A small scale business can be originated by one individual or a group of individuals using their personal wealth. However as the business grows and need to be expanded, more funds will be needed, which is often outside the funding capacity of the original capital contributors. Many investment options available to large scale companies such as share issues, private placements are not available to small scale startup businesses. Therefore, the following alternative funding options can be considered by startup businesses.
How Startup Funding Works
Funding from Family, Friends and Other Acquaintances
This is the most convenient way of obtaining finance for a startup business. It is a much less complicated and less time-consuming process in obtaining finance since legal interventions and documentation is minimal. However, the amount of funding that can be obtained in this method may be limited.
A loan from a bank or a financial institution can be obtained by presenting the business proposal and a loan can be secured against a collateral. A collateral is a property or other significant asset that is kept by the lender until such time the loan is paid off, in order to recover the lost proceedings if the loan repayments were not made.
Venture capital is a form of private equity and venture capitalists are companies that have a pool of private investors that fund small startup businesses. Venture capital is also called ‘risk capital’ due to its inherent risk. They are interested in recovering their finance with a maximum return and take active participation in business’s decision making.
Angel investors or business angels are a group of investors that invest in entrepreneurs and small scale startup businesses. These investors are generally high-net-worth individuals who not only have the funds, but also the business expertise that can help entrepreneurs and startup businesses with their decision making. These investors are typically former employees who have held senior management positions in reputable organizations or successful entrepreneurs.
It is very important to have a lucrative business plan if approaching both venture capitalists and business angels. Since both these options require injecting a significant amount of capital into the startup and is highly risky, they will only invest in businesses that have potential to make greater returns in the future. They also require much higher returns compared to other financing methods due to their inherent risk. Once the business is established both venture capitalists and business angels will seek exit strategies.
This is another form of alternative finance for small startup businesses and this raises small amounts of funds from a large number of investors. Crowdfunding is often effective through social media sites which operate as platforms that bring investors and small business owners together. Crowdfunding has the potential to increase entrepreneurship by expanding the pool of investors from whom funds can be accessed easily since this is a relatively less risky form of obtaining finance. This is also a relatively convenient way of obtaining finance since internet sources such as social media are widely used in the current business environment.
In order to select the most suitable financing option from the above, the following should be considered.
- Maintaining the control of the business
- The degree to which fund providers will be engaging in decision making in the business
- Rate of return expected by fund providers
- Legal implications
At the very beginning of the startup business, some of the above financing options may not available since business angels and venture capitalists may not be willing to invest in a just a ‘business idea.’ Instead, they will prefer to invest in an already initiated business. Thus, different types of financing options can be considered in a staged approach i.e. at first. The business idea can be financed by personal or family funds and then gradually the assistance of a business angel or a venture capital firm may be considered in order to achieve a stepped growth at a rapid pace.
While the above financing options are ideal for early stages of a business, the further it expands these funding options may not be sufficient. Once the business evolves into such a stage, an option to gain access to finance from external investors can be considered. The business can be listed on a stock exchange and shares can be issued to the general public. This offering is named as Initial Public Offering (IPO). The requirements to disclose information and corporate governance is much elaborative once the business is listed on a stock exchange.