to create a solid foundation upon which growth and success can continue long after the business has graduated. While similar, incubators and accelerators are distinct. Accelerators, as the name implies, focus on the earliest stage of a business and are designed to quickly prepare a business for initial funding. Incubators tend to operate more slowly and are more focused on the business operating sustainably. In either case, a business must be selected for participation and the eligibility criteria are stringent to ensure that a business has the greatest chance for survival. Incubators and accelerators are not designed to nurture poorly conceived business ideas. For more information, check out the National Business Incubation Association (www.nbia.org).
Crowdfunding; Peer-to-Peer Lending
The presence of crowdfunded initiatives has exploded in recent years primarily, in my opinion, due to our ability to connect with a large number of people in a relatively short amount of time. All of which is possible by any number of social media platforms. With respect to businesses, crowdfunding generally refers to raising cash for a business endeavor through small donations from a large number of people. The primary limitation on this source of financing is the inability of the business to provide a return on the investment as would commonly be seen in a normal investment transaction. While there is often some nominal benefit to the investor, maybe a discount or swag, the transaction looks more like a donation than a traditional investment. This all recently changed under The Jumpstart Our Business Startups Act (JOBS Act) wherein companies were authorized to offer and sell equity securities through a special purchase process. This brought crowdfunding closer to traditional investing models in that those investing are given an equity stake in the business. Due to its recent adoption, this tool as a financing source has not yet been fully explored but it does appear to be promising for the right business. Lastly, there are a number of businesses that facilitate peer to peer lending. Probably the most recognized name in the industry is Lending Club. Like its competitors, Lending Club matches financial need with investor desire. That is, a business with a long history of stable revenue and name recognition could use Lending Club to obtain a loan from an investor(s) who is looking for a better-than-market rate of return with a low risk of default.
Businesses today are presented with more options than ever to seek financial assistance. Not only is this the result of technology, but also enterprising groups looking to sit outside the box. While peer to peer lending would have been possible without today’s technology, it would not have been possible without the idea of someone who thought that traditional banking and capitalization could be done differently. As with other business decisions, it is wise to consider a variety of alternatives. How you choose to finance your business should be given the same scrutiny.