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Start-ups: debt vs equity vs other (or of all of the above)

More than two thirds of Australia's start-ups believe they need funding to survive through 2016, according to the StartUp Muster Report 2015. Plenty of existing small businesses are also on the lookout.

 

" Too many start-ups try to do it alone and have a tight grip on their business but in doing so fail to leverage the experience of others."
Kate Gibson, General Manager Small Business Banking, Australia at ANZ

We're well into the New Year, so if you're one part of a startup or existing small business wondering how you're going to survive the next 9 months, you must be thinking of finance. But what kind?

There are a variety of financing options available to small business operators and start-ups, with equity financing, venture capital arrangements and crowdfunding platforms now all in the mix.

While a breadth of options is great, there are pros and cons to each, because each has different risks and returns for both you as the owner and for the party who provides the funding.

It's worth understanding what your options are and remembering it's not always a case of choosing just one – you can use different options in combination.

INTERNAL FUNDING

Bootstrapping is the traditional way to fund a small business. Australian Government research indicates personal savings are used by 50 per cent of all start-ups, with personal credit cards also popular.

If starting from scratch, using savings can help get you off the ground and, once operating, you can use cash flows from the business to fund growth. Optimising your available cash flow means understanding your working capital cycle really well.

So how can you improve the terms on which you source goods and services from suppliers? And how can you improve the speed with which you receive payment from your customers? This is a great article on the various ways you can improve your cash flow.

  • Advantages - You are not giving up any ownership of your company, therefore you get to keep control and enjoy all the upside your hard work creates.
  • Disadvantages - You can only grow as quickly as you can generate cash to do so. This means you may not be able to seize opportunities when they present, like a big contract you can't afford.

Three things to consider when funding business growth

  • Know what you need the funding for and what you can afford: understand your cash flows both short and medium term.
  • Pick the right combination of funding to meet your needs and cash flow capacity.
  • Find supporters and mentors: the advice you can get from those who've gone before you can be just as valuable as the funding you are looking for.

EQUITY FINANCING

TV shows like Shark Tank and Dragons' Den have shone a light on equity financing. Raising equity is generally the option high-growth businesses will look to when growth is dependent on deploying funds.

In cases like this the upside is speculative and inherently risky. As a consequence the investors are going to be looking for a high level of return by taking a stake in your business.

  • Advantages - Equity financing doesn't require immediate repayment, enabling investment for growth before cash-flow is established.
  • Disadvantages - Equity investors take a share in the company and the future profits it generates. You may need to sacrifice some control over the future direction of the business, depending on agreements reached with investors.

Click image to zoom Tap image to zoom

Illustration: Danielle Entwistle, ANZ.

Now let's consider some other possibilities in the funding universe:

CROWD FUNDING

More recently crowd funding has emerged as another form of equity financing with platforms like VentureCrowdOurCrowd and KickStarter, allowing entrepreneurs to pitch to a large number of small equity investors.

Whether these investors get equity in the company or early access to the company's goods or services (pre-sales) depends on the platform.

In 2014, 3.3 million people pledged more than $US500 million on Kickstarter to bring more than 22,000 projects to life. Australia's recently passed crowd-sourced equity funding bill seeks to make crowd funding easier for businesses and safer for investors.

DEBT FINANCING

Why would you go to a bank for finance? Well, debt financing whether from a bank or a credit union doesn't give the provider any direct share in the upside you create.

You don't give them any stake in your business, but you do commit to repayment of the funds over an agreed period. The return the debt financier earns is through the margin they make on the funds extended (the interest rate less the cost of funds).

Because of the need for regular repayments, debt financing is generally suitable for businesses already operating and have known cash flows they can use to meet the debt repayments.

To protect themselves against losing their capital, debt financiers will usually, but not always, require you to provide a form of security in case you are unable to repay the loan.

No matter which funding method you choose, there are some other important points to remember.

VALUATIONS CAN BE TRICKY

Typically the most complex aspect of raising capital through equity is an agreement on the valuation of the business. Many people I speak to are small-business owners with big plans for the future, with huge cash flow projections and a desire to succeed.

However, because these business owners are starting out and have already put everything into the business, they may have limited net assets, some losses due to significant upfront investment and potentially limited intellectual property.

These factors, along with differing valuation principles and methodology often make reaching the desired valuation difficult.

This in turn can make raising equity to fund their future growth a challenge. If you are interested in learning more about valuations www.business.gov.au is a good starting point.

TIMING IS EVERYTHING

Generally, the longer business founders can maintain ownership the more its value grows. That results in a smaller percentage needing to be sold down the track to achieve desired capital levels to fund expansion.

However, this is a double edged sword. The earlier the funds are acquired, even at the expense of a lower valuation, the faster a business should be able to accelerate. Having a smaller ownership in a bigger business can be preferable to owning the whole thing if it's worthless.

EARMARK THE FUNDS

Both debt and equity funders want to understand how the business will use the funds and this will be generally documented in the contract. It's vital every dollar is accounted for with a plan on how it will be deployed.

Paying out creditors and drawing funds out of the business are generally not well supported as these activities don't produce a return or grow enterprise values. Hiring, investing in systems and processes, protecting intellectual property and product development are all more attractive reasons.

Developing a business plan and cash flow forecast can assist with detailing this.

SURROUND YOURSELF WITH SUPPORTERS

Too many start-ups try to do it alone and have a tight grip on their business but in doing so fail to leverage the experience of others.

The start-up community is gaining momentum in Australia and with government and industry working together to help change the conversation around innovation.

In every major city, there are coworking spaces, mentors, speaker and networking events which open a world of potential investors, customers, partners and suppliers.

The value of these relationships is evident by the fact 25 per cent of start-ups use accelerators/incubators, according to the StartUp Muster Report, and 40 per cent of respondents said they couldn't have launched their start-up without them.

BATTLE THROUGH

I've been humbled at how generous many people are in the start-up community and importantly how willing other businesses are to share their insights and stories of battling through and winning.

Wayne Gerard at RedEye is a great example of this on the Brisbane start-up circuit. RedEye is a business ANZ proudly funded through its original $A1 billion start-up pledge. The group now has 80 employees spread across three global sites.

If you're still sitting there thinking about how to get the most out of your business this year, now is the time to do a business plan and get out there: good luck with building your business to be the best it can be.

Kate Gibson is General Manager Small Business Banking, Australia at ANZ

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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