Financing a Start-Up or Growing Small Business

Financing Strategies

There are several alternative strategies used by business owners (often more than one is used).  The attraction and viability of different methods will depend on the individual circumstances, such as the type of business, the owner’s history and financial standing, the business vision and expectations among them.

1. Bootstrapping & Personal finance or lower level debt
2. Operational funding and debt (usually shorter term in nature)
3. Longer term debt (usually used for acquisition of larger assets)
4. External equity

Bootstrapping & Personal Finance

This is a way to finance the business without substantial borrowings or external equity.  As such it also incorporates a substantial proportion of personal finance and lower level debt.  Many successful companies including Dell Computers were started this way.

The most common form of bootstrapping is owner financing – the use of personal savings and credit cards as well as re-investing any profits back into the company. Family loans are also common to help get the business started.

Cash flow management by delayed payments of accounts payable while collecting from customers as quickly as possible is also a commonly used strategy.  Some tactics include discounts for cash payments and use of debt collection agencies.

Overhead and expense minimization is also important. The first part of this is having a miserly approach to expenses. Sharing office production or storage space, supplies and equipment with others is a common start-up method of keeping overheads down. The same principle applies to using part-time employees and commission sales people, keeping inventory levels to a minimum.

Accessing government grants and subsidies can also be useful.

Operational Funding & Debt

Shorter term funding is commonly called working capital. The distinction I make here is that these strategies involve formally negotiated contracts rather than the looser, more ad hoc arrangements typical in bootstrapping or personal finance arrangements.

These include:

• Bank overdraft as a floating safety net. Whilst this is flexible and convenient, you should not use this for longer term financing as the interest rates will typically be a bit higher, and it is generally repayable on demand;
• Commercial bill – to cover seasonal fluctuations or for specific one-off needs, usually for a term of between 30 to 180 days. Interest is often payable in advance;
• Debtor finance such as factoring. Availability may be an issue as usually only offered to businesses with proven sales history over a certain limit; and
• Trade credit – either standard terms such as 30 days or individually negotiated terms.

Sources of such funding includes banks, building societies or credit unions, finance companies and brokers. The same sources apply to longer term debt instruments.  It always pays to shop around as the competitiveness of varying instruments and credit providers can change daily.

Longer Term Debt

These forms of borrowing arrangements are usually put in place for financing the purchase of equipmet or other assets, business expansion or the development of new products.  It includes:

• Term loans – usually used for acquisition of productive assets such as land & buildings, plant & equipment or business acquisition.  Many business owners will extend their home mortgage as a funding strategy as this usually carries lower interest and bank fees than commercial loans (between 1% and 2% interest differential is common).  The funds are then “lent” by the owner to the business;
• Personal loans or hire purchase – generally used for purchase of motor vehicles and other equipment;
• Leasing finance – also used for plant, equipment and motor vehicles, with the advantage that no deposit is required as the equipment being financed becomes the security in most cases. Leasing is generally more expensive than term loans, but is the most readily available form of small business finance.

External Equity

In the same way that a publicly listed company can raise additional capital by issuing shares, so can a small enterprise.  The Corporations Act places many restrictions as to how the business can go about this, and this is beyond the scope of this article.

Many business owners are protective of their ownership, thinking that they somehow lose if they include others in the business. This is a limiting mind-set, as it is better to have share of something larger than 100% of soemthing small. Bill gates owns less than 8% of Microsoft, yet is one of the richest men in the world!

There are three types of investors who might contribute capital to a growing enterprise:

• Venture capital and/or private equity funds – these generally invest later in the business development stage as they look for returns from commercialisation of the business;
• Angel investors – so called because they nurture their investment and the company by an active participation (typically through management guidance and assistance); and
• Individual investors – the Corporations Act imposes several restrictions on how these investors can be found and how they may invest in a business. It is advisable to use the services of a professional investment matching service such as Transition Capital - www.trtansitioncapital.com.au or the Australian Small Scale Offerings Board (ASSOB)  - www.assob.com.au in pursuiing this strategy.