Coming up with a great business idea isn’t a problem. The problem is in actualizing that idea and turning it into a profitable business. The next thing that follows is the million-dollar question: “Where do I get capital to turn my idea into a profitable business?” Unless you have ready cash laying in the bank or a wealthy relative ready to come to your rescue, raising capital to start or grow your business isn’t the easiest thing to do. Resourceful entrepreneurs will always find ways of bootstrapping their ventures. However, depending on the nature of your business, there is a limit to which you can do that. It reaches a time when you need hard cash to move forward. In that regard, you need to find ways of raising capital.
The source of your capital depends upon the amount of money you need to start or grow your venture. You should have a business plan that outlines your financial needs, where you intend to get the funds from and how you will spend the money. Having said that, your first task is to estimate how much it will cost. Here are a few areas you need to consider while calculating your financial needs.
Once you are comfortable with your estimates, keep them handy because they will form an important reference when seeking external funding for the business. These estimates are your foundation stones for your financial planning.
Is the bank the best place to look for startup capital?
One of the main sources of funding for small businesses has traditionally been the bank loan, backed by security or guarantor. At the center of it, banks have always lent to people with good credit score and locked out the rest. Therefore, as much as you may need money to run your business, banks are not the best places to go if you are just starting out. Banks normally lend money to established businesses, with operating history. The banker’s primary concern is whether you are able to make on time regular repayment and the only way they can be sure is by looking at your operating history. So the fuel to advance you a loan is mainly a good cash flow and a good credit rating.
In other words, it is widely acknowledged that banks are no longer meeting the funding needs of businesses, particularly of SMEs. The fact that banks are fundamentally profit institutions makes it hard for them to approve loans. They would only do so unless they are convinced you will not only pay back the loan plus the interest, but also make timely payments. Thus, banks have tightened their lending criteria, meaning it is next to impossible for a small startup to access a traditional bank loan.
Small business owners must now seek alternative means of funding their businesses. The good news is that there are other alternatives to funding aside from the traditional bank loans. According to a survey by Huddlebuy conducted in 2012, about 65% of entrepreneurs contemplate seeking alternative sources of capital outside of bank loans. Some of the alternative sources include merchant cash advances, venture capital or angel investors, networking, friends and relatives, and crowdfunding, among others. In this post, we will focus on the three most significant ones: merchant cash advances, venture capital and angel investors, and crowdfunding.
Because traditional banking sometimes proves impenetrable for small business, merchant cash advances might be the best option for startups looking for capital. Small business owners who need faster, safer or easy way access to capital are turning to this burgeoning industry. Observers say that the tight credit environment being championed by the traditional banking industry has increased the demand for merchant cash advances.
According to Business Week, small businesses who don’t qualify for loans form the bulk of the clientele base of cash advance providers. It is a growing industry worth about $10 billion annually. It is important to note that merchant cash advance providers are not lenders. Instead, they are more like merchants who purchase future income from your business. So those who take the cash can enter into an agreement with the merchant cash advance providers to pay less amount of money in slower months, unlike loans that fix repayment amounts. In other words, merchant cash advances do not have fixed repayment amounts or fixed maturity of the advanced amount.
People who turn to merchant cash advance services say accessing traditional loan is not easy. “It’s the only way that I’ve found of getting funds that I need,” says one entrepreneur who turned to merchant cash advance provider.
The best thing that ever happened to entrepreneurs who don’t qualify for loans is MCAs. MCAs are good solutions for those people who have little collateral, poor credit rating or little to business history. If you receive most of your revenues through credit card payments (such as online businesses), then qualifying for cash advance is even easier.
However, one thing we mustn’t forget is that cash advances are relatively more expensive than bank loans and other sources of funding. But the convenience, ease and flexibility of the services offered by MCAs easily make up for the high costs.
|Advantages of Merchant Cash Advances||Disadvantages of Merchant Cash Advances|
|Fast and easy access to cash||Higher fees than bank loans|
|Easy approval process—same day approval||Deductions of credit card receipts can reduce cash flows|
|Flexible payment arrangement|
|People with bad credit rating can access the services|
|No restrictions in terms of how you can utilize your cash|
|You can pay loan with a percentage of your credit cash receipts|
|No hidden fees|
|No collateral required|
Angel investors can also be an excellent source of funding for startups, but the only problem is that less than 1% of startups are lucky enough to convince risk-averse investors to commit their funds on their business ideas. This path could be the best, but it’s a difficult one. It has to do with the timing and leveraging the right contacts. Apart from that, one has to establish trust with the investor and assure them that they will get their money back, plus interest.
The investor also needs to be the right business partner; otherwise you are likely to experience problems with each other along the way. In a word, attracting angel investors is a tricky business. No matter how nice the negotiations turn out to be, the devil is the details. I have seen some entrepreneurs who ended up regretting ever taking money from a venture capitalist because they realized that they gave up too much stake in the company, yet they are the ones doing much of the work. In most cases, getting money from angel investors turns out to be the most expensive. For instance, if you seek out $50,000 from an angel investor in exchange for 40% stake and your business becomes successful, you will end up paying a lot of money to the investor in form of shared profits. Let’s say you make one million in profit: your investor takes home $400,000. It can be that expensive.
Having said that, angel investors or venture capitalists could be really resourceful and the experience and expertise they bring on the table can be invaluable. Naturally, venture capitalists are established business moguls with a lot of quality contacts who can help your business to take off at a lightning speed. So looking at how much the venture capitalist takes is being simplistic. You need to have a bigger picture of the situation. In that regard, partnering with the right venture capitalist can be tremendously fruitful experience – it is always better to have a quarter of an ocean (partnering with the right investor) than keeping the whole of a pond (going out on your own). The benefits of receiving angel investment go beyond the purely financial.
As already mentioned, entrepreneurs have started looking away from traditional way of raising capital—the bank loan—and to modern ways of raising startup capital through such methods as crowdfunding.
What happens in crowdfunding is that an entrepreneur attracts a crowd of people known as backers who undertake to give a given sum of money. It can be as low as $1. This normally goes towards making the first product or paying the infrastructure of the company. In return, the backers will receive the first product (at subsidied price or no cost), made one of the shareholders or offered other agreed gift. The backers can also decide to donate the money without expecting anything in return – although this is very rare. The initiator of the crowdfunding project must state his/her financial goal. If enough is received to meet or exceed the target, the project is considered successfully funded. On the other hand, if the entrepreneur fails to meet the financial target, the project fails and the founder may seek other alternatives or rework the original idea. The bottom line is that backers must be convinced to pledge their money, meaning the project must sound viable.
Many projects have received funding ranging from a few tens of dollars to millions of dollars. Crowdfunding is the real deal so long as you can come up with a viable project. However, only a few projects that are exciting enough to arouse the crowd succeed in the crowdfunding arena. We have seen projects get zero backers despite the fact that the founder really put in a lot of effort and thought in coming up with the idea. So it is not a walk in the park.
There is no right or wrong source of funding for any business. The best source of business capital depends on your unique needs and the situation you are in. It is advisable that you consider carefully the available sources of capital, bearing in mind that cost, risks, ease of access, repayments terms and amount of money needed are some of the most important factors to consider.
About the Author
Manny DeMonte is the VP of Sales at Prime Funding Source with over 15 years experience in multiple financial fields. Manny knows exactly what it takes to successfully help his clients accomplish their goals by understanding their needs and guiding them to the right outcome.