1. Ways to raise funds for business

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Find various ways of raising capital for SMEs and understand the relationship between the source of funding and the growth stage of the business.

Content:

Business funding stages
SME Fundraising stages and funding strategies
Comparison of fund-raising methods

Small and medium-sized enterprises (SMEs) are the backbone of our economy, but they often face financial challenges. Financial resources are very important for SMEs as they need funds to cope with their daily expenses, manage their inventories, take advantage of growth opportunities, expand their business, scale up their activities, invest in research and development and much more. An SME with a unique business idea and great potential can turn into a big business if it gets the funding and the right advice.

A company must consider the following important factors when seeking to raise capital.

Assessment of the financial requirements
Amount of funds required
Business revenue
Use of personal assets as collateral
Ownership of business property
Willingness to sell shares
Repayment terms

In this chapter, we will go through various ways of raising capital for SMEs and also understand the relationship between the source of funding and the growth stage of the business.

Business funding stages

Let us start from scratch. Suppose a person or a group of people has a unique idea that they believe can make a good business. However, in order to turn the idea into reality, they need funds to start their venture and eventually turn it into a big business. Let us take a look at how an SME can raise money for their business venture.

Stage 1: Own funds (self-financing or bootstrapping)

In the beginning, no one believes that the business idea is feasible. Therefore, it is very difficult to get money from a source other than your own money. Investing your own funds in a business is known as self-financing or bootstrapping. This is a way of financing small businesses with the owner’s resources, i.e. personal savings, income from the business, etc.

Stage 2: Funds from family and friends

Once you have convinced your close associates and acquaintances of the desirability of your business venture, you can raise funds from relatives and friends. They may offer to finance your business either as a loan or by taking a stake in your business.

Stage 3: Angel investors

Angel investors are an extension of stage 2. Angel investors can come from the entrepreneur’s family and circle of friends, or ambitious individuals or groups of individuals with surplus funds who invest their own funds in a business in return for equity or convertible debt (that is later converted to equity). As the name suggests, these investors act as angels by supporting the entrepreneur in the early stages of their business with seed funding. Seed financing is the financing of a business at a very early stage, when the future of the business is not yet certain. Seed financing begins when an investor buys your idea.

Stage 4: Debt Funding

The entrepreneur needs more funds to establish their business model. The next source that can be tapped is therefore debt financing. Debt financing involves borrowing from external sources.

Below are the sources of debt financing with the approximate interest rates charged by each of these sources, in ascending order.

Public sector undertaking (PSU) bank (with collateral) – 8-9% interest charges
Private sector bank (less collateral) – 9-10% interest charges
NBFC (partial or without collateral) – 11-14% interest charges
Lower tier NBFC (without collateral) – 14-18% interest charges
AIF (Alternative investment funds) (without collateral) – 16 – 24% interest charges

Ideally, any entrepreneur would prefer a loan from a PSU because of the lower interest rates. However, since the business is not yet fully established, it is difficult to obtain a loan from PSUs and private banks due to strict documentation and collateral requirements. Therefore, at this stage, funds can be raised from (AIFs), non-banking financial companies (NBFCs) or high-risk takers who are willing to offer loans to businesses at higher interest rates and without collateral.

Stage 5: Equity Funding

Once the business model has been established, entrepreneurs seek equity financing through various rounds of fundraising before going public to raise capital.

