Getting funding for your business is one of the biggest challenges when it comes to running your business. In this article, we look at the various options and their pros and cons.
For entrepreneurs, this may seem like the easiest and most straightforward route to funding a business. However, lots of intentional thought needs to precede a decision.
In terms of structure, debt is relatively straightforward. An amount is lent as principal, and interest accrues on the outstanding amount. However, what's crucial to understand (and often overlooked), is the capacity of the business to service the monthly payments as outlined in the payment schedules.
The key things to look out for when looking to take out a loan are below.
1. Loan use: What are the funds from the loan going to be used for in the business? Prudent use of loan proceeds would be towards funding a working capital gap (ie - to fund payment of suppliers before clients pay) or towards acquiring an asset that supports cash flow generation. Non-prudent use of loan proceeds includes the purchase of luxury/vanity assets that don't generate cash or financing of general operational expenses that can't be covered by revenue.
2. Payment schedules: In most cases, interest and principal payments are done monthly for the duration of the loan. This approach is mostly adopted by banks. In the case of venture debt (debt provided by venture capitalists and angel investors), the payment schedule is mostly structured in a manner that suits the company's cash flows. You could find companies that pay interest only quarterly and then pay part of the principal at the end of each year. The payment schedule is dependent on the type of business and the sector it operates in. In doing your research, ensure you choose a payment schedule that you're confident in making. It's all too easy to miss payments, especially in the volatile and uncertain economic times we find ourselves in.
3. Interest rate: A lot goes into determining an interest rate for a loan. Kenyan banks are first guided by the Central Bank Rate and are then allowed to place a margin on top of the rate for the different loan products they offer. There is a risk-return continuum that lenders prefer to keep in balance, the higher the risk, the higher the return.
When negotiating any loan, ensure to understand the various options you have in terms of the loan product, the collateral required, and the interest rate tied to it. For example, an unsecured loan (without any collateral) would have a higher interest rate while a secured loan (against a car, or a piece of land) would have a lower interest rate. Other lenders may take into account the type of business you're engaged in to determine a rate. The higher the perceived risk of the business, the higher the rate.
Finally, ensure to compare the rates among various lenders to get the best rate available. With increased competition amongst banks and digital fintech lenders, one is likely to see a wide range of interest rate offerings for the same product.
Other forms of debt financing:
Venture debt: In simple terms, venture debt is debt lent out by Venture Capital firms with a focus on early-stage companies. Venture debt is typically expensive, as the typical investees are early-stage companies fraught with numerous risks. As a result, venture debt is normally flexible in terms of tenor, rate and payment schedules.
If one is to consider venture debt, make sure to use the criteria set out above (use of cash, payment schedule and interest rate) to determine the possibility of repayment. In addition, venture debt tends to leverage the use of covenants (financial & information) covenants that compel the borrower to adhere to certain financial performance and furnish the lender with information and access to employees and information.
Digital fintech lending: There has been a recent wave of digital fintech lenders in the African space, all with a promise of instant access to cash, typically via a mobile phone or an application. Though most of these loans are targeted toward individuals, there are certain digital loan products that are tailored for small businesses.
Most, if not all, digital fintech lending products have high-interest rates and should only be considered if a business is making enough of a margin to cover this interest. If not, it would be safer to use one of the other options discussed above.
Convertible Loan Agreement: A convertible loan agreement (CLA) is a loan agreement that would eventually convert into an equity shareholding. To keep it simple, this type of loan is considered by businesses that are considering a long-term partnership with a debt provider/investor.
A key reason why an entrepreneur would opt for a CLA is that they consider the business to have massive equity value in the future and wouldn’t want to hand out a large piece of equity to an investor at the present value.
Another reason why an investor would opt for a CLA is that they consider the business too risky now to have equity shares and would therefore consider having returns from a debt investment until the company matures into a less risky profile.
Equity financing is selling shares in your business to finance growth & expansion. Equity financing can be complex in terms of structuring, valuation, and the types of long-term equity partners you would like to bring in.
If considering selling shares in your business, it is advisable to seek out professional financial consultants to handhold you during the process. Key things to consider when looking at selling shares in your business are below:
- Valuing your company: If a company’s valuation is lowered significantly than its intrinsic value, the business owner can be significantly diluted and cede a controlling stake in the business.
- Holding of majority voting shares: A finance professional can guide an entrepreneur not to cede a significant amount of voting shares in the company.
- Vision alignment with potential new equity shareholders: An entrepreneur must ensure that they are aligned in terms of business goals and objectives before inviting other new shareholders to the table.
Grant financing is mostly available for charitable foundations or organizations committed to a certain cause. Grant financing can be viewed as an affordable means to finance your business if the products/services serve a specific purpose linked to public or environmental benefits. Grants typically do not take the form of equity or debt and can be viewed as charitable donations to a company with an aim of advancing access to its products or services.
Grants can be structured in various ways, however, obtaining them is an arduous task that entails heavy due diligence and reports to ensure that the funds will be used towards the objectives of the funder. An entrepreneur should seek the guidance of grant consultants/managers/advisors when seeking grants to finance their business.
Before you seek any financing for your company, it is imperative that you understand your business intimately. This will enable you to know what kind of funding would work best for you, what you can repay comfortably and the stakes at hand. As always, it is important to do your due diligence and seek the advice of an expert, where necessary, before jumping in.