Small businesses face many issues in comparison to the well established organizations. However, among several issues one of the major issues that small businesses face is to raise capital. Many small businesses and entrepreneurs may have the ability to make their organization a big organization however because of lack of investment they are not able to do so. With the increased risk in the market, banks and venture capitals have also become very much risk averse instead of accepting the risk and growing their investment. This has also lead to such situation where small businesses face different issues in raising funds to grow their business.
This article discusses about one of the main issues that small businesses and entrepreneurs face in expanding their business, problems in raising capital particularly in the current climate. Moreover, the article evaluates different financing alternatives that the small businesses have along with pros and cons of these alternatives. In addition to this, the article discusses about financial information that investors would like to know before making the investment decision in any business and to evaluate the riskiness of the business or investment.
DIFFICULTIES FACED BY SMALL BUSINESSES IN RAISING MONEY IN THE CURRENT CLIMATE
After the recession, investors have become reluctant to invest their capital. Even if investors are investing their money, they are evaluating the risk and making sure that their investment yields positive returns as even investing in big organizations have yielded negative returns in the last few years. Not only the general investors, but even banks have become reluctant in making investment in different businesses particularly new start-up businesses. Therefore after the recession, it has created problems for small businesses to raise money.
A research conducted by Barclays Bank has revealed that one third of the students would like to setup their own business in future (Hilpern, 2006). Considering the aims of the students, it would be difficult for such high ratio of students to start their business as raising capital has become difficult in today’s environment. Banks and venture capitalists are among the top most sources of financing used by small businesses. Banks and venture capitalists are now more closely analyzing the risk of their investment and analyzing the feasibility of the business before providing the capital to the business owners (Brav, 2009).
It has been found that loans and capital distributed in the United States through Small Business Administration have considerably reduced by 20% in the year 2012. Thus, it is showing that the situation has still not improved although the economy is showing signs of recovering the recession. Moreover, business plans submitted by small businesses and entrepreneurs with the aim of raising funds have been rejected by investors and venture capitalists. To be precise, only 2% of the business plans received have been able to successfully raised funds from investors (Prive, 2012).
Ifeanyi (2011) has said that there has been a drastic decrease in lending of small business in the last few years. SBA report published in the year 2011 has revealed that the value of small business loans in the year 2010 has been equal to $652 billion which has considerably decreased from the year 2008 where this value was equal to $712 billion (Ifeanyi, 2011).
ALTERNATE SOURCE OF FINANCING 600 WORDS
There are different sources of financing that businesses can use in order to raise capital. Broadly, these sources of financing can be segregated into two types; internal and external sources of financing (Gaff, Kimball, & Hanson, 2012). Internal sources of financing are basically the sources of financing that an organization generates from the entrepreneurs or the directors. However external sources of financing consist of raising capital from outside the company (Gitman, 2003). There are different internal and external sources of financing and this article now will discuss some of the alternatives that small businesses can have in order to raise capital.
Internal sources of financing
Not only small businesses but even large corporations use retained earnings as the main source of financing and investing. However small businesses are either not able to earn so much profits that they could use and reinvest it and make sure that their financing needs are fulfilled. Therefore, the major drawback of retained earnings for small businesses is that it is not as high as big organizations and thus, it is not able to meet their needs. However, the advantage of this source of financing is that it will cost the entrepreneur or small business less than other financing options (Lee, Lochhead, Ritter, & Zhao, 1996).
Investment from the directors
Generally, directors or the entrepreneurs have already invested their capital in the business. But still, the directors can further increase their investment and help the business to generate more funds.
External sources of financing
Bank loans is one of the most used external sources used to finance the capital not only by small businesses but by large corporations as well. However the major disadvantage of loan from the bank is that the business has to generate sufficient cash flows in order to repay the installments or the finance cost. Although different banks are offering loans for small businesses as well however if the business is not able to repay its payments then it could lead to bankruptcy. After the recession, there has been a significant decline in the loans provided to small businesses by banks and venture capitalists (Ifeanyi, 2011).
Some banks allow entrepreneurs to allow flexibility in paying their finance cost. Moreover, if the business expects cash flows immediately then it can be a good option instead of sharing the stocks or equity of the business with the venture capitalists. As this source of financing would allow the business to take advantage of leverage as well as achieve higher profitability ratio.
Venture capital is the individual investors that invest in businesses generally at the early stage of the business and thus the risk of investors is high. However, the investors are able to earn money by sharing the profits from the business. For small businesses, venture capital is an important and advantageous source because businesses do not have to pay a fixed cost for raising the capital. However, if the business is able to make good profits, then higher share has to be given for raising the capital and thus cost of capital becomes high (McLaney, 2009).
Crowd source funding
Crowd source funding is another source of external financing. The concept of crowd source funding is raising capital by encouraging different people to invest money generally through internet. The equity of the investment is shared among different investors (Clawson, 2011). However, people believe this investment source as risky and therefore people, in this recessionary period, would prefer more secure investment rather than investing in risky businesses. On the other hand, there are advantages of raising capital via crowd source funding as well and some of the advantages include; it is easier to raise money, it reduces the risk of the business, and it also acts as a marketing tool (Prive, 2012).
