The subject of business finance involves a whole array of different options. On the surface, it can look reasonably complex but looking at each option in isolation can help make the situation more transparent. This article will look at different types of business finance and how you should prepare your pitch.
Different Types of Business Finance
Whether you are a start-up business, looking to expand, considering refinancing, or a long-term recognized operation, different types of business finance are available. These include:-
Many people seem to view venture capital as extremely high risk, potentially high return business finance. However, this is not necessarily the case. In simple terms, venture capital is a form of private equity provided to start-up companies and small companies. Venture capital finance is normally provided at a relatively early stage, attracting an above-average degree of risk. Consequently, venture capital investors will look for an above-average return, the risk/reward ratio.
Traditionally, venture capital finance is sourced from well-off investors, investment banks, and financial institutions. Rather than investing directly, they will often provide capital for a venture capital trust (pooled investment vehicle) focused on particular areas of business.
The term “seed funding” comes from the fact that this type of finance tends to be the first official equity fundraising. This is effectively the “seed” from which the business will hopefully grow and create a significant return for early-stage investors. If the company is successful, it will likely go on to a range of different fundraisings, with the next stage known as Series A rounds.
Generally, seed fund investors will look to take an equity stake in the business and/or issue a specific convertible note (debt). There would be different rights and protections for these options, especially if the company failed and was liquidated. This type of finance tends to come from private investors, including family and friends/acquaintances.
A business loan is a more straightforward and more traditional way to raise funds for a new venture. The monies are generally supplied by banks and specialist business loan companies, with the funds repaid on a pre-agreed timescale. Unlike venture capital and seed funding, providing a business loan does not usually involve an equity stake in the underlying business. However, this can be an option for some of the more specialist providers.
While normally there is no equity stake, it may still be relatively early-stage funding. Consequently, the client may need to provide a personal guarantee. In effect, this means that if the business is not successful and unable to repay the loan, the client will be personally liable to cover any outstanding funds. This type of arrangement can also involve an element of collateral.
Asset finance tends to be a more short-term type of business funding. The borrowings are backed by company assets, including inventory, investments, machinery, and monies held on deposit. This allows companies to raise capital relatively quickly while the lenders have a degree of security, as the transaction is asset-backed. In addition, the fact that these arrangements tend to involve short-term funding reduces the risk of unexpected events in the future.
If the company couldn’t repay the funds in the agreed manner, then the lender has the option to take control of the collateral. This can then be liquidated and used to repay outstanding monies. As there tends to be significant “headroom” between the funding provided and the collateral value, the risk usually is relatively small.
Applying for Business Finance
We will now look at the specific information required when applying for different types of business finance. While there are many common elements, there are various additional issues to consider with each option. Of course, a solid business plan, cash flow projections, and a deep-seated knowledge of the market go without saying. However, there is more…..
Applying for Venture Capital Finance
In general, venture capital finance can be one of the more challenging options to test any applicant. There are many factors to take into consideration such as:-
- Formal pitch/presentation
- Synergies between your company and the venture capital providers
- A detailed understanding of the application process
- Potential deal terms
- Possible issues which may arise
- Exit routes
The venture capital market is enormous, with many companies focusing on particular types of business. If your company does not fit the criteria of the venture capital group, then it is unlikely you will be able to secure finance. It is fair to say that this application process is more rigorous, detailed, and potentially time-consuming than any other. However, if you can secure venture capital finance, you are likely to receive additional support and advice.
It is fair to say that venture capital investors tend to take a more hands-on approach and always have one eye on an exit route. There’s no point in having a paper profit if you are not able to realize it!
Applying for Seed Funding
There are many potential finance providers when it comes to seed funding. These include family and friends, angel investors, incubator funds, and even venture-capital trusts. The key to a successful seed funding application is approaching the right people and knowing when to approach them.
It is fair to say that the seed funding market is very different from other business finance options. Some of the factors to consider with your application include:-
- Personal investment in the business – always a recognized sign of confidence
- Know your business AND know your competitors
- What makes you different from your competitors?
- Underfunding is a sin
- Provide a detailed list showing how funds would be spent
The issue of “underfunding” is something that may surprise many people. Surely potential investors want to invest as little as possible for as large a stake as they can negotiate? Wrong.
It is as much a sin to underfund your business as it is to overfund it. There needs to be a balance between funds raised and how the funds will be used, but underfunding could ruin a potentially successful idea. There may be occasions where seed funding investors will offer additional capital, over and above that requested, if they see long-term attractions.
Applying for Business Loans
A business loan is a more traditional route to raise finance for a new business idea. Many applicants will approach banks with which they already have a relationship, whether personal or business. While every business finance application requires a deep-seated knowledge of the company and the market, the devil is in the level of detail.
When applying for a business loan, you will need to demonstrate:-
- An ability to repay the loan
- Strong business idea
- Understanding of cash flow
- Growth expectations going forward
- Detailed knowledge of your customers/market
You tend to find that many business loans are backed by either assets or a personal guarantee from the applicant. This ensures that if the business idea is not successful, the applicant will take on a personal responsibility to repay the debt. Unlike venture capital/seed funding, it is uncommon for a lender to take an equity stake in the business.
Therefore, as long as you have a sensible business idea and can guarantee repayment of funds, you stand a good chance of success. On occasion, the lender may decide to release funds after specific targets are met. This can reduce their risk/exposure while heavily incentivizing the business owner.
Applying for Asset Finance
The situation when applying for asset finance is more straightforward than any of the above. There is every chance of success if you have assets to back short-term finance, liquid or near-liquid assets. While the finance company will consider the type of business, there tends to be a greater focus on the type of asset and the duration of the finance.
Consequently, when applying for asset finance, you will need to provide:-
- Level of finance required
- Duration of loan
- Asset backing available
Asset finance can be beneficial where a company is asset-rich but experiencing short-term cash flow issues. It is simply a means of “working” existing assets to raise finance to cover a funding shortfall. A legal agreement will ensure that the assets in question are effectively “owned” by the lender until the loan has been repaid in full.
It is essential to recognize the most appropriate type of business finance for your business when making an application. For example, venture capital and seed funding finance tend to be riskier options involving an equity stake. At the other end of the spectrum, we have asset finance which is the more secure, with funding backed by an appropriate level of collateral. In between, we have traditional business loans where applicants also come under a degree of scrutiny.
While venture capital and seed funding providers “prefer” to see clients investing their funds in the business, skin in the game, this is not the case for asset finance. Many people pursuing business loans often have limited personal funds for investment. However, the business loan provider will likely request a personal guarantee, or appropriate collateral, from the client in an individual capacity.