The primary source for small business funding should be your own savings. By staking your own money you demonstrate your confidence in the business idea. Lenders and outside investors would look for such a stake from promoters.
Only highly innovative projects with credible growth and profit potential would attract outside funding without any investment on your part. And that too only if you are able to convince the investors and/or lenders that you are a businessperson worth their risk.
Typical small business funding sources include:
- Owner’s funds consisting of your own savings and the money you might be able to borrow from relatives and friends
- Long term loans from banks against mortgage of property and business assets
- Short term borrowings in the forms of bank overdrafts and working capital loans against the security of inventories and discounting of sales invoices
- Government grants for specific projects tht fall within the eligibility criteria for such grants
- Venture capital and angel investor funds for high profit and high growth potential projects
Types of Loans
You should start on your small business funding campaign only after working out your total project cost as oultined in the article Small Business Planning. Different items of the project cost would be funded in different ways. A clear idea about funding methods would help you seek appropriate funding.
The following table indicates typical funding for different items:
|Asset Financed||Typical Financing Method|
|Land and Buildings||Mortgage Term Loans|
|Machinery & Equipment||Term Loans or Lease|
Finance with a charge
|Vehicles, Office Equipment,|
|Hire Purchase, Installment|
|Inventories||Line of credit or Working|
capital loan against pledge
|Accounts Receivable||Invoice discounting, Factoring|
|Money for investing in business||Personal loans against|
credit record, Venture capital
We will look at each type of funding.
Mortgage loans are raised by mortgaging immovable property. For small business funding, the property could be your residential house. If you fail to pay back the loan, the lender could attach and sell the property.
Term loans mean long term loans. You obtain such loans for financing long-life business assets, such as buildings and plant.The mortgage loan mentioned above is a term loan.
Term loans could also be secured by business assets (such as machinery) and repayment guarantees – particularly government guarantees in the case of small business funding.
Lease and Hire Purchase
Instead of buying a business asset outright, you could arrange with a financier to purchase it and lease it to you. Under lease financing, you pay only a periodical lease rent for use of the asset. Land, buildings and machinery could thus be obtained on lease.
Hire purchase is similar. You pay only a monthly hire to use an asset. Hire purchase is usually for medium term and is used for vehicles and other shorter-term assets.
Under both arrangements, you might (or might not) have an option to purchase the asset at the end of the lease or hire purchase period. These options become attractive when you don’t want to spend heavy amounts initially.
Under lease/hire purchase arrangements, you are not the owner of the asset. If you prefer immediate ownership, you could opt for installment payments. Under this option, you pay the price of the equipment in installments, with interest on outstanding balances.
Overdraft or Line of Credit
Banks might allow you to overdraw your account i.e. draw cash in excess of the amount at your credit. Such overdrafts are allowed only upto an agreed maximum limit. You pay interest only on the actual amounts so overdrawn.
This arrangement is beneficial when your needs are fluctuating. You could draw when necessary, and pay back when cash comes into your business. The overdraft would be reduced with consequent reduction in interest payments.
Working Capital Loans
You could borrow money by pledging your inventories. Under pledge, the physical custody of the asset is with the lender. In the case of business inventories, this could be effected by keeping the materials or merchandise under lock and key. The materials remain at your premises but the keys to the lock are with the lender.
Another type of working capital loan is obtained by discounting your accounts receivable. You get a percentage of the credit invoice amount immediately from the discounter. The discounter would collect the invoice amount directly from your customer, and adjust the loan and interest from the collections.
Invoice discounters check the financial soundness of your customer and also your credit management policies. Only if they are satisfied on these matters would they agree to fund you.
One source of small business funding for very small enterprises is personal loans against your credit card. If you have a good credit record, lenders might be willing to extend loans against your personal security without insisting on a collateral. However these are likely to be small loans.
Venture Capital and Angel Funds
Business Angels are wealthy individuals who are looking for attractive returns on their cash. If you have planned your small business in detail, and the plan reveals a potential for high profits and fast growth, business angels might feel interested.
Venture capital companies also take up shares in promising business ventures. They are more organized in their approach, and also exercise some control over running the business.
These small business funding sources could be tapped if your business is innovative in approach or products. Such innovative businesses could establish market leadership and command premium prices before competition appears. It is this premium potential that attracts angels and venture capitalists.
The Loan Proposal
Your small business funding exercise would generally involve making formal loan applications. A well prepared loan application could create a good first impression and make the lender consider it seriously. How do you prepare such a loan proposal?
Both getup and content of the proposal should be impressive. Getup is a matter of using high quality paper, neat layout, excellent printing, an attractive cover and good binding. Use of charts and graphs where appropriate adds to the good impression.
The major content would be your business plan, prepared as explained in the Small Business Planning article. As mentioned therein, the business plan would include Profitability and Project Cost Estimates, Cash Flow Statements and Balance Sheets.
Cash Flow Statement
It is cash flows that determine your financing needs. Cash flows are different from profits in that:
- Cash flows include capital items like purchase of premises & equipment, receipts and repayments of loans, etc. Profitability statements exclude these kinds of items.
- Cash flows consider the time lag between actual incurrence of a sale or purchase and the related cash receipt or payment. Profitability statements are prepared usually on “accrual” basis.
Typical items included in the cash flow statement would be:
- Owners’ Capital contributions
- Loan receipts
- Cash surplus from operations
- Increase in accounts payable
- Sale of capital items
- Fixed capital expenditure such as:
- Premises related expenditure
- Plant related expenditure like machinery, power supply, water supply and other
- Furniture and fittings
- Increase in the following working capital items:
- Inventories of raw materials and supplies
- Work in process
- Inventories of finished products
- Accounts receivable
- Deposits and advance payments
- Loan repayments
- Cash deficit from operations
- Dividend payments or funds withdrawals by owners
The cash flow statement would start with opening cash balances. The net surplus or deficit of cash flows for the period would be adjusted against this opening balance to arrive at the closing balance. A negative closing balance would indicate the need for funding.
Initially, there would be more cash outflows than inflows. You would have to pay for the premises, equipment, fittings, working capital items and initial publicity before you begin to generate inflows. Even after operations start, the operating expenses could be significantly higher than your sales income during the initial months. It is these excess outflows that must be funded with owner’s funds and external borrowings.
Lenders want to ensure that loans are repaid. They seek to ensure this primarily by checking the past credit behavior of the borrower. Has the person been scrupulous in meeting payment commitments? If you have a good credit record, bring it to the attention of the lenders.
The next major criteria is the project itself. Has it been prepared realistically or does it merely represent optimistic hopes? Does the plan attend to all relevant issues, including compliance with government regulations? Is the profitability sufficient to meet loan repayment obligations in time?
Substantiate your estimates with specific findings from the field. Show that you have studied the market conditions, technological requirements and personnel availability. If you have experience of successfully managing people or getting sales, highlight these experiences.
Don’t Give Up
If you have prepared well, and made a good presentation, and yet your loan request is turned down, don’t give up. Approach other lenders. Learn from the experience, however, and make any modifications.
Many people see government grants as a primary small business funding source. This is a completely wrong approach. Unless you want to set up a business in an undeveloped or disaster area and government support is specifically announced for this purpose, you are not likely to get a grant to start a small business.
Grants are announced for specific purposes and projects. They are also subject to rigorous conditions. Often, you have to match grant amounts with your own funds.
Check with your nearest small business support agency whether you could be eligible for some grant. If you are, find out full particulars and develop a project that could receive grant. Then submit your grant application in the required format to the competent authorities.