Monday, January 17, 2011

Financing Your Business Part 1: Equity


Dear Investor Juan,

Many aspiring entrepreneurs fail to put their business ideas into reality because there's almost no way for them to access external financing, like through banks, for example. Most financial institutions have very strict requirements: banks, for example, require at least three years of operations; and even if the individual has real property that may be used as collateral for a business loan, it does not guarantee approval.

Based on my research and personal experience, banks charge an annual interest rate of 14 to 17%. Individual lenders (loan sharks), on the other hand, charge as much as 8% a month, which is equivalent to 96% annual interest. I guess this is the reality in the Philippines, where wealth distribution and access to capital are dismal.

What's the best way to finance a business startup? I fear that my personal funds won't be enough for the business that I have in mind, so I may have to turn to other sources.



Dear Anonymous,

Raising the necessary capital is the second most important challenge would-be entrepreneurs would have to face in founding a new business (coming up with a sound business model, of course, should be the most important concern for entrepreneurs, but that's a matter for another post). In forming your business, you would need to have enough cash for machinery and equipment, the purchase or lease of real property for your office and/or production facilities, investment in raw materials or merchandise, buffer or contingency funds, and registration costs, among others. And even if you're able to successfully form your business, eventually you'll need to expand, and your profits may not be enough to finance this growth.

Entrepreneurs turn to two main financing sources at the onset of the business: equity and debt (which are both considered external sources; internal financing comes from the business's earnings). Equity represents ownership in a business, and the consequent claims of owners on the earnings and assets of the firm; in other words, equity is money that comes from the owners and investors of a business. Debt is debt, money that comes with an obligation to repay the borrowed amount, plus interest, in future periods. Naturally, startups would have to turn to equity financing first as the business entity would have to first exist before it can borrow money, although entrepreneurs can also avail of personal loans to finance their businesses (something that will be discussed in Part 2).

Here are some obvious and not-so-obvious sources of equity financing.

1. Your own money. As an entrepreneur, staking some of your own money is something you cannot avoid (although in some cases, certain skills and non-economic assets can buy you a stake in a business as an industrial partner); in any case, risking your own money shows other potential investors and creditors that you are confident of the soundness and prospects of your business, so it becomes easier to convince them to take the plunge with you. But since most of the time you what you have won't be enough for your business (like in your case), you have to turn to other sources like...

2. Your family and friends. If you can't convince the people closest to you that you have a winning formula, how can you convince anyone else? But even if you are able to wow your family and friends with your business plan, unless you come from a clan of hacienderos or politicians, available funds will still most probably be limited. Also, before you ask your loved ones to be your business partners, remember that money can fray even the strongest ties, so try your best to convince everyone that it's not personal, just business.

3. Angel investors. These are individuals who have excess capital earmarked for investment in new new and existing firms. Since these investors are presumably very wealthy, they are likely to have more available capital than your family and friends.

Angel investors will likely just be interested in businesses that they are familiar with and industries with which they have extensive experience. Also, with their extensive experience, they can provide helpful advice and connections to you and your business.

I don't know any angel investor personally, but I'm sure we all know the type. The best example I can think of is the character "S.R. Hadden" of Hadden Industries in the 1997 film Contact starring Jodie Foster (it's a great film, you should see it).

4. Venture capitalists. These are organizations whose business it is to invest in startups; by investing early in a business's life, venture capital firms or VCs bet that phenomenal growth will follow if the business becomes successful. Like in the U.S. where the VC industry is much more developed, in the Philippines local VCs are also partial towards businesses that have a high-technology base, so if your just thinking of a kariton food business, forget it. But if you do get VC funding, you get to benefit from value-added services like management and technical assistance, strategic guidance, and network of contacts.

There are active VCs operating in the Philippines: perhaps the most notable of these are Narra Venture Capital and ICCP Venture Partners. For smaller scale businesses, there's the Small Business Corporation, a government-owned and -controlled entity that provided financing (both equity and debt) to small and medium businesses.

If you're considering approaching an angel investor or venture capitalist for additional financing, the most important issue you need to think of is having to give up partial control of your business to strangers. If you want to maintain absolute control, or at least keep it within your circle, you might want to just borrow your capital shortfall, which is something we'll discuss in Part 2.

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