One of the most significant challenges in starting a new business is access to finance.
There are primarily three sources of funding for a business: equity, debt and sales. Equity is the contribution of shareholders. Debt is the contribution of external funders through e.g. loans, debentures and other loan mechanisms and the easiest to access is sales.
You often do not need a lot of capital to start a business – but you do need to sell. If you project requires a massive layout before you even start selling – you may be required to raise some funds.
These funds will need to be used to enable you to sell your product – a not only to cover operational expenses. A lot of would-be entrepreneurs aim to raise enough money to pay their salaries. This is not what capital is for. Capital is there to make sure that you can get a return – so it needs to be applied to making sure that you have a product to sell and that you are selling and delivering it – so that you can get paid. Some working capital may enter into the picture – but this should be directly linked to the amount of time it takes for your customer to pay you.
Some recent trends in funding are starting to change the landscape and new opportunities for funding businesses are presenting it-self daily.
You may also be surprised to hear terms such as crowd-funding, cloud labour, crowd creativity, distributed knowledge creation and open innovation. You will be excused for a couple of seconds for nearly missing the next trillion-dollar wave of business innovation.
For many entrepreneurs first tier funding from a commercial bank is simply not an option due to
- extremely high security requirements
- very high interest rates
- complexity of schemes
- complex methods of investment assessment
- long lead times
Africa as a collective has a very poor venture capital market. In South Africa there is a health venture capital market with 0.17% of GDP in funds under management in this sector (KPMG, 2012). This is down from 0.24% in 2011 but still remains higher than that of China and Russia as a percentage of GDP. Another fascinating aspect is that 76.9% of venture capital funding is related to Black Economic Empowerment (BEE). There is a desperate need to apply venture capital funding to new business creation and the availability of low cost access to finance remains a significant hurdle to African businesses. The same pattern repeats itself in most developing countries.
The real challenge is getting access to capital somewhere between banking rates and micro lending rates, without the complexity of public fundraising and listings. It would be logical to try to get a group of investors together to limit the risk of investment. The challenge is that managing a large group of investors in equity schemes is often very challenging and requires a great deal of savvy to limit the risk of investors while making good on the return promised to them. Many a good idea has failed because too many people wanted in, or promises made panned into the distance.
Banks also require new ventures to have a track record – usually 1-3 years so that this makes it difficult to use the collective will of a group of people as security for a loan or to get into a new industry.
The options are usually to
- Take out a loan
- Take out a second mortgage
- Get a group of people to contribute an amount towards a central pool that can be used to seed an investment
- Raise money through family
- Get an angel investor
- Find an early stage venture capitalist that takes a higher stake while assisting the start-up
- Work through business incubators
Each of these have pros an cons, and may be the correct option for your business. As usual it is important to investigate the real cost of the money that you are receiving. To work this out you need to get the full present value or full future value of each of the options for your business plan. Hidden costs such an interest, increases and changes in multiples for selling or settlement needs to be considered very carefully.
While it is possible to start a business with other people’s money – it is also important to recognise that no-one is going to give money away for nothing and as a minimum you will be required to serve the interest on any amount borrowed. Issues of control also enter the picture and you have to evaluate where it will end up and what value the investor will continue to add to the investment scheme. Before going into a deal, ask yourself how you will get out if you need to.
In addition, you are likely to have to provide security for any investment, contract or major commitment that your company will enter. This may be daunting when you have to pledge you and your wife’s assets for your new business to rent a photocopier.
With this as the background it may be interesting to look at other sources of funding.
Crowdfunding falls into the category of funding with the basic idea being as follows
- A large group of investors, all contribute to a central pool
- There is a guaranteed level of reward
- Fees are managed
There are currently an estimated 500 web services that aim to raise funds for kickstarting web-sites. One such site Kickstarter.com gives a good example of a well executed service in which different people can contribute to ideas and “rewards” are given. So in order to raise $ 15,000 for a new gameboard development, the creators offered a copy of the board game to anyone contributing more than a certain number of dollars. So this means that thousands of people are taking the risk. The interesting aspect of this is that more than the original $15,000 was raised allowing the team to focus on further expansion. If you sponsored more than a certain amount you may get naming rights or a simple thank you. The web-site will take a fee which for different web-sites range from 1%-15% for putting together the funding. By different people in the “crowd” bidding to support ideas – the most successful ideas then become reality and creates and investment that is worth investing in.
These types of value added fundraising methods is likely to start dominating the landscape more frequently as investors combine and create low cost, high value ways to invest in start-ups and ideas.
Open source software has proven this business model as it is a type of crowd-fundraising. If you like a product, then contribute to it by promoting it or adding to the code base. Everyone wins over time.
Through BBBEE types requirements in South Africa, there is an emerging type of investment in which companies give money to a central organisation such as Raizcorp to assist them to buy equity in emerging small businesses with the required equity requirements. They take care of the complexity. These investments creates collective investment in these smaller operations while providing a return on an otherwise potentially wasted opportunity. By pooling collective requirements, new market opportunities often emerge.
Another interesting mechanism that is emerging is investing in your customer. Companies are trading equity in their customers for their products in large purchases. If your product or service can add significant value to your client, one mechanism may be to invest your services, while creating an increase in value. This captures the client for life, creates value for your investment and helps both organisations prosper over time. While this idea is not new, it is starting to grow as a method for binding organisations together into co-owned value chains.
In the final analysis, the best way to make profit is still to buy and sell and it may be more interesting to figure out how to get the money out of the pockets of your customers, than from a bank. It may be better to start selling smaller amounts, make some money and use that to fund the growth of your idea. One person with an idea, borrowed stock from a friend and in time became the largest owner in their specific category of product. But all money from sales was re-invested in buying stock for more sales.
KPMG, SAVCA (2012) Venture Capital and Private Equity Industry Performance Survey of South Africa covering the 2011 calendar year.