Seed or pre-seed financing via venture capitalistsVenture capital (VC) are companies that invest funds raised from various private individuals, pension funds, insurance companies, etc. A venture capitalist can invest anywhere between Rs. 3 crores to Rs. 40 crores in a company, depending on its needs, and receives a certain percentage of the company’s shares in return. The shelf life of VC funds is up to 3 years.A venture capitalist invests once he understands the business and has an idea of its scalability.
Pre-Series A FundingIn Pre-Series A funding, VCs invest in the company at a discounted rate that allows for a better valuation. Up to this stage, investment is only on the promoter and the company. The actual investor only comes into play in the next round, i.e. Series A financing.
Series A financingSeries A financing is carried out by VCs and large family offices. This is ideally the proper round of funding when actual investors desire to invest their funds in an established company that is capable of generating revenue.The VCs invest the pooled funds of other investors and large family offices which are private companies that invest the funds of wealthy families to generate high returns and achieve diversification.
Series B financingThis is another round of financing when the company has built up a brand image. At this stage, private equity (PE) investors with a minimum investment capacity of USD 5 million look to invest in the company. VCs usually exit at this stage.
Series C, D, E financingThe company can raise funds in several rounds depending on its needs and growth plans. Each successive round is referred to as Series C, D, E, etc. The PEs invest in the company at different valuations. Once the company is fully established, it aims to grow into a large company with further expansion plans. At this stage, the company may seek an IPO.
IPO (exit phase)Generally, after a Series D or E financing round, a company decides to go public, where PEs want to exit the company through an offer for sale.The above steps are the general funding cycle. Apart from this, entrepreneurs can also avail funds from incubators, accelerators, government programs, peer-to-peer lending and crowdfunding. However, it is not always possible to get funding from these sources.

SME Fundraising stages and funding strategies

The source of funding is generally related to the stage of the company. A newly founded company cannot obtain a bank loan or go public in the early stages. Therefore, each source of financing is relevant to the growth stage of the company. Below you will find an overview of the appropriate sources of financing depending on the stage of the company

Stage of the company	Stage Description	Suitable source of financing
Pre-seed stage	You have a business idea and want to start a company	BootstrappingFunds from your close network.Grants
Seed stage (pilot project)	Idea is converted to real product/service. Phase in which the product/service is tested to see how the it works in the market , also known as Proof of Concept	Angel investors.Government schemes.Incubators.CrowdfundingAccelerators.
Series A stage(Growth stage)	The launched product was a success, the business idea is viable and revenue generation has begun. In this phase, the company needs funds for product development.	Venture capitalist.Bank loans.
Series B,C, D, E stage(Expansion)	The company has reached stability and wants to expand further.	Venture capitalistsPrivate Equity Investors.
Exit stage	Transition from start-up to large company and further expansion	Pre IPO capital.IPOOffer for sale.BondsDebentures.

Comparison of fund-raising methods

In this section, we will compare some fundraising methods in order to identify the main differences and select the most suitable methods for the organization.

Equity financing vs debt financing

Feature	Equity Financing	Debt Financing
Definition	In equity financing, capital is raised by selling shares in the company (diluting ownership) to investors in exchange for cash.	In debt financing, funds are borrowed from lenders (e.g. banks, financial institutions or private lenders) with the promise to repay the principal plus interest over a certain period of time.
Ownership	Investors who acquire equity (shares or stocks) become part owners of the company and share in its profits and losses.	Lenders do not receive ownership rights in the company, but are creditors who expect the borrowed funds to be repaid with interest.
Return on investment	Investors generally expect a return on their investment in the form of dividends (if issued) and/or capital appreciation.	The company must make regular interest payments and repay the principal in accordance with the terms of the loan or bond agreement.
Payment obligation	No obligation to repay funds to investors.	The funds raised through loans must be repaid with interest within a certain period of time.
Risk	Dilution of company ownership.	Pressure of the repayment obligation.
Decision Making	Investors have a say in the company.	No involvement in the business.
Sources	Angel investors, IPOs, crowdfunding, incubators, venture capital, private equity investors.	Government loans, loans from banks and other financial institutions and Government schemes.

IPO Vs Bank Loan

The type of financing an SME decides on depends on numerous factors.

Nowadays, many SMEs go public to raise money. Some companies prefer to take out a bank loan rather than go through the IPO route. The difference between raising capital through an IPO and a bank loan is explained below:

