Businesses need to incur costs at every stage of their lifecycles to make profits. From the initiation stage of a business, where there are costs such as registration costs, to maturity stage of business, where different operation costs occur, costs have to be borne.
To fund these costs, businesses need finance in different forms. While finance is important for a business, there are limited sources of finance for businesses to obtain.
2 Sources of Finance
The sources of finance for businesses can be classified into two main categories.
1) External Sources
External sources of finance are those which are obtained from sources that are outside the business. The two main types of external finance for businesses are equity finance and debt finance.
Equity finance is the type of finance that dilutes the control of a business. Equity finance is provided to the business by its owners. For almost all businesses, the first form of finance they obtain is equity finance.
This is obtained in form of an investment by the initial owners of the business. By obtaining equity finance, businesses give the equity finance provider control over the business and its decision-making process. Equity finance providers are paid a proportion of the earnings of the business.
The second type of external sources of finance is debt finance. Debt finance is provided by third parties to a business. For businesses, any finance that is not provided by the owners is debt finance.
Debt finance does not dilute the ownership of the business as it does not give the providers of the finance any controls over the business and its decision-making process.
Debt finance providers are paid interest payments depending on a pre-determined rate. Interest payments on debts are made regardless of the amount of earnings of the business.
2) Internal Sources
Internal sources of finance are those which are obtained from within the business. The main source of internal finance for a business is the revenues and profits it generates from its daily operations.
This is mainly generated in form of any proceeds from sales. Internal sources of finance are considered superior to external sources because not only do they not come with any added stipulations such as paying a portion of earnings or interests but are also the cheapest source of finance. A stable source of internal finance is also an indicator of the good performance of a business.
Unlike large businesses, smaller businesses do not have the same options and flexibility when it comes to raising finance. For small businesses, obtaining finance is more difficult than it is for large businesses.
This is due to the fact that small businesses do not have the same level of resources to attract different types of finance providers. Smaller businesses may also not have the same credit ratings and trust in the market as compared to large businesses.
For small businesses, the best option among different sources of finance is equity finance. This is because small businesses do not have the resources to meet the requirements for debt finance.
Debt finance, for smaller businesses, needs some type of certainty regarding the recoverability of the loaned amount. For large businesses, this certainty is provided by assets provided as security to the debt finance-providing institution. Small businesses may not have the resources to provide security.
Sources of Equity Finance for Small Businesses
The sources of equity finance for small businesses are as follows:
1) Initial owners of the business
As mentioned above, the first source of finance for a business, and the first source of equity finance, is the initial investment that the first owners of the business make in the business.
The initial owners of a business provide the business with the funds necessary to take care of the initiation charges of the business and other initial business activities. These funds are also used to get the activities of the business going.
2) Angel Investors
Angel investors are investors that provide finance to small businesses with high growth potential. Angel investors can either be wealthy individuals or groups. Angel investors look for businesses that have a high growth potential.
Since large businesses have already achieved a majority of their growth potential, they are not attractive to angel investors. Small businesses, on the other hand, may have not met their growth potential and, therefore, are more attractive to angel investors.
3) Venture Capitalists
Venture capitalists are, generally, groups or businesses that are very similar to angel investors and provide loans to small companies. Venture capitalists target small businesses with future growth potentials that can help generate wealth for the group or business.
Venture capitalists, like angel investors, only provide finance to small companies because small businesses have a lot of unrealized potentials that can be met.
4) Initial Public Offerings
An Initial Public Offering (IPO) is also an option for small companies to raise finance when the company first goes public. IPOs are used in the later stages of a company’s lifecycle.
An IPO can generate the most portion of the equity of a company. For example, Facebook, in 2012, raised $16 billion through its first IPO. However, for an IPO to be successful, the company must show promise and impress the public first.
Tips To Obtain Equity Financing Small Business
While there are different equity financing options available for small businesses, there is also a lot of competition for this equity finance. There are a lot of businesses that are competing for the same equity finance sources. Therefore, it is tougher for businesses to compete and obtain equity finance.
For businesses to successfully obtain equity finance, they must beat the competition. This can be done by following a few simple tips. While these tips can help businesses successfully snatch the equity finance despite the competition, it can also help businesses that may not be facing a high level of competition.
1) Have a Unique Idea
As mentioned above, investors look for unique businesses that have a high growth potential that will generate wealth for them. If a business’ idea is to imitate the success of a company like Microsoft or Facebook, then it is bound to fail. Investors cannot predict the future and whether the business will actually be profitable or not.
Therefore, their decision of whether to invest in a business or not depends on the idea behind the business and whether they deem it is unique.
2) Prepare a Business Plan
The role of a business plan in attracting investors cannot be stressed enough. For businesses to attract any potential investors and raise finance, they should impress these potential investors.
This can be done by developing a robust business plan. A business plan contains information about the business itself, its plans and its finance requirements.
Experienced investors use business plans to filter out any businesses that, in their opinion, do not have the potential to generate wealth. Therefore, a proper business plan should be developed by small businesses when looking for equity finance.
3) Identifying the Source of Equity Financing
Small businesses looking for equity financing must also identify the source of the equity financing they desire. Businesses must decide whether they want to attract angel investors, venture capitalists or the general public.
Each source of finance will have its own advantages and disadvantages and it is up to businesses to decide which source meets their demands. The business plan might also have to be adjusted according to the source of equity financing the business is targeting.
4) Develop Connections
As previously mentioned, there is a lot of competition trying to obtain equity finance. Many small businesses try to obtain finance from these sources without any networking.
Since the competition is tough and there are a lot of small businesses trying to target the same sources of finance, not all businesses may get a chance to properly get their business idea through to the potential investors.
Therefore, it is necessary that small businesses develop connections with the type of potential investors they are targeting to get their idea through.
5) Consult Business Incubators
For small businesses that have a unique idea but do not have the experience necessary to figure out how to run things, going to business incubators is a good idea.
Business incubators are organizations that exist to provide help and guidance to businesses that have great ideas and no expertise. These organizations can help businesses make decisions about which source of equity finance is the best for them or how they can obtain it.
6) Offer a Solid Exit Strategy
An exit strategy defines how investors will dispose of their investments. Angel investors and venture capitalists will not invest in a business that does not offer them a solid exit strategy.
These investors look for businesses in which they can invest for a specific period of time and then take their investment and any profits they have made on those investments back with them.
Therefore, for small business looking for these sources of equity finance, they must offer them with a solid exit strategy.
7) Be Open and Transparent
Small businesses need to ensure that they are open and transparent with any potential investors. This means that these businesses need to disclose all required information about the business, whether favorable or adverse for the business, to the investors.
Investors prefer businesses that are candid with their equity holders. This also allows investors to make well-informed decisions about investments.
Businesses can obtain finance through many sources that can be either external or internal. For small businesses, raising finance may not be as easy as it is for larger businesses. In some circumstances, it is favorable for small businesses to choose equity finance over other sources of finance.
This equity finance can be obtained from different sources such as from the initial owners of the business, angel investors, venture capitalists or Initial Public Offerings (IPOs).
Small businesses must follow some tips to obtain equity finance such as having a unique idea, preparing a business plan, developing connections, and being open and transparent with the investors.