Financing Small Business

By Khyathi Hegde

Articled Assistant


Prepared On:
29/06/22


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Small business financing refers to the means by which an aspiring or current business owner obtains money to start a new small business, purchase an existing small business or bring money into an existing small business to finance current or future business activity.

Though starting a small company sounds rewarding, financing them can become difficult.

The difficulty of accessing capital is because many small businesses applying for loans are new, and banks typically want to see at least a five-year profile of a healthy business before extending an offer.

Therefore, these small businesses search for alternative financing.

What is alternative financing?

Alternative financing is any method through which business owners can acquire capital without the assistance of traditional banks. By this definition, options such as crowdfunding, online loan providers qualify as alternative financing.

There are several reasons why small business owners might turn to business loan alternatives. Here are three of the most common.

  • Lower credit requirements: Traditional banks are almost certain to decline loans to borrowers with credit scores below a certain threshold.
  • Easier qualification: Not all small business owners meet the additional requirements to apply and be approved for traditional loans. In these cases, business loan alternatives are helpful.
  • Faster approval: Traditional bank loans can take weeks to be approved, whereas some business loan alternatives give you access to funding in as little as one week.

GRANTS

Government Start-up Incubators and Grants

    Features

  • Start-up incubators are institutions that help entrepreneurs to develop their business, especially in the initial stages. Incubation function is usually done by institutions who have experience in business and technology world.
  • Pros

  • Incubator support includes providing technological facilities and advice, initial growth funds, network and linkages, co-working spaces, lab facilities, mentoring and advisory support and there is no obligation to return the funds.
  • Cons

  • Approval processes may consume a lot of time, lot of approvals and documentations involved which might result in delay in arrangement of required funds.
  • References: Karnataka elevate, Patent reimbursement, Start-up India


DEBT FINANCING

Invoice financing or factoring or Bill Discounting

    Features

  • With invoice financing, also known as factoring, a service provider fronts you the money on your outstanding accounts receivable, which you repay once customers settle their bills.
  • Financing through factoring is based on the transfer of accounts receivable to the factoring supplier, who pays the invoiced amount to the company within 24 hours and claims the payment from the debtor in turn.
  • Cred, India Factoring
  • Pros

  • This way, your business has the cash flow it needs to keep running while you wait for customers to pay their outstanding invoices.
  • It means that even new businesses can gain liquidity quickly and flexibly.
  • Cons

  • Factors will restrict funding against poor quality debtors or poor debtors spread, so you will need to manage these funding fluctuations.
  • Some customers may prefer to deal directly with you.
  • Exorbitant interest rates.

Lending Institutions

    Features

  • There are several independent lending institutions that can help raise finance for a small business in India. The requirements to secure a loan can be exhaustive for a small business at most banks.
  • Bajaj Finance Ltd, Shriram Transport Finance Company Ltd, Muthoot Finance Ltd.
  • Pros

  • Unlike banks, these institutions are willing to take the risk to finance a small but solid business if basic eligibility criteria are met. This is a very effective source as there are high chances that the loan will come through.
  • These institutions exist to cater to the newer and smaller entrepreneurs who have trouble taking their proposals to traditional sources. While they don’t come with as great a repute as banks, the financial help provided by them is great for most small businesses.
  • Cons

  • There might be huge interest rates involved as they are undertaking the risks to finance small businesses.

EQUITY FINANCING

Bootstrapping

    Features

  • Bootstrapping your start-up means growing your business with little or no venture capital or outside investment.
  • It means relying on your own savings and business revenue to operate and grow. While mostly explored by start-ups, bootstrapping can be an effective way of securing finance for smaller existing businesses as well. A small business requires capital when wanting to scale up or expand.
  • It can also be for acquisition of equipment, logistics or payroll management. Bootstrapping involves either investing one’s own funds into the business or getting some money from friends and family at low interest rates.
  • Some well-known bootstrapped start-ups are Zerodha , ZOHO, 42 Gears, Fusion charts.
  • Pros

  • Bootstrapping is one of several excellent non-dilutive financing methods. Until you change your mind, you and your co-founders will be the only owners of your business.
  • This level of control will allow you to concentrate more on laying a solid foundation and perfecting operations, which might lead to more long-term development.
  • Cons

  • Although bootstrapping gives you more control and gives you ownership of the earnings, it also comes with a higher chance of losses and failures.
  • Some bootstrapped businesses fail because of a lack of revenue: profits are insufficient to cover all costs.

Angel investors

    Features

  • Many think that angel investors and venture capitalists are the same, but there is one glaring difference.
  • While a VC is a company (usually large and established) that invests in your business by trading equity for capital, an angel investor is an individual who is more likely to invest in a start-up or early-stage business that may not have the demonstrable growth a VC would want.
  • Getting the nod of an angel investor(s) to fund a business is a big deal for most businesses. Depending upon their background and expertise, angel investors also tend to take a keen interest in the business and offer advice and suggestions for improving the revenue generation.
  • Angel investors are Mumbai Angels Network Private Limited, The Chennai Angels.
  • Pros

  • The greatest advantage of receiving funding from an angel investor is that there is less risk than if you take out a small business loan. Unlike loans, you do not have to pay back the funding from an angel investor because they receive equity in exchange for financing.
  • Cons

  • After investing their money in a start-up, most angel investors take a hands-on approach to the business which would result in loss of control.

Private Equity

    Features

  • Private equity is equity—shares representing ownership of, or an interest in, an entity—that is not publicly listed or traded. Private equity is a source of investment capital from high-net-worth individuals and firms. These investors buy shares of private companies—or gain control of public companies with the intention of taking them private and ultimately delisting them from public stock exchanges.
  • Large institutional investors dominate the private equity world, including pension funds and large private equity firms funded by a group of accredited investors.
  • Examples of Private Equity are jetty ventures, KKR etc
  • Pros

  • Private equity valuations are not affected by the public market. A company won’t have to go through a bank and high-interest loans to support themselves financially.
  • Cons

  • For people who have built their own company from the ground up, handing over shares and relinquishing part of their control can be a difficult part of private equity.

Venture capitalists

    Features

  • Venture capitalists (VCs) are an outside group that takes part ownership of the company in exchange for capital. The percentages of ownership to capital are negotiable and usually based on a company's valuation.
  • This is a good choice for start-ups who don't have physical collateral to serve as a lien for a Loan. The benefits of a VC are not all financial. The relationship you establish with a VC can provide an abundance of knowledge, industry connections and a direction for your business.
  • They tend to stay with the business till it’s either acquired by someone or till it goes public. The only possible downsides are that they exercise control and there is a lot of accountability towards the VCs.
  • Well known venture capitalists are accel partners, nexus venture partners, kalaari capital.
  • Pros

  • Many successful start-up founders become partners at venture capital firms after they exit their businesses. These individuals often have experience scaling a company, solving day-to-day and longer-term problems, and monitoring financial performance.
  • When you receive venture capital funding, you’re getting what’s often referred to as “smart money.” This means the money you get comes with the added benefit of the expertise of the venture capital firm.
  • Cons

  • Depending on the size of the VC firm’s stake in your company, which could be more than 50%, you could lose management control. Essentially, you could be giving up ownership of your own business.

Disclaimer:

“The information contained herein is only for informational purpose and should not be considered for any particular instance or individual or entity. We have obtained information from publicly available sources, there can be no guarantee that such information is accurate as of the date it is received, or it will continue to be accurate in future. No one should act on such information without obtaining professional advice after thorough examination of situation.”