Importance of Financing for a Business
As a business owner, there are many important decisions that are required to be taken, the most important is how to get financing for a business. Business owners have many things to consider such as the business plan, the business offering, market, pricing, profits if they should utilise open accounting etc. For the business to achieve success and long-term stability, the most important and challenging task is to select a source of finance that requires immense knowledge and research.
Finance work as a lifeblood
A business cannot carry on its operations even for a single day without finance, so securing a business loan can be like blood for the body. Finance is required in a business for various operations such as asset creation, exploring new products and markets, operational expenses, cash flow management, management of unavoidable risk, and for-profit creation. Businesses at any of the above stages may not have adequate funds for their operations and that is why business requires financing from outside.
Importance of Finance
The importance of finance in a business is to ensure that the business runs without any obstacles and at the same time to ensure that the funds are protected and secured for the long term. Whether it’s about starting a new business or growing an existing business, funding is an inevitable part.
Analyzing the Requirements and Source
Financing decisions affect both the risk and profitability of a business so selecting the right source of finance for your business is of crucial importance to drive profitability and also ensure success. Before choosing the source of finance it is also necessary to know how much money it requires.
Factors to be Considered for Selecting a Source of Finance and Various Financing Options
There are wide varieties of financing options that are available to fund your business which is typically divided between equity and debt financing. Each of the options has its own advantages & limitations. Business owners must consider them when going to select a source of finance as long-term planning of the business depends upon it.
A business can also consider a combination of the debt-equity mix as its source of finance. It is necessary to understand the factors such as the nature of the business, size of business, cost of finance, types of expenditure, and also some future forecasts about the business to take the right decision. Return on investment (ROI) is another important aspect that a business owner must check before deciding on a source of finance.
Types of Financing
Debt vs. Equity
There is a lot of difference between equity and debt. Equity financing means giving a part of ownership to someone and sharing profits and decision-making with them. Equity financing options generally include Shares, Angel investors, personal savings called Bootstrapping, venture capital, etc.
On the other hand, debt financing refers to borrowing from outside to fund working capital. The debt financing options include loans from financial institutions, loans from family and friends, bonds, etc.
Business owners must decide which source will suit them best. Where equity financing brings a lot of managerial skills, experience, and wisdom to the business and keeps you debt-free, debt financing can help in maintaining ownership of the business and are also tax-deductible.
When talking about the disadvantages, equity financing can lead to dilution of control while debt financing involves a high-interest rate and its repayment can become difficult. When choosing about the above, some factors to be kept in mind are Risk, cost, control, long term or short term.
The first and foremost person that you should turn to when you want to find a way to kick-start your business is yourself. In fact, self-financing is at the top of the list among the methods that start-ups use to get their businesses off the ground. Besides this, even if you wish to opt for another source of financing for your business, you would need to convince the venture capitalists, or even banks that you have enough faith in your business to be the first person investing in it.
You can think of what and how much to invest by going through your assets thoroughly. They may include equity in real estate, savings accounts, recreational equipment, collections, vehicles, and retirement accounts. It is entirely up to you to either sell your assets one by one or use them all together for a loan.
Things to remember when indulging in personal investment
Once you have settled into the idea of investing your personal money into the business, there are some points that you should keep in mind to protect your money and business. Below are some ideas on how you can achieve it:
- Separate accounts
Your business account must be separate from your own personal account. This ensures that you are safe from the legal liabilities that may arise when you are operating your business and making decisions.
- Manage Accounting
When you are investing in a business, you should keep track of the business funds and your personal funds and draw a clear line between the two. Other than this, you should also note down the correct amount that your business owes you and the status of ownership that you have. This will protect you from accounting and taxes issues.
- Finance Management
It is a wise idea to invest in accounting software to keep track of your income and costs.
- Practice Invoicing
It is really important that you manage the invoicing religiously when you are putting some money into your personal business. It needs to be done when you are putting some money in or withdrawing an amount from your business.
Disadvantages of Personal Investment in a Business
- The major disadvantage of doing a personal investment in your business is that it puts a strain on your personal and family life financially. This is why it is recommended that you leave a contingency fund. This will ensure that you have a backup amount of money present in your account to get you through the difficult days.
- By investing in your business yourself, you may be missing out on the amazing opportunities that collaborating with venture capitalists would have gotten you. There are many investors and venture capitalists out there that provide mentoring and great opportunities for you and your business if you wish to associate with them.
- The third major disadvantage of self-financing is that you might have put everything at stake for the sake of your business. You are at a high risk of losing your home or other precious possessions in case your business goes under.
It may be that you fall short of a certain amount of money required to launch your own business, and you decide to turn to your friends and family for help. The money offered by friends and family for a business is referred to as “seed money” or “love money”. In short, love money refers to the amount raised by the business owner’s friends, family, and even business associates.
Advantages of Opting for Love Money
There are many advantages of turning to friends and family members for money for starting your business. Here are some of them:
- There is no need to walk into the room in a formal manner and explain to them your entire business plan. Your close associates are already aware of your character and the circumstances that you are in. So, you will not need to convince them with a business plan for the money.
- It is highly likely that most of your family and friends will offer you money interest-free or even at a low rate.
- Other than this, the major advantage of turning to love money for financing your business is that your friends and family will be flexible with your terms. They may offer you loans without security.
- Also, your friends and family members may also agree to a longer repayment period than most banks and may even accept less return than banks.
