Choosing the right types of funding

There are three main ways to fund your business:

1. Use your own money, also known as bootstrapping.
2. Borrow, eg loans from a bank.
3. Seek investment in return for a stake in the business, also known as equity capital. This includes crowdfunding and investors.

Different sources might be more appropriate in certain industries or at certain stages of business.

Business planning and estimating start-up costs will give you an idea of which options are best for you. It can also be a good idea to talk to a financial advisor or accountant.

Introduction to business planning

How much money do you need to start a business?

Tips on getting financial advice

Whichever funding type you choose, it’s likely you will bear at least some of the costs of starting up. Common examples include:

• personal savings
• personal loan
• using your home, car or another personal asset to guarantee a loan.

Using personal finances for your business has its upsides. You won’t give up any control of your business, as you would if you got investors involved.

And if you seek investors later on, they are much more likely to back you if you can prove you’ve put your own money into the business.

Here’s an overview of how funding types typically fit with stages in a business’s lifecycle. If you’re on to your second or third business, you’ll likely have more options than someone new to business.

It’s common to have funding from a variety of sources. Which ones you use will depend on factors like:

• your stage of business, eg starting out, growing fast
• your industry
• how appealing you and your business — or your business idea — are to funders.

It’s worth exploring all sections to find funding options to suit your goals and your finances.

Good fit for

• Bootstrapping
• Asset finance

When you’ve got a great idea but not much else, you’ll need to rely on your own money or investment from friends and family. Most new businesses need $50k-$100k to get off the ground.

It’s difficult for those new to business to get a loan. If you do, you’ll be asked to use personal assets as security, eg your house. Even unsecured loans are hard to get because lenders will be looking at your cash flow, which might be non-existent.

Bootstrapping

This means starting a business using your own money. By keeping start-up costs low and using profit as the main funding source, you can bootstrap your new business without relying on bank loans or investors.

While it might sound like an ideal and easy way to kick-start your business, bootstrapping isn’t always the best option.

It works best for business models that don’t involve heavy spending to start up, and have the potential to quickly start making money. If your business might take a while to cover costs, it’s best to consider other options. Bootstrapping might put too much pressure on your savings or credit card.

If you think bootstrapping might work for you, it’s a good idea to talk to a financial advisor or accountant first.

Asset finance

Asset finance is a loan to pay for a particular asset, eg a delivery van. The lender buys the asset for you, then you pay them back in monthly instalments. The loan is secured against the new asset, or existing assets as well. They’re usually shorter-term loans, from 6 months to 5 years.

Make sure you understand the terms before signing anything.

Bootstrapping and Asset finance – upsides and downsides

Good fit for

• Reward-based crowdfunding
• Peer-to-peer lending
• Family and friends.

These funding types are all derived from individuals  – strangers, those you know, and people with businesses similar to yours – rather than from banks and financial institutions.

Peer-to-peer lending

Peer-to-peer lending is a process where you can take a loan from someone else (not a bank or any financial institution). It’s also known as social lending or crowd lending. Websites that could help you set this up are Harmoney and Lending Crowd. These websites connect someone who wants to borrow money directly to a lender or investors.

Crowdfunding

This is a popular way to get funding for creative work, but it’s also becoming a more common way to raise capital for entrepreneurial projects.

It’s much like charity fundraising. On a crowdfunding website you create an online campaign featuring your business, product or idea, and set a fundraising target. People then back your project.

You can offer incentives, eg gifts or company shares, in exchange for their money.

Do your research to make sure you pick a credible crowdfunding website. There are many, including ones based in New Zealand.

You are revealing your ideas to the public, so there are some risks to your intellectual property (IP).

Types of IP and how to protect them

Friends, family and fools

Your personal network is more likely to trust you and accept your business case than other types of lenders or investors.

But introducing money into a personal relationship can strain ties and damage trust. The critical business acumen provided by a professional investor will also be missing.

Select who you approach carefully. Make sure you formalise the arrangement with a signed contract setting out the terms and conditions. Having it in writing will help prevent any misunderstanding or disputes.

Crowdfunding, Peer-to-peer lending, Friends, family and fools – upsides and downsides

Good fit for

• Cash flow loans
• Credit cards
• Angel investors.

