Equity Financing Options For Small Business
Cash is the lifeblood of any business, especially a small business. A small business by definition is ‘small’ with limited capitalization and fewer options to raise cash to finance operations. It thus follows that cash management to record and control cash coming in an out of the business is of paramount importance. Everything about the small business must be structured to maximize cash operations, including retaining cash as long as possible within the business while ensuring that cash due to the business is collected as soon as possible.
The first consideration given to cash management is how the business is financed. If a small business is financed the wrong way, it will bleed cash from inception. A bank loan taken too early by a small business will burden the business with interest cost and slow down growth. Too often, the only finance available to small business are bank loans, and that is unfortunate. Bank loans, as offered in Nigeria, are expensive and are determined upon possession of sufficient collateral. Many small business cannot afford to pay double digit finance costs nor do they possess sufficient collateral to secure funding from a bank.
Small business have to consider seriously the equity option in funding, especially in the early part of the business life cycle. Every business has four unique phases; Startup, Growth, Maturity and Renewal/Decline. In each of these stages, the type of finance needed by the business will change.
Every business has the initial start up period where their products or services are being evaluated in the marketplace. If consumers like the offering, the business sales start to grow and customers are added. In the growth stage, the business enters a period of rapid acceleration of sales with operational growth. Activities become more scalable during this period. When the business enters maturity, sales and growth will plateau off as the company reaches all her identified customers and/or competition reduces the companies share in the market. Next phase is either the business reinvents itself, records growing sales and cash flows or dies. What sort of equity financing can a small business explore in these stages?
Start Up Stage
At startup, the business is either at idea conceptualisation or where the initial idea is being developed into a viable business for adoption by customers. The business at this stage has no clear laid down process, everything is new. The risk of business failure at this stage is extremely high and lenders also know this. This financing is a challenge, what sort of financing is useful here?
Founders own saving; first person to fund a business should be the founder(s), they create the idea, they should put their own money in first, it’s also the cheapest form of finance available.
Family, friends and employees : if family and friends accept the business model and pay to use the product or service, then there is a possibility the larger market will be accepting it as well. This funding type allows the founder tap into the first local base of support, removing the need to make costly interest payments. How does a paid employee invest in a company? By accepting to work for equity in the business instead of a salary. Founders and family and friends financing take place at startup stage. They do not cost the business any interest to fund.
Series A: this is the first round of funding done by the company outside the tight circle of family and friends. Source of series A finance will come from angel investors, accelerators and micro venture capital firms, and is usually done via selling preferred stock to these investors.
Seed funding: If a business has successfully navigated through start up and is now in the growth stage, the next form of financing is seed funding. Seed financing is capital raised by offering equity or ownership in the business in exchange for cash. Seed financing can be done by family and friends and also by investors known as angel Investors. Seed funding is generally used to support and sustain business growth. Seed funding generates cash flow to the business without a mandatory repayment with interest as with traditional loans.
Serie B Funding: is intended to take the business to the development stage, scale up and build market share. At the growth stage, the business has shown that it a viable business concern, duplicating best practises to generate revenues. Series B funding is done by venture capital firms.
Series C Funding: also called later stage funding. This funding round occurs when the company has been successful in acquiring and retaining market share whilst remaining a viable going concern. This funding is usually to take the business public via a private or public offer. This is usually when the angel investor and venture capital firm exit via the public offer.
Where does bank funding come in?
From founder to family & friends to series funding, these are all equity. Why? because it’s patient capital, Equity does not impose mandatory interest payments, thus allow the small business grow without the heavy burden of fixed repayments on loans.
But does the company need bank loans? Yes to finance working capital. Working capital is capital the business uses in day to day operations, i.e. liquidity. While a business may be financed by equity sources, it may still require loans to fund certain operations like filling orders to customers. what are sources of working capital to a SME?
- Bank overdraft
- Bank loan
- Equipment Finance
- Invoice Factoring
- Trade Credit
These financing sources are all short term in nature, repayable from cash generated from operations and specific in nature. In essence, they are self liquidated from earning and are not designed to fund non sales transactions like salaries.
Small business have to refocus capital raising away from debt into equity. Granted the private equity and venture capital space remains limited but small business die either due to lack of financing or taking too much bank loans at the start of their operations without having the subsequent cash flows to cover these open positions.
Cash again is the life blood of a business.
Kalu Aja is a Financial Planner and Economic Strategy Consultant with over 20 years expertise in the financial services industry. He manages a personal finance advocacy; Financial planning with Kalu Aja. Follow him on twitter @FinPlanKaluAja.