Small and medium-sized enterprises (SMEs) are vital to our economy, yet securing funds is a common hurdle they face. Financial backing is essential for SMEs to cover daily operations, manage inventories, seize growth opportunities, expand, scale activities, and invest in R&D, among other needs. With the right funding and advice, an SME with a unique business idea can grow into a substantial enterprise.
When a business seeks capital, several crucial factors must be considered:
- Financial requirements assessment
- Required funding amount
- Business revenue
- Collateral through personal assets
- Ownership of business property
- Willingness to sell shares
- Repayment terms
In this chapter, we'll explore various ways SMEs can raise capital and how these funding sources align with different business growth stages.
Stages of Business Funding
Let's start from the beginning. Imagine someone with a unique idea that could blossom into a successful business. To turn this vision into reality, they need initial funding. Here's how an SME can secure the necessary capital:
Stage 1: Self-Financing or Bootstrapping
Initially, convincing others of a business idea's viability can be challenging. At this point, funding often comes from personal resources in what is known as self-financing or bootstrapping. This method involves using personal savings or income to finance the business.
Stage 2: Funding from Family and Friends
Once you persuade those closest to you of your business's potential, you can secure financial support from family and friends. They might provide loans or take equity in the business.
Stage 3: Angel Investors
Angel investors are a natural extension of the previous stage. They can be family, friends, or other individuals with surplus funds who invest in exchange for equity or convertible debt. These investors provide seed funding at the business's early stages, acting as 'angels' by backing the entrepreneur when future success is uncertain.
Stage 4: Debt Funding
As the business model solidifies, more funds are needed. At this point, debt financing becomes an option. This involves borrowing from external sources, each with different interest rates:
- PSU banks (with collateral): 8-9%
- Private banks (less collateral): 9-10%
- NBFCs (partial or no collateral): 11-14%
- Lower-tier NBFCs (no collateral): 14-18%
- AIFs (Alternative Investment Funds, no collateral): 16-24%
Entrepreneurs typically prefer PSU loans due to lower interest rates. However, strict documentation and collateral requirements can make this challenging for young businesses, making AIFs and NBFCs attractive alternatives.
Stage 5: Equity Funding
Once the business model is established, entrepreneurs can seek equity financing through various fundraising rounds before going public. Venture capitalists (VCs) invest funds raised from private individuals, pension funds, and insurance companies. VCs can invest between Rs. 3 crores and Rs. 40 crores, taking a share of the company in return.
VCs invest when they understand the business's scalability. In Pre-Series A funding, VCs invest at a discounted rate, improving valuation. Actual investors come into play in Series A financing, where VCs and large family offices invest in revenue-generating companies.
As the company grows, private equity (PE) investors enter, often investing a minimum of USD 5 million, while VCs typically exit. Companies may go through multiple funding rounds (Series C, D, E, etc.), each with different valuations. After Series D or E, companies might go public, offering PEs an exit through a sale.
Aside from these stages, entrepreneurs can explore incubators, accelerators, government programs, peer-to-peer lending, and crowdfunding, though these sources aren't always available.
SME Fundraising Stages and Strategies
Funding sources often correlate with a company's growth stage. A new company can't secure a bank loan or go public immediately. Each financing source fits a particular growth stage. Here's an overview of appropriate funding sources for each stage:
| Stage of the Company | Stage Description | Suitable Source of Financing |
|---|---|---|
| Pre-seed Stage | Business idea stage | Bootstrapping, network funds, grants |
| Seed Stage | Proof of Concept phase | Angel investors, government schemes, incubators, crowdfunding, accelerators |
| Series A Stage | Growth stage, revenue generation starts | Venture capitalists, bank loans |
| Series B, C, D, E | Expansion stage | Venture capitalists, PE investors |
| Exit Stage | Transition to large company | Pre-IPO capital, IPO, bonds, debentures |
Each stage comes with its own set of suitable funding sources, ensuring that the company's financial strategy aligns with its development phase.
Comparing Fund-Raising Methods
In this section, we'll compare different fundraising methods to highlight their key differences and help you choose the most suitable approach for your organization.
Equity Financing vs. Debt Financing
| Feature | Equity Financing | Debt Financing |
|---|---|---|
| Definition | Raising capital by selling shares, diluting ownership | Borrowing funds with a repayment obligation |
| Ownership | Investors gain ownership and share in profits/losses | Lenders are creditors without ownership rights |
| Return on Investment | Returns via dividends and capital appreciation | Regular interest payments and principal repayment |
| Payment Obligation | No repayment obligation | Must repay borrowed funds with interest |
| Risk | Ownership dilution | Repayment pressure |
| Decision Making | Investors have a say | No business involvement |
| Sources | Angel investors, IPOs, crowdfunding, incubators, VCs, PEs | Government loans, banks, financial institutions, government schemes |
IPO vs. Bank Loan
Choosing between an IPO and a bank loan involves several factors. While many SMEs go public to raise capital, some prefer bank loans. Here's how the two compare:
| Feature | IPO | Bank Loan |
|---|---|---|
| Growth Phase | Public offering after business establishment | Loan post-seed funding stages |
| Access to Capital | Large capital pool without repayment stress | Short-term needs with repayment obligation |
| Ownership | Ownership dilution | No ownership dilution |
| Interest Payments | No interest obligation, but dividends improve shareholder value | Interest payments mandatory |
| Duration | Lifetime until repurchase, dissolution, or share sale | Short-term with specified repayment period |
| Repayment | No repayment obligation | Must repay principal and interest |
| Increased Visibility | Boosts market visibility and credibility | Not possible with a bank loan |
| Liquidity for Owners | Share sales provide liquidity | No such opportunity with loans |
| Regulatory Requirements | Compliance with costly regulations | No regulatory requirements |
Key Takeaways
- Companies can tap into various funding sources, opting for equity, debt, or a combination.
- Fundraising strategies vary by company stage.
- Self-financing, grants, or prize money offer limited early-stage funding.
- Choosing the right funding method depends on a company's needs, growth phase, and goals.