Feature	IPO	Bank Loan
Growth phase	A company can only go public once it has established its business.	A company can opt for bank loan post seed funding stages.
Access to capital	An SME may opt for an IPO if it needs a large amount of working capital without the stress of having to pay it back. An IPO can provide access to a large pool of capital from public investors.	A bank loan is more suitable for short-term capital requirements as it carries with it the obligation to repay principal and interest.
Ownership	Dilution of ownership rights.	No dilution of ownership rights.
Interest payments	No obligation to pay interest. However, the company pays a dividend to shareholders to increase the shareholder’s value.	You must pay interest on the loan amount.
Duration	Lifetime, unless the company buys back or dissolves or the investor exists by selling his shares.	Short term. Companies must repay the loan within the specified period.
Repayment	No obligation to repay	Obligation to repay principal and interest
Increased visibility	An IPO can increase the company’s visibility and credibility in the market.	Not possible with a bank loan.
Liquidity for owners	Owners and investors can monetize their investments by selling shares in the public markets.	Bank loans do not offer such an opportunity.
Regulatory requirements	Companies that go public must comply with various regulatory requirements, which can be costly and time-consuming.	No such regulatory requirements need to be met.

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Key Takeaways

A company can raise funds from various sources, either in the form of equity or debt or a combination of both.
The fundraising strategy depends on the stage of the company.
A company can also self-finance, apply for grants or win prize money to invest in the company, but the amount is very limited and is only suitable for the seed or pre-seed stage.
The company should choose the funding method that best suits its funding needs, growth phase and business objectives.

Next Chapter

Frequently Asked Questions

1. How can a company raise money to grow?

A company can raise money through:

Equity financing.
Debt financing
Others (without dilution or obligation to repay)

Debt is usually cheaper than Equity because it guarantees repayment. Debt capital can be obtained by taking out loans or issuing corporate bonds in exchange for cash. Conversely, equity can be raised by going public through an IPO, angel investor, venture capital, or private placement.

In the very initial stages, a company can also self-fund or take funds from close friends and family or apply for grants.

2. How can we raise funds through Equity Financing?

We can raise funds through equity financing by giving away a part of our company in return for funds from investors. Equity financing involves dilution of ownership. Some of the popular ways to raise funds via equity financing include:

Initial Public Offering.
Private Placement.
Offers for Sale.
Venture Capital.
Angel Investors.
Private Equity.

3. How can we raise funds through debt financing?

Debt financing involves borrowing funds from lenders in return of interest payment against the borrowed amount. The borrowed amount is required to be repaid after specific agreed tenure.

The popular debt financing sources include:

Bank loans.
Loans from non-banking finance corporations.
Issuance of bonds and debentures.
Peer to peer lending.
Loan from the government.

4. What funding is available for small businesses?

Small Businesses can get loans from various sources, such as government loans like Pradhan Matri Mudra Yojana, Bootstrapping, Loans from friends and family, crowdfunding, angel investors or venture capital funds.

As and when business grows and company looks for expansion, it can also go for bank loans, issuance of bonds and debentures and eventually IPO.

5. How do companies raise capital after IPO?

After going public, companies can raise funds through secondary market via the below:

Rights Issue.
Further Public Offer (FPO).
Issuing Preference Shares.
Issuing Bonds or Debentures.
6. How can I raise funds for my business?
The options for raising money for an SME company are described below.
Self-financing: Use personal savings to fund the start-up.
Business loan: Seek small business loans, but approval is not guaranteed.
Crowdfunding: Use platforms such as Kickstarter, GoFundMe and Indiegogo.
Angel investing: Secure funding from wealthy individuals with a solid business plan.
Personal contacts: Consider raising money from friends and family.
Venture capitalists: Look for investments from firms that specialize in established businesses.
IPO: Raise capital by taking shares public for the first time.
Glossary
Bootstrapping (Self-funding)Bootstrapping means starting a business without getting outside investment. It is a mode of self-funding with no external source of funding.Read more
Venture CapitalVenture capital (VC) is private equity financing provided to startups, early-stage, and emerging companies with significant growth potential.Read more
Startup AcceleratorsStartup accelerators are special programs that help new companies with mentorship, resources, and networking in exchange for equity.Read more
Startup incubators (Business incubators)Startup incubators are specially designed programs to support businesses in the early stages of business.Read more
Peer to Peer lendingPeer to Peer lending is a method of raising funds through an online platform where borrowers put their funding needs.Read more
CrowdfundingCrowdfunding involves raising money from many individuals, often through online platforms, who collectively contribute small amounts of capital.
CrowdfundingCrowdfunding involves raising money from many individuals, often through online platforms, who collectively contribute small amounts of capital.