Ways to raise funds for business
Find various ways of raising capital for SMEs and understand the relationship between the source of funding and the growth stage of the business.
Find various ways of raising capital for SMEs and understand the relationship between the source of funding and the growth stage of the business.
Planning an SME IPO?
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Planning an SME IPO?
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Small and medium-sized enterprises (SMEs) are the backbone of our economy, but they often face financial challenges. Financial resources are very important for SMEs as they need funds to cope with their daily expenses, manage their inventories, take advantage of growth opportunities, expand their business, scale up their activities, invest in research and development and much more. An SME with a unique business idea and great potential can turn into a big business if it gets the funding and the right advice.
A company must consider the following important factors when seeking to raise capital.
In this chapter, we will go through various ways of raising capital for SMEs and also understand the relationship between the source of funding and the growth stage of the business.
Let us start from scratch. Suppose a person or a group of people has a unique idea that they believe can make a good business. However, in order to turn the idea into reality, they need funds to start their venture and eventually turn it into a big business. Let us take a look at how an SME can raise money for their business venture.
In the beginning, no one believes that the business idea is feasible. Therefore, it is very difficult to get money from a source other than your own money. Investing your own funds in a business is known as self-financing or bootstrapping . This is a way of financing small businesses with the owner's resources, i.e. personal savings, income from the business, etc.
Once you have convinced your close associates and acquaintances of the desirability of your business venture, you can raise funds from relatives and friends. They may offer to finance your business either as a loan or by taking a stake in your business.
Angel investors are an extension of stage 2. Angel investors can come from the entrepreneur's family and circle of friends, or ambitious individuals or groups of individuals with surplus funds who invest their own funds in a business in return for equity or convertible debt (that is later converted to equity). As the name suggests, these investors act as angels by supporting the entrepreneur in the early stages of their business with seed funding. Seed financing is the financing of a business at a very early stage, when the future of the business is not yet certain. Seed financing begins when an investor buys your idea.
The entrepreneur needs more funds to establish their business model. The next source that can be tapped is therefore debt financing. Debt financing involves borrowing from external sources.
Below are the sources of debt financing with the approximate interest rates charged by each of these sources, in ascending order.
Ideally, any entrepreneur would prefer a loan from a PSU because of the lower interest rates. However, since the business is not yet fully established, it is difficult to obtain a loan from PSUs and private banks due to strict documentation and collateral requirements. Therefore, at this stage, funds can be raised from (AIFs), non-banking financial companies (NBFCs) or high-risk takers who are willing to offer loans to businesses at higher interest rates and without collateral.
Once the business model has been established, entrepreneurs seek equity financing through various rounds of fundraising before going public to raise capital.
Venture capital (VC) are companies that invest funds raised from various private individuals, pension funds, insurance companies, etc. A venture capitalist can invest anywhere between Rs. 3 crores to Rs. 40 crores in a company, depending on its needs, and receives a certain percentage of the company's shares in return. The shelf life of VC funds is up to 3 years.
A venture capitalist invests once he understands the business and has an idea of its scalability.
In Pre-Series A funding, VCs invest in the company at a discounted rate that allows for a better valuation. Up to this stage, investment is only on the promoter and the company. The actual investor only comes into play in the next round, i.e. Series A financing.
Series A financing is carried out by VCs and large family offices. This is ideally the proper round of funding when actual investors desire to invest their funds in an established company that is capable of generating revenue.
The VCs invest the pooled funds of other investors and large family offices which are private companies that invest the funds of wealthy families to generate high returns and achieve diversification.
This is another round of financing when the company has built up a brand image. At this stage, private equity (PE) investors with a minimum investment capacity of USD 5 million look to invest in the company. VCs usually exit at this stage.
The company can raise funds in several rounds depending on its needs and growth plans. Each successive round is referred to as Series C, D, E, etc. The PEs invest in the company at different valuations. Once the company is fully established, it aims to grow into a large company with further expansion plans. At this stage, the company may seek an IPO.
Generally, after a Series D or E financing round, a company decides to go public, where PEs want to exit the company through an offer for sale .
The above steps are the general funding cycle. Apart from this, entrepreneurs can also avail funds from incubators, accelerators, government programs, peer-to-peer lending and crowdfunding . However, it is not always possible to get funding from these sources.
