WHY MIGHT A NEW BUSINESS FIND IT DIFFICULT TO RAISE EXTERNAL FINANCE?

New businesses enter the market every day with hopes to achieve success. However, most of these businesses fail to succeed and never achieve their true potential. There are many factors that decide whether a business is going to be successful or not.

Among these factors, one of the biggest factors is the fact that these businesses fail to generate the required funding to truly fund their activities.

Sometimes the reason why new businesses cannot generate finance is due to fundamental problems with the vision of the business or the steps taken to achieve these visions.

However, sometimes the reason startups cannot generate funds is because there is a limited amount of funds that are available for the businesses to obtain. Since entrepreneurs are entering the market regularly, startups have to compete to obtain these funds.

The main source of finance for startups is the finance provided by the original owners of the business. These owners provide the required funds to get the business registered and fund its initial activities. Once the business is registered, businesses need more funds to operate.

Unless the owners are wealthy, startups must generate funds from external sources to meet these needs. These funds can be generated from the general public but startups don’t have the required reputation and trust for the public to invest in them.

Angel investors and venture capitalists are people or firms that look for opportunities to invest in startups. They invest high amounts of finance in new businesses in order to generate high incomes once the businesses become successful.

However, every 1 in 10 or even 20 new businesses actually end up generating wealth for the angel investors or venture capitalists. This is why they also prefer to invest in businesses with sound ideas and plans. This makes obtaining finance from these sources even further difficult for new businesses to obtain.

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Finally, businesses can completely ignore the external sources of finance and generate finance internally. However, startups rarely make profits in their first years of business.

Assuming they do make profits, these profits are, generally, not enough to fund daily activities on a regular basis. Therefore, the need for external finance still exists.

7 Reasons:

As mentioned above, startups find it difficult to obtain finance from external sources. The reasons why it is difficult to do so are below:

1) Nature of New Businesses

Generally, investors prefer to invest in businesses with lower risks. The nature of startups makes them a high-risk investment for investors. Although these high risks come with high rewards in some cases, in other cases, it may result in losses to the investors. This makes investing in startups nonattractive for investors especially ones that are risk-averse.

When investing, investors also rely on the information available to them to determine whether the expected rate of return of the investment is worthwhile. For large businesses, this information can easily be obtained from the market and the financial statements of the business. For startups, the market might not have enough information to provide about which can prevent investors from making well-informed decisions regarding the investment.

2) Bad Business Model

As previously mentioned, another reason why startups find it difficult to obtain external finance is because of bad business models.

When investors look to invest in a business, they look for a business that can generate wealth in the long run. If the business model of the startup is fundamentally flawed, it will not generate any finance.

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Experienced investors can easily identify businesses with flawed business models and filter them in their initial screening of investments. This also includes angel investors and venture capitalists.

3) Competition

Another reason why obtaining external finance is difficult for new businesses is increased competition. As the number of new businesses grows in the market, investors get more options to invest in the business of their choice.

Due to the great number of businesses competing for external finance, startups find it difficult to compete especially without resources.

4) Financial Position and Performance

When investors provide finance to a business, they look for businesses with strong financial positions and performance. This is done to decrease any risk that investors take with the investment.

Startups in their initial years cannot display the financial position and performance that is needed to attract potential investors. Even when obtaining debt finance, financial institutions such as banks provide loans to businesses with a strong financial position.

5) Guarantees and Credit Rating

Debt finance providing financial institutions require businesses to provide a guarantee in form of assets kept as security and owners’ personal guarantee.

For startups, with no assets to provide as security, it may be difficult to obtain this finance. Owners of the business may also not be willing to provide personal guarantees to the bank further making it difficult to obtain finance.

Furthermore, these financial institutions may require the business asking for finance to meet certain criteria of credit ratings. Startups that have no prior history of business or creditworthiness will find it difficult to meet the criteria as specified.

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6) High Cost of Finance

As mentioned above, startups may not meet the requirements set by the finance providers to obtain finance. The institutions providing the loan will reject the request for finance in this situation because providing finance to these businesses is risky for the finance providers.

However, in case the finance providers do provide the business with finance, the finance will come at a very high price for the business.

For example, when banks provide finance to businesses that cannot provide an asset as security, it is provided to the businesses at a much higher rate than is normally required.

While this type of finance is readily available to the startup, it may not be feasible for startups to acquire a higher rate of interest finance at an early stage in their lifecycle.

7) Not Understanding the Needs of Investors

Finally, another reason why startups find it difficult to obtain external finance is that they lack the knowledge to properly understand the needs of different types of investors.

Startups will need to change their strategies according to the group of investors they are looking to attract.

For example, if a startup wants to attract angel investors, it must understand that angel investors look to invest in businesses that can make profits quickly and make strategies accordingly.

Conclusion

Apart from the initial investment by the owners of a new business, it doesn’t have other options but to obtain external finance. This external finance, however, is difficult for startups to obtain.

This may be due to different reasons such as the nature of new businesses making investing in them riskier, bad business models, higher competition, etc.

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