Disadvantages of Opting for Love Money
As with all things, with many positives, there are also some negatives associated with love money. Some of the disadvantages of love money are mentioned below:
- Money may cause someone to whom you are in debt to think that they are more in control over you since you are in debt to them. They may try to exert their views over you, criticize you for your choices, and lifestyle habits, or even eye your banking information. Therefore, it is largely important that you make sure to pay your family members on time without delay.
- Borrowing money from your friends and family may cause you both to have a strained relationship. It might be that they are not willing to offer you a loan but feel obligated to do so. They may also worry if they will ever get their money back. So, it is important that you keep all your family members and friends in the loop about when you are going to make payments to them and when you are expecting delays in it.
- Another major advantage of borrowing money from friends and close associates is that they offer little to no legal protection. It might be that a family member or a friend turns on you and demands a full return on their loan. To avoid such a situation, you should create a promissory note loan agreement that highlights all the important points such as interest rate, terms of the loan, loan amount, and the repayment schedule.
Venture Capital, more commonly known as VC, is a form of private equity financing that is offered to start-ups or small businesses that are considered to have high growth potential. Even though it is more common for new businesses, it is also used by businesses that are at different stages in their development.
How does Venture Capital Process Work?
- To obtain VC funding, you will first have to be introduced to a venture capitalist by a party that is familiar to both of you. The standard of the introduction will determine whether the venture capitalist is interested in your business or not.
- If the Venture Capitalists are interested in your start-up, you will receive a call from them for an appointment.
- Going by the conversation you had with them on call, if they are still interested in your business, they would ask you to submit a pitch deck. If they are satisfied with the pitch deck that you have submitted, you will then be called in for answering questions.
- After you have answered all their questions, they may present you with a term sheet. A term sheet has the terms for a possible offer of funding. However, it is a non-binding agreement.
- After they have handed over the term sheet to you, the venture capitalist will be preparing to perform due diligence on you. This is done so that the Venture Capitalist has a good idea of they will get a good ROI.
- If the Venture Capitalist is completely satisfied with everything, they will then extend you the documents stating the terms and conditions of their funding to you.
- You will then be required to make a decision of whether you accept or reject their offer. If you choose to accept it, the funds will then be transferred to your account.
An angel investor is a high-profile person with a large income who invests in new or small business ventures. They are mostly looking for a higher rate of return than they would normally get from traditional investments.
Pros and Cons of Angel Investors
The biggest pro of having an Angel investor is that it is way less risky than debt financing. Other than this, most angel investors take a long-term approach to business and understand business fairly well.
However, a major disadvantage of turning to angel investors for funding is that they become part-owners of your business, which means they have a lot to say in how you choose to run your business. They will also get a share of your profits in the event that your business is sold.
Convey Your Ideas Thoroughly
In case you decide to settle on an angel investor to secure funding for your business, then it is important that you communicate exactly how you wish to go forward. This is done to avoid the clash between the investor and yourself if you both have opposing ideas about your business. You also want to get a good idea of what the investor is like to work with.
Business incubators are programs that are specially devised to help start-ups grow and innovate. The BI is tasked with providing mentorship, education, workspaces, and access to investors. Business Incubators mostly operate at a lower cost in their early stages. BI requires an application to join and demands commitment for a certain time period.
Crowdfunding refers to the amount collected from many individuals to finance a business. In crowdfunding, investors can either donate money to a charity or they can get some benefits in return. An example of such a benefit is getting equity in the company for which the money was raised.
There are also many government grants that are available but they are available for specific organizations such as non-profit organizations. These are offered to small businesses if certain conditions are met. Many businesses fail because they do not have adequate knowledge about the pros and cons of financing options. It is also worth taking outside consultation to take the right decision in this case.
Meaning of Credit Score and its Importance
Business owners must also be aware of the concept of credit scores. The credit score plays a key role in a lender’s decision to offer credit. It is a score between 300 and 850 which depicts the creditworthiness of consumers. The higher the score, the better a borrower is in the eyes of the lender. A business must check their credit score before going for borrowing as it is a way lenders check the probability of repayment of a loan. A business will get a loan easily if it has a good credit score.
As financing can make or break a business, deciding about how to go for a source of finance is challenging. It is imperative to study the available options before making any decision. Understanding your business and its needs is crucial. Take outside consultation with industry experts if you are not sure about deciding the method of financing.
Well equity and debt both are good financing options, a mix of debt and equity can really prove fruitful as too much debt can choke the cash flow of business which is required at the time of growth and excessive equity may dilute control. Also, do not forget to look at your credit score if you are thinking of borrowing.
If you are a student and planning for running a business in the future, this is the right time to gain knowledge about financial planning, forecasting, and management.
If you are a business owner, ensure that you have a strong and energetic finance team that would help in bringing benefits to your business.
Check out this interesting infographic guide below created by the guys at Finbri which speaks about the different financing options that are available to suit your business needs. It gives both the negatives and positives of each option. It discusses in detail which financing option is best for which type of business and offers practical tips to make a good choice between the available options.
In the end, it also discusses credit score, what it is, and how it affects the business. Although running a business is a tough row to hoe, it can also become exciting and rewarding with some right decisions.
The basic goal of “The Business Goals” is to help the entrepreneurs’ community in achieving their goals and business objectives by providing the authentic and latest entrepreneurial ideas.