The source of funding is generally related to the stage of the company. A newly founded company cannot obtain a bank loan or go public in the early stages. Therefore, each source of financing is relevant to the growth stage of the company. Below you will find an overview of the appropriate sources of financing depending on the stage of the company
|
Stage of the company |
Stage Description |
Suitable source of financing |
|---|---|---|
|
Pre-seed stage |
You have a business idea and want to start a company |
|
|
Seed stage (pilot project) |
Idea is converted to real product/service. Phase in which the product/service is tested to see how the it works in the market , also known as Proof of Concept |
|
|
Series A stage (Growth stage) |
The launched product was a success, the business idea is viable and revenue generation has begun. In this phase, the company needs funds for product development. |
|
|
Series B,C, D, E stage (Expansion) |
The company has reached stability and wants to expand further. |
|
|
Exit stage |
Transition from start-up to large company and further expansion |
|
In this section, we will compare some fundraising methods in order to identify the main differences and select the most suitable methods for the organization.
|
Feature |
Equity Financing |
|
|---|---|---|
|
Definition |
In equity financing, capital is raised by selling shares in the company (diluting ownership) to investors in exchange for cash. |
In debt financing, funds are borrowed from lenders (e.g. banks, financial institutions or private lenders) with the promise to repay the principal plus interest over a certain period of time. |
|
Ownership |
Investors who acquire equity (shares or stocks) become part owners of the company and share in its profits and losses. |
Lenders do not receive ownership rights in the company, but are creditors who expect the borrowed funds to be repaid with interest. |
|
Return on investment |
Investors generally expect a return on their investment in the form of dividends (if issued) and/or capital appreciation. |
The company must make regular interest payments and repay the principal in accordance with the terms of the loan or bond agreement. |
|
Payment obligation |
No obligation to repay funds to investors. |
The funds raised through loans must be repaid with interest within a certain period of time. |
|
Risk |
Dilution of company ownership. |
Pressure of the repayment obligation. |
|
Decision Making |
Investors have a say in the company. |
No involvement in the business. |
|
Sources |
Angel investors , IPOs, crowdfunding, incubators, venture capital, private equity investors. |
Government loans, loans from banks and other financial institutions and Government schemes. |
The type of financing an SME decides on depends on numerous factors.
Nowadays, many SMEs go public to raise money. Some companies prefer to take out a bank loan rather than go through the IPO route. The difference between raising capital through an IPO and a bank loan is explained below:
|
Feature |
IPO |
Bank Loan |
|
|---|---|---|---|
|
Growth phase |
A company can only go public once it has established its business. |
A company can opt for bank loan post seed funding stages. |
|
|
Access to capital |
An SME may opt for an IPO if it needs a large amount of working capital without the stress of having to pay it back. An IPO can provide access to a large pool of capital from public investors. |
|
|
|
Ownership |
Dilution of ownership rights. |
No dilution of ownership rights. |
|
|
Interest payments |
No obligation to pay interest. However, the company pays a dividend to shareholders to increase the shareholder’s value. |
You must pay interest on the loan amount. |
|
|
Duration |
Lifetime, unless the company buys back or dissolves or the investor exists by selling his shares. |
Short term. Companies must repay the loan within the specified period. |
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|
Repayment |
No obligation to repay |
Obligation to repay principal and interest |
|
|
Increased visibility |
An IPO can increase the company's visibility and credibility in the market. |
Not possible with a bank loan. |
|
|
Liquidity for owners |
Owners and investors can monetize their investments by selling shares in the public markets. |
Bank loans do not offer such an opportunity. |
|
|
Regulatory requirements |
Companies that go public must comply with various regulatory requirements, which can be costly and time-consuming. |
No such regulatory requirements need to be met. |
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A company can raise money through:
Debt is usually cheaper than Equity because it guarantees repayment. Debt capital can be obtained by taking out loans or issuing corporate bonds in exchange for cash. Conversely, equity can be raised by going public through an IPO, angel investor, venture capital, or private placement.
In the very initial stages, a company can also self-fund or take funds from close friends and family or apply for grants.
We can raise funds through equity financing by giving away a part of our company in return for funds from investors. Equity financing involves dilution of ownership. Some of the popular ways to raise funds via equity financing include:
Debt financing involves borrowing funds from lenders in return of interest payment against the borrowed amount. The borrowed amount is required to be repaid after specific agreed tenure.
The popular debt financing sources include:
Small Businesses can get loans from various sources, such as government loans like Pradhan Matri Mudra Yojana, Bootstrapping, Loans from friends and family, crowdfunding, angel investors or venture capital funds.
As and when business grows and company looks for expansion, it can also go for bank loans, issuance of bonds and debentures and eventually IPO.
After going public, companies can raise funds through secondary market via the below:
The options for raising money for an SME company are described below.