Starting a new venture

Published: 11 June 2013

Starting a new business is an exhilarating, empowering and exciting opportunity. But like all business opportunities, it is accompanied by challenges – especially regarding the financing of your business. This week's newsletter sets out to explain how to access finance for a new venture by thinking about new sources of funding. Please note that you should fully investigate your financial options and make reasonable decisions based upon an adequate assessment of your finances with a qualified professional.

Debt, Equity and Sales
There are primarily three sources of funding for a business: equity, debt and sales. Equity is the contribution made by shareholders. Debt is the contribution made by external funders, for example, through loans, debentures and other loan mechanisms. Sales is the easiest type of financing to secure.

While you often do not need a lot of capital to start a business – you do need capital to sell. And, if your project requires a massive layout before you even start selling – you may be required to raise funds.

These funds are required, not only to cover operational expenses, but to enable you to sell your product. A lot of would-be entrepreneurs aim to raise enough money to pay their salaries. This is not the purpose of capital. Capital exists to ensure that you can get a return on your investments, it needs to be applied to make sure that you have a product to sell and that you are selling and delivering it – so that you can get paid. Some working capital may enter into the picture, but this should be directly linked to the amount of time it takes customers to pay you.

Recent financing trends

Some recent trends in acquiring funding are starting to change the entrepreneurial landscape and new opportunities for funding businesses are presenting themselves daily.

For many entrepreneurs, first tier funding from a commercial bank is simply not an option due to:

    extremely high security requirements;
    very high interest rates;
    complexity of schemes;
    complex methods of investment assessment; and
    long lead times.

Africa as a collective has a very poor venture capital market. Despite this, South Africa has a relatively strong venture capital market for a developing country (venturecapital, 2013). When looking at investments in venture capital as an expression of GDP, while investments in venture capital have declined since 2011, South Africa still performs well when compared to countries with similar economic conditions (venturecapital, 2013). Another fascinating aspect is that 76.9% of venture capital funding is related to Black Economic Empowerment (BEE).

However, there remains a desperate need to apply venture capital funding to new business creation and to improve the availability of low cost access to finance, which remains a significant hurdle to African businesses. Similar challenges are also faced by other developing countries.

The real challenge is getting access to capital that falls somewhere between banking rates and micro lending rates, without the complexity of public fundraising and listings. It would be logical to try to get a group of investors together to limit the risk of investment. The challenge is that managing a large group of investors in equity schemes is often very challenging. This requires a great deal of savvy to balance limiting the risk of investors with making good on the return promised to them.

Banks also require that new ventures have a proven track record – usually 1-3 years – making it difficult to use the collective will of a group of people as security for a loan or to get into a new industry.

The options are usually to

    save;
    take out a loan;
    take out a second mortgage;
    get a group of people to contribute an amount towards a central pool that can be used to seed an investment;
    raise money through family;
    get an angel investor;
    find an early stage venture capitalist that takes a higher stake while assisting the start-up; and
    work through business incubators.

Each of these options has its own set of corresponding pros and cons, and each may be variably suitable depending on your circumstances. As usual, it is important to investigate the real cost of the money that you are receiving. To work this out you need to get the full present value or full future value of each of the options in your business plan. Hidden costs such as interest, increases, and changes in multiples for selling or settlement need to be considered very carefully.

While it is possible to start a business with other people's money – it is also important to recognise that no one is going to give money away for free, and as a minimum, you will be required to serve the interest on any amount borrowed. Issues of control also enter the picture and you have to evaluate what value the investor will continue to add to the investment scheme. Before going into a deal, ask yourself: “How will I get out of this agreement if I need to?”

In addition, you are likely going to have to provide security for any investment, contract or major commitment that your company will enter into. This may be daunting, especially if you have to pledge your personal assets so that your new business can rent a photocopier!

With this in the background, it may be interesting to look at alternative sources of funding.

Alternative sources of funding

'Crowdfunding' is a type of funding premised on:

    a large group of investors, all contributing to a central pool;
    a guaranteed level of reward; and
    fees being managed.

There are currently an estimated 500 web services aimed at raising funds for kick-starting web sites. One such site, Kickstarter.com, provides a good example of a well-executed service in which different people can contribute to ideas, and “rewards” are given. For example, in order to raise $15,000 for a new game board development, the creators of the game offered a copy of the board game to anyone contributing more than a certain number of dollars. So this means that thousands of people took this risk just for the chance to win a copy of the game. The interesting aspect of this is that in the end, more than the original $15,000 was raised, allowing the team to focus on further expansion. In this way, the website was able to raise money by repaying contributors with a free product, or simply through a simple thank you. Websites are not free and range from charging 1-15% of the total profits for putting together the funding. But they allow access to a crowd, where different people in the 'crowd' bid to support ideas – the most successful ideas then become reality and create an investment that is worth investing in.

This type of value-added fundraising is likely to start dominating the landscape more frequently as investors combine and create low cost, high value ways to invest in start-ups and ideas.

Open source software has proven that this business model is a type of crowd fundraising. If you like a product, then contribute to it by promoting it or adding to it in any way you can. Everyone wins over time.

Other financing options in South Africa
Through BBBEE requirements in South Africa, there is an emerging type of investment in which companies give money to a central organisation, such as Raizcorp, to assist them in buying equity in emerging small businesses with the required equity requirements. The larger organisation takes care of the complexities. These investments create collective investment in smaller operations, while providing a return on an otherwise potentially wasted opportunity. By pooling collective requirements, new market opportunities often emerge.

Another interesting mechanism that is emerging is investing in your customer. Companies are trading equity in their customers for their products in large purchases. If your product or service can add significant value to your client, one mechanism may be to invest your services while simultaneously creating an increase in value. This captures the client for life, creates value for your investment, and helps both organisations prosper over time. While this idea is not new, it is starting to grow as a method for binding organisations together into co-owned value chains.

In the final analysis, the best way to make profit is still to buy and sell, and it may be more interesting to figure out how to get the money from your customers than from a bank. It may be better to start selling smaller amounts, make some money and use that to fund the growth of your idea.

Conclusion
There are many new and emerging ways to fund and grow your venture. You might not have considered them because they go against the grain and are not the traditional sources of funding we study in entrepreneurship. But it is a good idea to investigate alternative methods of acquiring funds, as these may turn out to be the foundation on which a successful business is built.

Reference:
Venture Solutions, 2013, 'Innovation, Management and Commercialisation', http://www.venturesolutions.co.za/ (accessed 4 June 2013).

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- Regenesys