Borrowing from banks is every small entrepreneur’s nightmare. One gets turned down for bank loans for a variety of reasons, including lack of assets, collateral and business experience. Don’t despair, however. There are several common types of alternative sources of capital for setting up a business available to young companies.
Savings and Investments
The first source you should consider is your own savings and investments. One disadvantage though of self-financing is that if things did not turn out the way you want them to be it will be your money that goes down with the ship.
Angel investors are affluent individuals who provide capital for a business start-up, usually in exchange for ownership equity. These individuals are looking for a higher rate of return than would be given by more traditional investments (typically 25% or more).
Angel investors are an excellent source of early stage financing and high-growth start-ups. They are often willing to tread where there is too much risk for banks and not enough profit potential for venture capitalists. And since angel investors are often retired business owners and executives, they can also provide valuable management advice and important contacts.
Peer to Peer Lending
Peer-to-peer lending is a means by which borrowers and lenders may transact business without the traditional intermediaries, such as banks. It can also be known as social Lending, ordinary people lending money. The process may include other intermediaries who package and resell the loans–examples are Prosper.com and Zopa-but the loans are ultimately sold to individuals or pools of individuals. Prosper.com, which is available in the US only, offers business loans for small companies.
An enabling technology for peer-to-peer lending has been the internet, which connects borrowers with lenders, for example through an auction-like process in which the lender willing to provide the lowest interest rate “wins” the borrower’s loan. (wikipedia.com)
Instead of a bank loan, borrow smaller sums from several family members, friends, or colleagues. The lenders have no legal ownership in the business, but can act as advisors and cheerleaders for your venture. Remember though that nothing causes tension in a family like lending money that is never paid back.
Many business owners use their credit cards to fund their businesses. Credit cards offer the ability to make purchases or obtain cash advances and pay them at a later time. But as a long-term financing method, they can be expensive. Most credit cards will charge you 2% to 4% of the face value of a cash advance as a “fee” making this method of financing very risky.
Another source of capital for setting up a business is bootstrapping. It is a way to finance a business by saving rather than borrowing money. It’s being as frugal as possible so your business can be started on as little cash as possible.
The use of private credit cards is the most known form of bootstrapping, but a wide variety of methods are available for entrepreneurs. Other forms of bootstrapping include owner financing, minimization of accounts receivable, joint utilization, delaying payment, minimizing inventory and subsidy finance.
While bootstrapping involves a risk for the founders, the absence of any other stakeholder gives the founders more freedom to develop the company. Many successful companies including Dell Computers were founded this way.
Venture capital is not suitable for all entrepreneurs. It is an option for small companies that have a seasoned management team and very aggressive growth plans; however, venture capitalists will rarely invest in small businesses that have no intention of going public. If a company does have the qualities venture capitalists seek such as a solid business plan, a good management team, investment and passion from the founders, a good potential to exit the investment before the end of their funding cycle, and target minimum returns in excess of 40% per year, it will find it easier to raise venture capital.
The venture capitalist objective is to invest in a company for a short period of time – say 5 years – and then cash out of the business while making a significant return on their investment.