How do the different forms of funding work?
You’ve got a brilliant idea and you’re ready to strike out on your own and go into business. However, no matter how good your idea is, to succeed you will also need some funding to get that business off the ground. Very few of us have the kind of capital available to allow us to successfully launch a new business without outside funding. So where can you turn and how do the different forms of funding work?
Different options for raising capital
There are different ways in which you can raise capital for your business. What will be the right option for you might depend on the type of business you are starting, the stage of the business, and your business goals.
Common funding sources include informal or formal loan arrangements with friends and family, loans, venture capitalism (obtaining funds by providing an equity stake in the business), and crowdsourcing.
If you have friends and family willing to provide capital for your new business venture, it can be tempting to do so on an informal basis. However, this can be risky if you are not on the same page with respect to interest or repayments. Although it might present an upfront cost to get a lawyer to draft a loan agreement to clearly define the terms, it can save you from awkward conversations and even the loss of relationships in the future.
Alternatively, you might be interested in obtaining a business loan from a bank or other commercial lender. This might be secured by assets you hold or perhaps guaranteed by another, depending on the lender’s requirements. It is a good idea to shop around and obtain financial advice before taking out a business loan.
Another option is to seek funding from venture capitalists, offering them a stake or share in the business in exchange for funding.
Once revenue starts coming in, even if you are not yet profitable, you might consider a bridging loan. Sometimes these loans are used to fund the expensive process of an initial public offering, where shares in the company are offered to the public in order to raise revenue. To offer shares to the public on the Australian Securities Exchange, there are a number of legal and structural issues that arise, often requiring quick responses. In this instance, it is important that you seek financial and legal advice.
Different stages of funding
Funding for a new business start-up comes in many stages. The first stage typically draws on your existing financial resources, such as family and friends, credit cards, personal savings, etc, as mentioned above. This is known as pre-seed funding with resources usually coming from the founder and/or those interested in getting the new venture off the ground.
Once your start-up begins to grow, you will likely need additional funding to allow you to market, develop your product, or even to employ other staff to help in the business.
Seed funding typically represents the first official stage of raising funds for the new venture and may come from a range of sources including ‘angel investors’ who take equity in the company in exchange for their investment. To obtain this sort of funding, you will need to prove your business model to your proposed investor, who will expect a compelling and well-researched pitch. Whether further funding progresses from this stage depends on various factors, although, the next stage of funding is typically sourced externally through venture capital financing.
Venture capital finance exchanges cash for equity (ownership) in the business and can help scale up the business to new customers or channels. This form of funding may occur in multiple rounds or stages referred to as series A, B, C and D funding.. It is also possible that some investors might seek to become more involved in the organisation and provide expertise.
Series A funding is usually sought when a business is already profitable or when new investment is needed to continue to monetise and grow the business. You will need, at this stage, to be prepared to answer any due diligence questions from potential investors and provide financials setting out plans for growth and profit.
Series B, C, and D funding occur when the business is already well established and looking at expansion and/or new market opportunities such as expanding globally, developing new products or services, and/or acquiring other companies. At each stage, a valuation of the company will be determined, and as each series of funding progresses, the business will typically have achieved an increasing level of success.
The legal structure you choose might influence your fundraising opportunities. For instance, if you are offering an equity stake to prospective investors, or even looking largely to outside investment, a company structure with shares might be the appropriate vehicle. A company structure is also more appropriate if you intend to scale the business or one day wish to exit the business while it continues operating.
In contrast, if you intend to fund your start up through loans and personal finances, and are running the business alone, it might be suitable to operate as a sole trader. However, it is important to remember that sole traders have personal liability, whereas a company, as a distinct legal entity, provides a level of protection. With that in mind, companies have additional reporting obligations, so obtaining the proper advice at the beginning is important.
Conclusion – Enlisting professionals
Before you start raising capital, it is a good idea to enlist some help from appropriate professionals. In addition to speaking with a lawyer, you may need some advice from a financial professional on how to address your accounting requirements.
In addition to the financial and legal requirements, and depending on your own experience, getting professional help with your marketing strategy or business planning could help things run more smoothly.