The concept of crowd sourcing has been showing an increasing trend and it has been found that the capital raised through this source would reach up to $2.8 billion in the year 2012. This figure shows an increase of almost 91% from last year (Prive, 2012).
Loans and card payments
There has been an increasing trend of financing through secured against credit cards and debit cards. In this concept, the capital raised is repaid whenever the customer makes a payment to the credit or debit card. For the capital, the bank charges 20% of the amount till the time the total capital raised is not refunded. Generally small businesses use this concept of financing. The advantage of this source of financing is that the entrepreneur has to repay the loan according to the cash flow of the business. So if the cash is received quickly, then it will lead to quick repay of payment. Collin Brown who is the owner of the Chef Collin Brown restaurant operating in the region of East London has used this source of financing in order to purchase equipments for the restaurants and to create iPhone application (Clawson, 2011).
Government also assists different technology based businesses and innovative industries by giving funds so that it helps in improving the economic condition of the country. Nascent Green Investment bank is the prime example of government assistance in providing funds to invest in low carbon economy (Clawson, 2011).
The main advantage of this source of funding is that it is for small businesses that are starting their business as well as businesses that are looking to expand their business. Moreover, having access to funds is easier than other sources for technology based businesses (Clawson, 2011).
DESCRIPTION AND EXAMPLES OF FINANCIAL INFORMATION WOULD NEED
Before making the investment decision, investors, venture capitalists and banks require some information in order to analyze the feasibility of the investment as well as analyze the risk of the business. Some of the most important financial information that investors need to look at and know before making the investment decision has been discussed below:
One of the major financial information that banks and investors look at is the profitability ratio of the business. Profitability ratios include ratios such as net profit margin, operating profit, gross profit margin. This allows the investors to know the ratio of profits that the business would yield if the investment is made in the business.
The main objective of every investment is to earn the highest profits by taking the least risk, and therefore investors use profitability ratios to analyze the profitability and risk of the business. Investors not only analyze the total amount of profits, but in the profitability ratios as well. By using profitability ratios they are able to analyze the return from different investment options (Swedberg, 2000).
Return on investment
The other important information that investors look for is the returns on the total investment being made. This allows the investors to know the returns that the business would yield on money they have invested. Investors not only look for the highest returns but they also analyze the riskiness and probability of achieving such profitability (Swedberg, 2000).
Probability of success and market potential
Investors also use the probability of achieving the success by analyzing the good, bad and average conditions. For instance, the investors tend to analyze the worst situation that the business can go through and the profits that would be achieved at this condition. Thus this allows the investors to know the worst that can happen to their investment. Moreover, the potential of the market is important. Netflix, the famous rental DVD providers was able to raise money because of potential in the market (Berry, 2005).
Present value of the investment
Many investors need to know the timings of the cash flows before making the investment decision. Investment might look profitable in terms of numbers, but if it is analyzed and discounted and its present value is calculated then investment decisions can be changed. Therefore some investors use project appraisal techniques such as Net Present Value (NPV), Internal Rate of Return (IRR), Profitability Index (PI), payback period and such techniques to analyze the feasibility of the project.
Raising capital is important for every business to grow and take the advantage of the opportunities available. However it is important for entrepreneurs to analyze the feasibility and cost of funds as too high cost of finance can reduce the profitability and sharing the equity can lead to reduction in long term profits. Therefore, the right source of financing should be used.
List of References
Berry, T. (2005). ‘What Investors Look For in a Plan’. Entrepreneur, Available at http://www.entrepreneur.com/article/79834 [Accessed 13 January 2013]
Brav, O. (2009). ‘Access to capital, capital structure, and the funding of the firm’. The Journal of Finance, vol. 64, no. 1, pp. 263-308.
Clawson, T. (2011). ‘Alternative finance’. Director, Available at http://www.director.co.uk/MAGAZINE/2011/6_June/special-report-alternative-finance_64_10.html [Accessed 13 January 2013]
Gaff, B. M., Kimball, R. N., & Hanson, J. M. (2012). ‘Raising Capital: Where to Find It, How to Secure It, and Tips on What to Avoid’. Computer, vol. 45, no. 7, pp. 11-13.
Gitman, L. (2003). Principles of Managerial Finance. Addison-Wesley Publishing: Boston.
Hilpern, K. (2006). ‘How to start your own business’. The Independent, Available at http://www.independent.co.uk/student/magazines/how-to-start-your-own-business-409816.html [Accessed 13 January 2013]
Ifeanyi, K. (2011). ‘New Rules of Getting a Small Business Loan’. Inc. Available at http://www.inc.com/guides/201106/small-business-loans-new-rules.html [Accessed 13 January 2013]
Lee, I., Lochhead, S., Ritter, J., & Zhao, Q. (1996). ‘The costs of raising capital’. Journal of Financial Research, vol. 19, pp. 59-74.
McLaney, E. (2009). Business Finance: Theory and Practice, Pearson Education: New Jersey.
Prive, T. (2012). ‘Top 10 Benefits Of Crowdfunding’. Forbes, Available at http://www.forbes.com/sites/tanyaprive/2012/10/12/top-10-benefits-of-crowdfunding-2/ [Accessed 13 January 2013]
Swedberg, R. (2000). Entrepreneurship: The Social Science View. Oxford, Oxford University Press.