Unless your business has the Balance Sheet of Amazon, eventually you will probably need access to capital through SME Business Financing. For small businesses, finding the right SME Business Financing and funding model is vitally important. Take money from the wrong source and you may lose part of your company or find yourself locked into repayment terms that impair your growth for many years into the future.
Numerous small businesses are started each year. Despite businesses being different in terms of operations and products or services offered, they share a common aspect – they all need SME Business Financing at some point in their existence. If you have been running your business for some time now, you know that finding funds is not a simple task, especially in South Africa. If you are looking for simple ways to navigate the complex world of SME Business Financing, this short guide is for you.
In general, you can get SME Business Financing for your small business in three ways: Equity, Debt, and Mezzanine. Grant funding is also an option, which is not discussed in this Blog article.
SME Business Financing Guide 1: What is Debt Financing?
Debt financing is usually offered by a financial institution and is similar to taking out a mortgage or an vehicle loan, requiring regular monthly payments until the debt is paid off.
Advantages of Debt Financing:
- The lending institution has no control over how you run your company, and it has no ownership.
- Once you pay back the loan, your relationship with the lender ends. That is especially important as your business becomes more valuable.
- The interest you pay on debt financing is tax deductible as a business expense.
- The monthly payment, as well as the breakdown of the payments, is a known expense that can be accurately included in your financial forecasting models.
Disadvantages of Debt Financing:
- Adding a debt payment to your monthly expenses assumes that you will always have the capital inflow to meet all business expenses, including the debt payment. For small or early-stage companies that is often far from certain.
- Small business lending can be slowed substantially during recessions. In tougher times for the economy (or, in the current times we face with economic recession, COVID-19, loadshedding, and government corruption), it can be difficult to receive debt financing.
SME Business Financing Guide 2: What Is Equity Financing?
It comes from investors, often called “venture capitalists” or “angel investors.”
A venture capitalist is usually a firm rather than an individual. The firm has partners, teams of lawyers, accountants, and investment advisors who perform due diligence on any potential investment. Venture capital firms often deal in large investments (R20 million+), and so the process is slow and the deal is often complex.
Angel investors, by contrast, are normally wealthy individuals (HNI – High Net Worth Individuals) who want to invest a smaller amount of money into a single product/service/company instead of building a business. They are perfect for somebody such as the software developer who needs a capital infusion to fund the development of their product. Angel investors move fast and want simple terms.
In equity financing, either a firm or an individual makes an investment in your business, meaning you don’t have to pay the money back, but the investor now owns a percentage of your business, perhaps even a controlling one. For you to get capital for your business through this approach, you will have to sell an equity stake. Where equity is involved, you usually do not have to pay back the invested amount. The new party benefits from the cash flow, voting rights, and return on the investment, so effectively becomes a business partner in some sense or other. Some equity stakes are true business partnerships, while others are silent equity partners where there is no involvement in the business.
Advantages of Equity Financing:
- The biggest advantage is that you do not have to pay back the money. If your business enters bankruptcy, your investor or investors are not creditors. They are partial owners in your company and, because of that, their money is lost along with your company.
- You do not have to make monthly payments, so there is often more liquid cash on hand for operating expenses.
- Investors understand that it takes time to build a business. You will get the money you need without the pressure of having to see your product or business thriving within a short amount of time.
Disadvantages of Equity Financing:
- How do you feel about having a new partner? When you raise equity financing, it involves giving up ownership of a portion of your company. The larger and riskier the investment, the more of a stake the investor will want. You might have to give up 50% or more of your company. Unless you later construct a deal to buy the investor’s stake, that partner will take 50% of your profits indefinitely.
- You will also have to consult with your investors before making decisions. Your company is no longer solely yours, and if an investor has more than 50% of your company, you now have a boss to whom you have to answer.
Types of Venture Capital:
- Seed Funding: Seed funding or seed SME Business Financing occurs in the initial phase of an idea for an innovative product or service. It is reserved for product or service ideas that the venture capitalist is very excited about and feels that it will do very well in the market. Seed capital covers research and development costs associated with the idea and initial expenses such as conducting market research.
- Startup Financing: Startup financing occurs when the project has one full-time member of the management team working on it. That entrepreneur should be actively searching for other members of management to hire. At this point, the project, in the case of a product, should be in the prototype testing and finalisation phase.
- First-Stage Financing: In this stage, the product or service sold by the company has been fully launched, the company is 2-3 years old, but the goal now is to ramp up production and sales. The VC funding goes toward this by helping build the infrastructure of the company and distribution system, and covering marketing expenses.
