Sources of funding

Introduction

"Money begets money. – John Ray"

Setting up your own small business or becoming a contractor seems very appealing to many computer professionals. Though many businesses finance start-up or expansion from personal assets, sooner or later virtually all business owners need assistance from a financial institution. It is difficult to do business without ever using credit.

[PISE] lists the various sources of funding available but the main focus of this report will be to discuss how these ‘financial packages’ appeal to us and the difficulties which company’s or entrepreneurs face to obtain these funds.

The report will try to conclude with a justification as to why one method is preferred to another and evaluate against the most commonly used source of funding today.

Grants and Government initiatives

Throughout the UK, there are hundreds of grants and support schemes available via many different organisations and institutions. However, the acceptance criteria of applications depend on many factors.

[Government Paper] suggests that grants should “play an important role in boosting other – perhaps more relevant – areas of the innovation system”.

The factors may include the area of business start-up, certain business sectors or specific sectors of the population.

Whilst considering the variety of grants available, I was surprised at the amount and range of grants available and the many acceptance criteria. In many cases, the acceptance criteria was so strict and the grants so small, that the effort involved in application, hardly seemed worth it.

‘In many cases, companies have to guarantee a full time position for a local person within one year of the grant. Note that often, new businesses cannot guarantee that their business idea will work or support themselves, let alone fund an additional person.’[Carol Graham].

The ‘loan guarantee scheme’ guarantees loans from banks and other financial institutions for small firms which have tried and failed to obtain a traditional bank loan through lack of security. The main drawback of this scheme is that many companies do not fit the criteria, or for companies that do fit the criteria, a large amount of time and effort is required in application. Often the amount of effort involved in the application for the scheme far outweighs the benefits.

However, It is relieving to know (at this moment in time), that Government bodies and Institutions are playing an important role in providing grants in the ‘technology’ area.

With UK’s struggling hi-tech jobs sector, the government is trying to encourage enterprise. A fairly large scale but illustrative example is ‘Insight Direct’ (a US software firm), which received a £15m "Regional Selective Assistance" grant, in return for deciding to build its £67m HQ in Sheffield. [ZDnet]

[Government Paper] also suggested that institutions and organisations should provide grants for businesses which are gearing towards technology. The most appealing quality, however, ...

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However, It is relieving to know (at this moment in time), that Government bodies and Institutions are playing an important role in providing grants in the ‘technology’ area.

[Government Paper] also suggested that institutions and organisations should provide grants for businesses which are gearing towards technology. The most appealing quality, however, is the fact that grants do not have to be paid back to the organisation which gave it.

Equity Finance/Venture Capital

This type of financing is provided by professionals who invest alongside management in young, rapidly growing companies that show the potential for significant growth.

With an ownership interest, these investors have a stake in the success of the business, and with the acceptance of a higher level of risk comes the expectation of a higher return. Not only do they provide capital, they also are generally active in the management of the business, participating in management decisions such as the development of new products or services and business strategies. [British Venture Capital Association].

The table below summarizes some of the pros and cons of venture capital.

Table 1 – Pros and cons of venture capital [Natwest Bank]

With extensive experience, these investors bring considerable business knowledge to an enterprise; they are valuable resources in managing its expansion and have a long-term orientation when evaluating a firm's potential. However, despite this longer-term focus, these investors also have a definite exit strategy. They expect, at some point, to sell their share of the business.

Banker’s Loans

Unlike the venture capital business, banks are lending their depositors money and therefore operate on a much lower risk tolerance. Because bankers have a very low tolerance for error, they conduct careful analysis of a business's financial strength and ability to service the debt from its operations and cash flow. Banks can lend money to either purchase business assets, or to provide ongoing funding for business operations. In either case, banks carefully analyse the capacity of the business to generate the funds to repay the loan. Therefore, typically, banks rely on at least two years of financial statements and the business's track record of meeting its obligations to evaluate credit worthiness and debt-service capability. If it’s a new business then a concise business plan is required which will be thoroughly investigated. Bankers also recognize the need to provide financial planning assistance and specific financial management guidance but do not assume the same day-to-day management involvement as would a venture capital investor.

That being said, most people still imagine the loan officer as a big-headed man, sitting on a black leather chair behind a great oak desk, studying every little detail about their customer.

Luckily, things have changed; there are a lot more funds available to people, and you no longer have to beg for a loan. In fact, it's quite the opposite; banks are now fighting each other for the opportunity to gain new clients, or at the minimum, retain their current ones.

This fear of banking loan officers led some people to seek out a more certain alternative to meeting their financing objectives. Some people are so stressed about meeting banking loan officers, and are so sure that they'll be refused a loan, that they'd rather skip the whole process and jump right into dangerous waters with loan sharks and pay the exaggerated interest rates in exchange for their no-nuisance policy.

‘Today, most bankers are desperate to lend you money. There is an abundance of idle cash to lend, and the only way for banks to make money is to lend it -- even if it is at only a few percentage points higher than what it's costing them to hold the money.’ [Financial Times]

In my opinion, loan officers and banks are starting to feel the pressures of finding new customers. In some cases, according to the [Financial Times] they even have monthly quotas to fill.

Till this day, banks remain an important source of funding for small businesses.

Conclusion

Although very different, each of these providers of business capital faces a similar challenge - how to obtain quality information on the financial and managerial capacity of the enterprise. A problem facing all small business lenders or investors is the difficulty in gathering data that is certified or easily verifiable.

Because very little public information on small businesses is typically available, capital providers must collect proprietary data from the small business owner. As a result, strong relationships between entrepreneurs and their capital providers are critical to ensure access to and continuity in funding. [Financial Times]

To conclude, grants and other incentive schemes are attractive by the fact that they are not repayable, however the process by which one can obtain a grant is an extremely lengthy and tedious process as well as having many criterion to meet.

Venture capital/Equity Finance is also an extremely popular way to fund small businesses and entrepreneurs mainly due to the fact that large amounts of funds are available at no chargeable interest. These schemes have the added benefit of allowing their own experienced professionals to make management decisions of the business. This however, may not appeal to some people who would rather not share control of their business.

Banker’s loans are, by far, the most common sources of funding for small businesses. [Financial Times] states that last year, approximately 37% of funding for small businesses and entrepreneurs were obtained by banks and the remaining 63% covers other sources. The exhaustive, unappealing application process for which bankers loans were famous for, are now becoming a thing of the past.

Bibliography/ References

[PISE] – Professional Issues In Software Engineering – Frank bott

[ZDNet] – – Government aid brings tech jobs to Yorkshire.

[Carol Graham] – Sources of funding for businesses – Carol Graham (2000).

[Financial Times] – – The truth about bank loans.

[Natwest Bank] – Business Information Fact sheet, Seeking Venture Capital.

[British Venture Capital Association] –

[Government Paper] – - The use of incentives to boost innovation.