Three sources of private funding for small businesses

As an entrepreneur, you might require the capital to launch your business or perhaps, you have been in the business for a long, and you need capital to enlarge it. Either way, you require money as money begets money. 

If you are looking for finance for your small business, it is essential to consider all the options. Before initiating your small business finances, it is highly recommended to ensure private limited company registration in India to leverage various funding options. Check out the three crucial sources of private funding for your small business.

#1. Private equity for small businesses

For small businesses exploring their financial options, the first thing is to differentiate debt and equity financing, says Brian Cairns (CEO of ProStrategix Consulting). Debt financing is about taking out a loan, whereas equity funding is about purchasing a share of the profits or control over the company.

For many start-ups, getting investment is especially appealing because it does not clock any liabilities on the business’s balance sheet. Brian says the fundamental pro with any equity funding is that it is restricted to the nil effect on cash flow, and the main con is relinquishing partial control of the company. Private equity can be seen in two forms at the start-up level: venture capital and seed or angel investment.

#2. Venture capital

VC firms invest money in start-ups, generally in return for equity in the company. Venture capitalists scrutinize financial statements, business plans, and other business details to examine the investment’s total expected return before investing in a portfolio company.

Companies are likely to catch venture capitalists’ eyes if they have an immediate opportunity for growth as VC firms will usually want to exit within five years, says Brian. They are searching for rapid expansion that would accelerate the valuation.  

Such high-growth enterprises depict a lot of associated risk; that’s why VCs need a higher return on their investment from their portfolio companies than other private equity firms. VCs frequently also offer guidance to emerging companies like mentorship, access to sales networks and other developmental opportunities.

If a company is searching for private funding, looking for more than just money is the point. In many cases, the money might be more expensive than bank debt. Nonetheless, the value that can be created via that partnership far outweighs a low-interest rate, says Casey Berman (founder and managing director of Camber Creek).

The drawback to working with VC, as with any lender searching for equity, is that you would be relinquishing a certain percentage of your company. This also means that you will have a third-party to answer to as your business changes and grows. VC firms would likely need more oversight and reporting, says Brian.

#3. Seed or angel investing

Angel investors also provide finances in return for equity in the company. Angel investors are private individuals investing their money. They do have their own different ROI needs relying upon the risk appetite, which makes them better for the slow-growth companies. Not all money is created; equally, a VC is going to structure a deal one way, a private equity firm is going to do it differently, and angel investors are going to do it another way, says Berman.

Angel investing is seed investing where a group of people or individual or government agency offers capital. Generally, they provide funding via convertible note for a set of fractions of the company, no more than 20%, says Brian. Most IOUs or convertible notes are due in 3 to 5 years; at that point, the investor can reclaim the money along with interest or convert the note into shares or equity.

How can small businesses find private investors?

First, they have to be realistic about their options. VC firms tend to operate in the $2 million-plus range, whereas angel investors generally offer up $100000 to $500000, says Brian. It is up to the start-up to ensure they fit in the requirements while courting the private equity firms. The entrepreneur has to ensure that his/her deal fits within the box. If the resources and uses of the capital seem reasonable, if the pro forma is available, and if it is possible that they would obtain the projected return on their investment, says the Richardson (investor and director of Rutgers University Business School’s Centre for urban entrepreneurship and economic development)

For this reason, financial estimation like future capital needs, profit and revenue and an ROI timeline have to be crystal clear. Companies should avoid being enthusiastic about the metrics. Nonetheless, precision, not the volume, is the key.

What can small businesses do to attract investors?

Equity funding can be the best sources of raising debt for startups and SMEs, but it comes with the significant drawback of abandoning the control. On the other hand, some small businesses have the credit score or enough collateral to get a bank loan.

I. Alternative lenders

Fintech and alternative lenders could be a great funding option for small business owners. They offer short-term high-interest business loans to entrepreneurs searching to grow and enlarge with capital. The biggest drawback of it is its flexibility.

They do not require equity as well. Instead, they offer long-term agreements that mirror conventional banks but generally have more relaxed requirements for quality and higher interest rates. They also provide several loan packages like cash advancement, line of credits etc. and types. That’s why it is a viable option for small businesses. The drawback of alternative lenders are the high-interest rates and demanding loan agreements.

II. Obtaining debt financing

The advice for convincing lenders is not too far off from the advice for convincing investors as both of them seek assurance of future repayment. You might have heard that VCs tend to invest in people more than in ideas they bring to the table. It is true in the world of small businesses as well.

III. Search for the correct type of financing for your small business

It all starts with what you need money for and what lender makes the most sense for you to partner with as VC and alternative lenders can offer you the initial needed thrust and capital to get things going. The best way to finance is through connecting with investors of all types.