By Karen Utgoff
Does external funding appear to be an attractive approach for fueling the growth of your business? Before you leap to a particular funding option, consider four possible types — debt, equity, grants, and crowdfunding. I have written about the first three here and the last here. Each of these can come from a number of sources — for example banks, venture capitalists, or family — and, of course, you may want to mix and match.
In addition to considering which types and sources of funding are accessible given your situation, it’s important to take into account the risks associated with each. Below are some general thoughts; be sure to evaluate terms and conditions associated with each specific deal that you may be offered.
What financial risks are you willing to accept? Debt and equity — borrowing or sharing ownership — have different uses, benefits, and risks.
Banks and other commercial lenders may expect you to commit personal assets (homes, possessions and savings) in addition to company assets as collateral. If your business fails, the obligation to repay lives on. Even when businesses do well, they are often subject to unpredictable cash flows that may interfere with the ability to service debt. Using debt to purchase equipment, finance inventory, or bridge the gap between making a sale and collecting the revenue can work well unless there is concern about slow inventory turnover and/or customers stretching the time they take to pay — both common occurrences in a weakened economy or in the face of intensifying competition.
Angel and venture capital investors put their money at risk for the opportunity to financially benefit from ownership of part of your business, which they hope will significantly increase in value. Their initial investment may be in the form of convertible debt. To protect their position, investors may expect to participate in key decisions and serve on your board of directors. It’s important to understand the obligations that will result if the business fails; ideally investors will agree to take cash and remaining assets but not expect to get their original investment back. Be sure you understand when investors will want to realize a return on their investment. They may expect you to sell the company or to raise the cash to buy them out.
The risks associated with grants and crowdfunding are usually less daunting but can require some specific result such as delivery of a product, recognition of the funder, execution of a proposed project, and/or a report. Grant givers may also have specific accounting requirements or other standard terms you will need to satisfy.
What personal risks are you willing to take on? Even (or especially) when your friends and families are enthusiastic to help your business and spare you financial risks that come with borrowing from a bank or alternative lender, don’t underestimate possible damage to friendships, marriages, and parent-child relationships that could result. Whether you take a loan or offer them equity, they may have naïve and overconfident assumptions about future success.
Consider how you and they would get along if the business falls short of their expectations. Even if you were not obligated to repay in the event of a business failure, how would you feel if your parents or siblings lost their retirement funds?
Even when the business thrives, dealing with family/friend investors/lenders can become awkward. Some may want to help even when they lack the expertise to do so. Others may feel entitled to participate in operating decisions, suggest potential employees or drop in to “see how things are going.” What’s the plan to provide a return on their investment? To avoid awkwardness, or complicating future rounds of funding, clarify expectations and boundaries in advance. A sophisticated investor will welcome this too and may even take the lead on designing an arrangement that makes sense from both business and personal perspectives.
Can you mitigate the risks of and/or reduce your need for funding? While risks associated with external financing are significant, rewards can be substantial. Be sure you are ready to put the funds to work effectively and to make the most of every dollar. Will your team be prepared to make the most of the new opportunities to which the funding will be directed? Could you improve your cash flow to minimize the risk of problematic surprises? Is it possible to reduce the cash tied up in inventory? Is there a contingency plan to manage setbacks and unexpected obstacles?
Do you have evidence, or merely hope, that you will succeed? Whether the funding you seek is to purchase equipment that will increase the efficiency and profitability, to support the launch of a new product/service/location, or to provide stability over a tough period, you should do your homework. Since all forms of funding come with real costs, it’s important that you have evidence that the expected results will be worth the added burden. Will the changes you anticipate make your business stronger? Will they increase its value?
The right financing at the right time can fuel success. The above points are not intended to discourage you from seeking external funding. If they have, ask yourself why? Resolving those concerns can make for a stronger future business.
- How to Finance the Scale-Up of Your Company, Daniel Isenberg and Daniel Lawton, HBR Blog Network, August 18, 2014
- Government Grants May Help Ease Business Challenges, Amy Cortese, NY Times, August 14, 2014
- VC Funding Can Be Bad for Your Start-Up, John Mullin, HBR Blog Network, August 4, 2014
- Can’t Get a Bank Loan? The Alternatives Are Expanding, Amy Cortese, NY Times, March 5, 2014
- Funding a New Small Business? Don’t Bother with Banks, Karen E. Klein, Bloomberg BusinessWeek, February 3, 2104
- Angel or Devil: Who’s Really Investing in Your Start-Up?, Nir Eyal, HBR Blog Network, November 1, 2013
© Copyright Karen Utgoff. All rights reserved.