No matter the idea, getting the initial capital needed is pivotal. Generally, your business capital comes from your own hip pocket. But, in some circumstances this might not be achievable. This means that to establish and grow a business, you will need a little – or a lot – of cash to execute your plan.
First, it is important to distinguish between two types of funding: debt funding and equity funding.
Debt funding is where the business gets a fixed sum from a lender which is then paid back with interest. A debt funding lender does not receive any ownership (equity) of the business and instead the money lent must be paid off over a set period and the lender gets the benefits of charging a high interest rate. While people typically associate this type of lending with banks and credit unions, it is quite common for friends and family to help fund a business. A word of warning – debt funding can come with personal guarantees, which means that if the business is unable to pay off the debt, then your personal assets (such as your family home or your car) may be used to cover the costs.
Equity funding involves an investor receiving some equity (such as shares) in the business for providing a business with some money. An investor typically becomes a ‘shareholder’ who has an interest in the overall success of the business.
Choosing a funding model which fits you and your business can be hard. To help you, here is a list of the most common funding options and their pros and cons.
- Self-Funding – Bootstrapping
This is known as ‘bootstrapping’ and is where the business owner/s uses their own money to raise capital. A founder doesn’t have to give away ownership of their business in the early stages of growth. Self-funding operators also do not have to consider anyone but themselves when carrying out business decisions.
If a self-funded business succeeds, it may mean that the company grows in equity and value which the business owner/s can profit off when they sell the business. Alternatively, this higher value in the company developed over time may allow for the owners to have more power when seeking funding to explore their new ideas.
Apple, Facebook, eBay, Microsoft, Coca Cola and Go Pro were all bootstrapped companies!
- Friends and Family Funding
This funding method involves getting family and friends to invest in you and your idea. It is another way many early-stage startups raise the capital to get their ideas to a prototype or afford the resources to carry out their services. Either you, your family or your friends lend money to the business, which is then paid back to the investors when the startup begins to start making a profit.
This is an attractive method for many family and friends, primarily because there is somewhat less financial risk involved for the investors as they personally know the founder(s) and their business history. However, it is still important to keep the transaction at arm’s length.
Repayments are typically tax-free to you and tax-deductible for the business. It is also often easier to approach family and friends if you need them to invest more money to grow other aspects of the business. This personal connection means that they are more likely to reinvest as opposed to traditional lenders.
The downside, however, is that bringing money into personal relationships can be difficult and these loans can strain relationships. It is essential that you and your lenders have professionally drafted documents and each obtain legal advice. This helps all parties involved understand their responsibilities, risks, and how to mediate the situation if things potentially go wrong. Interest rates are also tricky to negotiate if your loved ones are inexperienced investors.
It can also seem like family and friends can give unwanted advice, so you should be prepared for investors to try to have a say in how the business is run.
As a final word of warning, when family and friends invest, it can be hard to know where the money came from. If you get a bank loan, you know that the money is coming from an investment fund, which is designed to loan money. When it is family and friends, where this money came from is not as clear cut. Your parents may have emptied their super because they believe in you and your idea. Your close friend may have invested in your business instead of their children or their own idea. The bottom line is that financial managers have limits for people who invest in property and the stock market. This is to stop unsavvy investors from losing all their money. Sadly, in this type of funding scenario, there is no such limit.
While this funding option may seem attractive, it comes with significant risks. It is important you are well informed so you can make the best decision for you, your business and your family and friends.
This modern way to fund your business or idea involves asking for money on crowd-funding websites. Crowdfunding works by obtaining small value loans (often $5) from a large number of investors. This is an attractive option for businesses who aim to sell a specific, marketable product.
When someone invests through a traditional crowdfunding website, they do not receive any equity of the company. Often crowdfunding investors receive a finished product, a small gift or even just a personalised thank you depending on the investment amount.
The Corporations Amendment (Crowd-sourced Funding) Bill 2016 introduced a new type of crowdfunding to Australian business. Known as ‘equity crowdfunding’, this allows individuals to invest small amounts in companies to receive small amounts of equity. There are only a few platform providers in Australia, such as OnMarket or Venture Crowd.
Crowdfunding is an attractive option as it creates public interest around your business, which effectively generates free marketing. It can also attract bigger lenders, such as venture capitalists, who see the hype generated by your idea or product and seek to invest.
