Navigating the entrepreneurial ecosystem we have seen the rise of alternative finance with early stage investment and equity crowdfunding providing new opportunities for SMEs to finance growth.
Most small and growing businesses lack of understanding of the kind of funding that’s most suitable for them. They opt for bootstrapping – growing without seeking external capital . Relying on friends and family alongside any personal savings you have may allow you to keep control while starting out, but it limits your potential to grow. On top of that, cashflow issues affect most businesses. Without access to external finance some businesses can fail unnecessarily.
A key choice for businesses seeking external finance is whether to take on debt, grants or sell equity. Each method has its own advantages and disadvantages. The right choice will depend on the business model, stage of growth, and the long-term goals of the founder.
Let us define these terms;
Debt involves borrowing money from a lender and then paying it back, plus interest, in regular instalments. Raising through debt enables founders to fund growth without diluting ownership.
By contrast, a founder raising finance through equity will give up a stake in their business in exchange for funds. A key advantage of equity finance is that there is no requirement to make regular monthly repayments.
Equity investors typically want to realise the value of the investment on an exit event. As a consequence, equity investors typically are more tolerant of risk and invest for the long term. A business would not usually turn to equity finance to meet a short-term financing issue. Debt, on the other hand, is more versatile. It can vary from overdrafts to cover day-today expenses, to the use of bank loans to finance to purchase equipment.
Grants can be an option for the founders of early-stage businesses who do not want to give away equity or take on debt. As they do not have to be repaid they can be attractive for startups that are pre-revenue. Grants typically have strict eligibility criteria and founders may also be reluctant to apply for grants due to the paperwork involved. In many cases, businesses outsource the process of applying to a third-party specialist. However, this typically reduces the total funding available.
So how do you decide a suitable financing option?
Founders should ask themselves the following key questions to determine the right type of finance for their business.
Am I seeking short-term working capital or long-term growth?
If you are seeking finance to fund day-to-day costs (known as working capital) such as wages, rent, or inventory, then debt will be more appropriate. If you are seeking long-term finance, you can seek a loan using traditional banks, direct lenders , or you can seek equity investment either through angel investment, equity crowdfunding or venture capital.
Am I generating revenue and do I have a trading history?
Lenders may ask for a trading history and revenue forecasts. If your business is pre-revenue or forecast to run losses in the near future and there is a high risk you will not be able to keep up with monthly repayments for debt
Do I have assets I can secure a loan against?
Not all lenders will require you to secure your debt against assets, but if you are unable to put up assets as security then you will typically face higher borrowing costs.
Do I need support (e.g. advice) alongside finance?
A key benefit from equity finance is the potential to gain trusted advisers committed to the success of your businesses. They may alert you to further funding opportunities, connect you with new clients, or help you with business strategy. In the case of angel investment, business angels often have experience as entrepreneurs and typically offer their time and guidance, alongside cash. Most accelerator programme offer pre-investment support to founders in exchange of equity or revenue share
What size of investment am I seeking?
The type of finance right for your business depends on the size of the investment you are seeking. For example, early stage businesses may be better off looking at pre-seed or angel investors for small (e.g. USD 50k or less) raises. While for founders seeking investments upwards of USD 1m, venture capitalists (VCs) or specialist direct lending funds are the main options.
What are my long-term ambitions?
If your investors do not share your long-term vision, then you are setting up for conflict down the line. Some founders aim to build revolutionary businesses that disrupt markets and employ thousands – for them, the sky is the limit. While other founders seek an exit within five to ten years, and expect to be acquired by a larger business. Finding investors who share your objectives is important.