Which is the best fit partly depends on your industry. Banks are reluctant to lend to businesses without plenty of assets, so it’s hard for those in hospitality or tech to get secured loans. Some lenders look at cash flow — useful for businesses not yet making a profit but with high turnover.

Many banks and other lenders offer various incentives and fee structures for small businesses.

Cash flow loans

These are backed by your expected cash flow, not your assets. They’re usually used to help a business cover operating costs for up to a year.

If you’re new to business, loans might be the easiest way to get funding. You’ll still need to do some legwork to apply — and set time aside for business planning to make sure it’s the right decision for you.

Shop around for a loan that offers you the lowest interest rates.

Banks will need proof you can afford your repayments. If you’re new to business, you will most likely need to apply for a personal loan or extra borrowing on a mortgage. Once your business is more stable, other options are likely to be available.

Credit cards

Business credit cards are useful for smaller purchases.

Like bank loans, different banks offer various rates and perks. Compare terms and conditions, eg annual fees, interest rates, finance changes and cash advance options.

Your business credit card doesn’t need to come from the same bank you take a loan from or use for your personal finances — but it often pays to build up a good history with one bank. Banks might be more inclined to give better offers to clients they know and trust.

Advice on borrowing money(external link)

Angel investors

An angel investor is a successful entrepreneur who puts money into innovative new businesses, particularly those run by a person or team they believe in.

They typically pick businesses in their field of expertise so their knowledge and experience can help it succeed.

They might:

• Loan you money, which you will need to pay back under their terms and conditions.
• Take a percentage of your profits.
• Ask for partial ownership of your business.

Tips to get investors on board(external link)

Cash flow loans, Credit cards and Angel investors – upsides and downsides

Good fit for: Secured loans, lines of credit, equity crowdfunding, funding from profits.

It’s easier to raise capital as you’ll now have:

• a proven business model
• income
• financial statements showing your performance over time.

Even if your statements are in the red, investors and lenders will be interested if you can show how your business will make money. It’s worth also thinking about asset loans — for details, see the business idea section above.

Secured loans

Typically from a bank, these require you to have an asset the lender can take if you can’t keep up repayments. The size of the loan depends on the value of your assets, including invoices, accounts receivables and stock. Banks use LVR — loan to value ratio — to work out how much to lend, eg if your assets are worth $2,000 and the LVR is 60%, you can borrow $1,200.

Lines of credit

A set amount of credit — either time to pay a bill, or a dollar amount — from a supplier or lender. You don’t have to use it all. It’s like an overdraft managed in a separate account, or a revolving mortgage. Your credit limit depends on your business, but it’s typically between 10% and 50% of the value of your cash flow.

Line of credit lenders like Spotcap prefer to fund those with experience — even if a business venture has failed, you learn from mistakes.

Equity crowdfunding

This type of crowdfunding involves offering part-ownership of your business, rather than rewards. Equity crowdfunding websites like Seed Invest and Snowball Effect connect business owners to potential investors. Pledgeme offers this as well as reward-based crowdfunding.

Funding from profits

This means reinvesting any profits in your business. Make sure you forecast future costs and income, and model if it makes financial sense to spend your profits on the business.

Secured loans, Lines of credit, Equity crowdfunding and Funding from profits — upsides and downsides

Good fit for: Venture capitalists, convertible notes, trade finance, secured loans, funding from profits.

If you’ve got loans secured with personal assets, eg your house, switch to using business assets as security. See 18 months or more for details about secured loans and funding from profits.

Venture capitalists and private equity firms

Venture capitalists are interested in commercialised growth businesses at this stage, especially those with annual turnover of at least $10m and still growing. Private equity firms look for businesses with annual turnover of at least $20m, with proven business and cash flow models.

These investors often put in large sums, are more hands-on, and expect more control and ownership in return.

Convertible notes

Loans that turn into equity later on — usually at a later funding round. Investors loan money with the understanding they’ll get equity in the company at a cheaper rate than later investors.

Trade finance and letters of credit

This is for businesses that trade overseas only — it’s common among importers and exporters. Trade finance is when a bank guarantees a supplier you’ll pay for their product. The guarantee is called a letter of credit.

Venture capital, Convertible notes and Trade finance – upsides and downsides