A downside, however, is that there is significant competition on crowdfunding websites, and it can be difficult to get investors unless your product really stands out.
Another concern is the issues with crowdfunding and the protection of your own intellectual property. There are countless reports of loss of intellectual property from these crowdfunding websites due to IP theft, and some people either manufacturing the product themselves, or registering your idea/trademark without your knowledge. This will cause significant difficulty if you ever try to register your idea or trademark in that foreign jurisdiction and once your business is a hit. Make sure that your business has its intellectual property registered and enforced.
- Venture Capitalists
A venture capitalist is a private investor who provides capital (cash) to companies in exchange for equity. Venture capitalists are usually employees of a venture capitalist firm, which is a business that makes their money by investing money into other companies. These firms typically target startups and small businesses that are high risk, but that also have the potential for significant growth.
This is a good option for startups looking to start scaling fast and big. You may know about ‘pitch nights’ usually held by coworking spaces. These are night where you can work on your pitch to investors, like venture capitalist firms. As the investments from venture capitalists range from small to large, your startup should have an ‘action plan’ prepared. This includes a plan addressing how you will use the investment money and efforts you will go to ensure business success. Another advantage with this option is that there is usually no obligation to pay the money back. If the business fails, then typically you aren’t personally liable.
While the investment from these venture capitalists sound attractive, these investments do come with some significant downsides. Firstly, venture capitalists require equity or some stake in your startup. Often this is a large or majority take of the company such as over 50% of the shareholding. This would mean that you no longer have control of your company or ability to make your own decisions.
- Angel Investors
The easiest way to remember angel investors is to think of an angel as an individual. Similar to a venture capitalist firm, an angel investor is seeking equity in the company in exchange for money. However, an angel investor is a wealthy individual – or group of individuals- instead of a company who is in the business of taking a stake in companies for profit.
These investors are often experienced business people willing to take bigger risks than a bank. They can offer their expertise and knowledge to help increase the growth of a startup. As most startups are created by a first-time entrepreneur, this knowledge can be invaluable.
The same risk as venture capitalists applies. Depending on the amount of shareholding that the investor takes, you may have to incorporate them in the decision-making process.
- Bank finance
Bank loans are infrequently used as a way to acquire startup capital. Businesses typically must apply with a sound business plan consisting of the estimated time of maturity, a forecast of profits, and how the business will operate. A business loan also usually requires a personal guarantee.
Business loans can be split into two categories: working capital loan or a standard business loan.
The first is a working capital loan, which is where a bank finances the everyday operations of the business. These loans are not long-term investments and are designed to cover a business’s short-term operational expenses.
The second is funding, which is where the bank loans money to the business for the agreed loan purpose.
You should shop around when looking for a business loan. Make sure that you research your lender and read all the loan terms and conditions, or better yet, obtain legal and financial advice before you sign anything.
- Scale up and sell
Scaling up your business to then sell your idea may seem counter intuitive. However, it come with some notable benefits. As part of the sale offer, you could determine your responsibilities and working conditions, including whether your skills need to be sold for a period of time with the business. While you would lose control over running your own business, there would be no personal financial risk to you anymore.
- Government Grants
The Australian Government offers many different grants and tax incentives to startups. This funding can be split into two categories – tax incentives and grants.
Tax incentives are available to any business – including startups – who meet the eligibility criteria. These are usually federal based and require applications to a department of the government, usually the ATO.
It’s important to note that small businesses can access a range of free tax concessions and reporting options, subject to eligibility. These concessions are available to a variety of different businesses. To determine whether your business is eligible, go to the Australian Taxation Office: https://www.ato.gov.au/Business/Small-business-entity-concessions/.
Grants requires a startup to apply and compete against other applicants. This typically involves preparing and submitting a business plan to a government grant committee, who compares your business plan and application to others competing for the grant. Grants can be offered by both the federal and state governments, but also many private organisations offer grant-based scholarships.
You now know a little more about the funding options available to you as a startup and small business. It’s essential that you obtain legal and financial advice early on in your business journey to make sure you are set up for the long haul and you’ve given yourself the best foot forward.
If you’re unsure about a document or situation or get approached by an investor, get in touch with the team at Bolter. We are here to help make it happen for you.