Start up Financing

Every small business faces the problem of getting start up capital. Startup capital can be defined as funds needed to setup the basic infrastructure and meeting routine operating expenses till the time the business starts generating positive cash flows to meet the operating needs. In the initial years of operation this need for finance is met through personal savings and internal accruals. However in the long run external funding is required to sustain the growth and development of the business.

Requirements:

Each small business needs capital to sustain. The requirement of capital varies from business to business depending on the stage of development, product and services offered, nature of the industry, scale of operations, etc. It is very difficult for an entrepreneur of small business to raise fresh start up loan. He has to invest his own personal savings in to the business. No bank will fund any business unless the entrepreneur has risked his own capital in to it. It is difficult to raise capital from banks and financial institutions, as the entrepreneur has no financial history to provide and no assets to be pledged as security.

It is essential to understand the sources of start up finance. Small businesses have access to traditional sources of finance. It includes family savings, borrowing from friends and relatives, individual investors, banks, government guaranteed loans, or venture capital firms.

Funds:

In small business funding scenario, empirical evidence shows that a majority of startup funding has been done through private individual sources. This includes putting in family savings, household savings as equity. It is coupled with borrowing money from friends, close acquaintances and relatives. The relatives and friends can be categorized as innermost contacts and outermost contacts. Innermost contacts may include close relatives, friends, colleagues at place of

work, mentors who have information about the individual and his business idea. The outermost circle comprises of individuals who are unaware about the small business startup idea but may be interested in providing an entrepreneur with funds if approached. Such contacts may include old teachers, local government body contacts, indirect contacts in financial companies and banks, etc.

In some cases the entrepreneurs form partnerships and contribute capital to start up a new venture. This typically happens in case of two individuals one of who has the necessary skill set and ability to start a business and the other has large capital but no business idea. Such a combination leads to a partnership, which provides all the resources to start up and promote the small business.

Venture Capital:

Venture Capital funds are also called venture capitalists. They offer seed or startup capital to set up business initially. These funds typically invest in sunrise industries. Sunrise industries are those, which are not well known today but have great potential to grown in future to come. This may be because of innovative technology, some new discovery, better way of doing things, etc. The entrepreneur has to present his business revenue model and should be able to convince the venture capitalist to invest their money at start up level to kick-start the business.

Venture capital funding is a high-risk high return kind of investing model. It entails high degree of risk as the investor is totally betting his odds on the future. It is the belief in the business model that drives a venture capitalist towards investing in the business. The venture capital funds act as equity partners in the business by providing necessary funds at various starts up points and also in some cases they provide the management expertise required to scale up and promote the business initially. Once the business starts generating regular stream of income as projected and starts to raise internal funds, the venture capitalists make move for a strategic investor. They sell their stake either to the promoters of the business or to some other strategic investor at a hefty premium. They earn supernormal returns if the business model is successful and is well accepted in the industry.

More options:

Another form of raising funds for starting business is by way of issuing convertible debt. Convertible debt is an innovative financial tool, which possess the nature of both equity and debt. It carries a fixed interest rate and is normally a zero coupon bond. The interest starts accruing and is ultimately payable on maturity. The instrument holder has the option of conversion of the debt instrument in to equity in future at a fixed price decided today. If the stock price as on the date of conversion is greater than the conversion price the investor would naturally get the debt bond converted in to equity and enjoy higher returns. On the other hand if the business model fails and the stock price in the market is not attractive enough then the investor would not convert the debt instrument in to equity. In that case he gets the fixed interest payment for the years he held the instrument.

There are some niche financial institutions that offer medium sized loans to small entrepreneurs, which greatly assist them in setting up shop. It includes financing to set up the basic infrastructure. This includes providing funds to buy computers, office furniture, office equipments like printers, fax machines, telephones, operating software, etc to run the business efficiently. They also provide initial working capital loans to start up the first cycle of operations.

Incase of small business offering professional services it becomes very necessary to have a cash reserve. In such professional services revenue model, the income or the real cash flow starts coming after a fairly long period of time. However the businessman has to incur overhead expenses right from the start up. This implies negative cash flow and has to be met by a cash cushion reserve. Such cash reserve has to be funded from personal savings, borrowing from private sources against the individuals goodwill and reputation, borrowing from banks and private lenders by keeping personal assets as mortgage.

Small Business Administration has compiled a list of bankers who are willing to finance start-ups in case of small businesses. It is essential that the entrepreneur approaches such banks with right kind of business model and presents a fair case to get funding for his business. The amount of capital needed has to be clearly worked out in terms of timing of cash flows. Such cash flows should be reinvested in the business as much as possible in the initial years to enable growth of the business.