- Second-Stage Financing: Second-stage financing takes place when a business’s product or service a business is selling very well. The financing goes toward the expansion of the business. It could be as simple as increased marketing expenses or as complex as entering new markets.
- Mezzanine (Bridge) Financing: Mezzanine financing is used at the end of a VC firm’s association with a company. It is used to either prepare a company for an initial public offering (IPO) to take it public. It can also be used to prepare a company for its sale to another company.
SME Business Financing Guide 3: What Is Mezzanine Capital?
Mezzanine capital combines elements of debt and equity financing, with the lender usually having an option to convert unpaid debt into ownership in the company.
Put yourself in the position of the lender for a moment. The lender is looking for the best value for its money relative to the least amount of risk. The problem with debt financing is that the lender does not get to share in the success of the business.
All it gets is its money back with interest while taking on the risk of default. That interest rate is not going to provide an impressive return by investment standards. It will probably offer single-digit returns. Mezzanine capital often combines the best features of equity and debt financing. Although there is no set structure for this type of business financing, debt capital often gives the lending institution the right to convert the loan to an equity interest in the company if you do not repay the loan on time or in full.
Advantages of Mezzanine Capital:
- This type of loan is appropriate for a new company that is already showing growth. Banks are reluctant to lend to a company that does not have financial data. A newer business may not have that much data to supply. By adding an option to take an ownership stake in the company, the bank has more of a safety net, making it easier to get the loan.
- Mezzanine capital is treated as equity on the company’s balance sheet. Showing equity rather than a debt obligation makes the company look more attractive to future lenders.
- Mezzanine capital is often provided very quickly with little due diligence.
Disadvantages of Mezzanine Capital:
- The coupon or interest is often higher, as the lender views the company as high risk. Mezzanine capital provided to a business that already has debt or equity obligations is often subordinate to those obligations, increasing the risk that the lender will not be repaid. Because of the high risk, the lender may want to see a 20% to 30% return.
- Much like equity capital, the risk of losing a significant portion of the company is very real.
- Please note that mezzanine capital is not as standard as debt or equity financing. The deal, as well as the risk/reward profile, will be specific to each party.
Whether you opt for an equity, debt mezzanine solution, it is essential to know that none of these options is either good or bad. The most appropriate SME Business Financing solution for your business is the one that meets your specific requirements.
More Information on SME Business Financing Options:
- Angel Investors: Angel investors can give you working capital for your business by buying a stake in your company. Besides the money, such investors can offer guidance and expertise in managing the business. However, it is quite challenging to arrange an angel investment opportunity. A potential investor will generally only put their money in a viable business, backed up by a strong business plan, with high growth potential.
- Crowdfunding: Crowdfunding has become a significant source of capital for small businesses in recent years. Businesses that focus on a human aspect tend to benefit more from crowdfunding than other business categories. The benefit with this financing approach is that all the money you receive is yours and you do not repay it. It might be challenging to benefit from this approach, especially if your business offers do not interest the crowd funders.
- Savings: Saving is one of the easiest ways of financing your business. Ideally, saving some amount for a given period gives you enough money to run your business. Despite this, most business owners are not able to raise sufficient capital from their savings for larger expansion projects or to manage unexpected situations where additional funds are needed. The insufficient income does not facilitate both daily operational spending and having some funds spare for savings. Saving to finance your business is a great idea; however, it can be inconsistent with the timeline of your capital requirements. It is advisable to avoid using insurance loans, home loans, and retirement savings to finance your business.
- Connect with a Lender Panel: Sometimes, finding the best small and medium business lenders can be challenging. Banks and traditional lending organisations might not be the best match for you for several reasons. For example, the time that these lenders take to address your loan request and process the application can be lengthy. However, some organisations offer you a chance to get a fast, reliable, and quick loan by smartly matching you with the right product and the best lender for your needs. Being able to apply for a loan in minutes as opposed to weeks may be just what your organisation has been looking for.
- Secure Debt: In secure debt financing, you will need to secure the loan using assets implying that the lender may possess the assets in the event that you default. Assets can be outstanding invoices from clients (Account Receivables), the company office or equipment (for example trucks, servers) and even newly purchased equipment, for example, if you are buying a new kitchen for your restaurant. Types of secured debt include factoring, reverse factoring, asset based lending (ABL), equipment financing, and mortgages.
- Unsecure Debt: In this case, you do not need any assets to secure the loan. The credibility of your business will be based on your time in business, cash flow performance and projections, industry risk, and customer-oriented risks. These facilities include working capital loans, lines of credit, merchant cash advances (MCA), and personal loans.