When funding a new business there are two types of funding sources, internal and external. Internal funding is the cheapest method of funding as you are not relying on the external market.

External funds are those that come from outside of your business and may come from Banks, commercial lenders, your Franchisor, suppliers or venture capitalists such as Business Angles.

When funding your venture you should always look to internal funding first. Most businesses us a mixture of both. The advantages are:-

  1. Using internal funds lowers the cost of gaining external funding.
  2. Lenders like to see that the business owner has some “hurt money” invested in the venture. This shows a greater commitment from the business owner to the business.
  3. It is unlikely that a lender will give you 100% funding. If they do then they will want ownership of the business.

Importance of internal/self funding

In most cases a business is started out of the cash reserves of the owner. For small business most financers will not lend unless the owner/s have a vested interest in the business. If you are unwilling to commit some of your own funds into starting the business then it is unlikely that a lender will and it may be that you need to re-assess the idea of going into business.

While some lenders will lend a larger amount they will ask for greater returns to match their greater risks. This will result in high interest rates or an equity stake in the business. The result is that you may not risk your money initially but in the long term you risk having ownership of the company that you have built..

When assessing deals lenders will look at key ratios such debt/equity and times interest cover. The less that you have to borrow then the better that these ratios are and greater your opportunity of gaining funding and the lower the cost of borrowing.

External Financing

Debt financing is the most common way of raising money and it is usually in the form of the borrower receiving a loan based on security of some sort being offered. When the loan is repaid the security is released. If the loan goes into default then the lender will call on the security to repay the debt.

There are various types of security that can be offered:

  1. Residential real estate:- This is a favourite of Australian Banks
  2. Commercial real estate:- The banks will lend less to this as often it has been built for a “special purpose”
  3. Guarantor:- May come from a relative, supplier or franchisor. The guarantor signs saying they will step in if the loan goes into default.
  4. Equipment:- Often these loans are in the form of leases, Hire Purchase or Chattel Mortgages
  5. Finished goods:- The value of stock for retailers
  6. Debtors List:- The lender will advance money based on the value of your receivables
  7. Business Assets:- In the case of certain franchise systems in Australia the lenders will lend against the assets of the business / new business including the good will.

While banks have been wary in lending to new businesses in Australia they have shown that they are starting to understand franchising and regard franchise businesses start ups to be lower risk than other forms of small business start up and as such most have a franchise lending policy

When assessing the deal the lender will assess both you and your business model. Therefore, you will need to be prepared to supply both business and personal data. When applying for a loan based on an accredited system you will need to supply a business plan and a projected cash flow analysis and personal debt position.

The franchisor is also a potential source of funding be it in the form of a guarantee for your bank loan, or reduced establishment costs. These are generally repaid by increase royalty and are usually at a higher rate than bank finance.

Other forms of finance are equity investors and venture capital. These entities will generally lend money to more risky ventures than the banks however, the trade off is that they will charge significantly higher fees. Venture capitalists also only fund a small proportion of the deals that they see each year. The disadvantages are that it is hard to secure funding and they expect high returns and an exit strategy. As they fund higher risk opportunities they will lose money on a number of deals so this is factored into the cost of your funding. If your business is successful the financier will end up with 20 –70% of the equity of the company.