What are the sources of funds?
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The main sources of funding for innovation activities are:
- Your own funds
- Government grants
- Family and friends
- Debt
- Equity
in that order.
Your Own Funds
You have to have enough confidence in your business to invest in it yourself or you can’t expect anyone, including government sources or banks, to invest in it. When you approach investors, be it family and friends, government sources, banks, or equity investors, one of the first things they will ask is how much money you have put into the business.
You may have assets in the form of savings accounts, equity in real estate and vehicles, valuable collections, and investments. You can sell some of these to get cash for your business and use others to get collateral in order to get a bank loan. It is advisable to track how much you have invested, including opportunity costs such as foregone salary.
Government Grants
Grants can be obtained from most levels of the government for a variety of purposes and industries, however government does not provide grants for activities that would normally be undertaken in the running of a business. The grants are often competitive and require a high level of preparation for obtaining them. They often come with a variety of stipulations such as achieving milestones, matching the grant money with external investor money, being at a specific stage in development or growth and require applicants to be investor ready.
The eligibility criteria, amount of funds available, funding conditions and activities all differ from grant to grant. To find out more information on grants and assistance programs that are available refer to http://www.business.gov.au/Business+Entry+Point/Business+Topics/Grants+assistance/
Family and Friends
Asking family members for a loan can result in flexible payment arrangements, and the finance can become available quickly, but it is highly advisable to put your agreement in writing. There is the danger of harming family relationships if things go wrong. In agreeing to a loan, it is advisable to set things up in as business-like a manner as possible.
Debt
Financing through debt refers to the sourcing of funds from a third party with an agreement to pay the money back, with interest, by a future date. Most commonly, debt arises through loans from financial institutions and credit unions. The main advantages and disadvantages of debt funding are shown below.
| Advantages | Disadvantages |
|---|---|
| Retain equity. | If the business is based on early stage IP it may not have sufficient cashflow to regularly repay debt finance. |
| Fixed interest rates. | If the company fails you may be personally responsible for the loan. |
| Flexible repayment options. | Investors may not invest if the debt:equity ratio is too high. |
| Lenders are usually less likely to take security in intangible assets such as IP due to the difficulties in valuation and an unpredictable market. | |
| Creates liabilities which must be managed. |
Equity
Financing through equity refers to the sourcing of funds from a third party with an agreement to give the investor a share of the actual business. Equity financing can come from many sources, most common of which are family and friends, business angels and venture capital investors.
Through equity investment the investor is granted a certain percentage of equity (shares or units) in the actual business. As security for this equity investment, the investor will generally want some influence over business decisions. A venture capitalist is likely to want at least one representative on the board of directors and other contractual concessions. However, some investors, such as family members or friends, may wish to be silent investors and contribute nothing more than capital due to a lack of knowledge or time. The advantages and disadvantages of equity funding are:
| Advantages | Disadvantages |
|---|---|
| Obtain funds without having to repay a specified amount of money. | Own less of the business and may lose some management control. |
Business Angels
Business angels are high net worth individuals who invest in businesses with their own money in return for equity. The most useful angels are entrepreneurs who have been successful and wish to give back to the industry from which they created their success.
Angels are usually willing to wait longer for returns than venture capital investors as they generally invest in early stage companies. The investment usually ranges from $20K to $500K. Experienced angels can also invest a lot of knowledge into the company alongside capital, having usually been through the business development process before. Advantages and disadvantages of Angel investors are:
| Advantages | Disadvantages |
|---|---|
| Potential for a longer period before returns are realised. | An angel may try to take over the business because they believe they know more. |
| An angel can bring a large amount of experience and knowledge to the company. | An angel can be difficult to locate and attract especially in Australia. |
| Angels have limited funds and may not be able to provide necessary follow-on funding. |
Venture Capital
Venture capitalists are fund managers who invest other people’s money into private companies in return for equity in the company. This equity is later released through an exit strategy, such as floating the company on the stock exchange, which can create the substantial return on investment required by the fund manager. Since a venture capitalist does not require the investee to repay the invested funds if a profit does not eventuate, provided that some part of the investment is not in the form of debt, venture capital is most commonly sought to finance high-risk projects such as the commercialisation of early stage intellectual property (IP). Such funding of early stage IP is often called ‘Seed Capital’. Venture capitalists usually have access to networks that can provide recruitment, potential customers, other investors and partnering opportunities.
Venture capital funding is often acquired with tighter restrictions than funding provided by angels. This is because the venture capital fund is required to make a return on investment by a specified date to the owners of the investment money. Conditions of investment can include the running of the business in a predictable way and the implementation of control mechanisms incase events occur which potentially threaten the investment. The rights of both parties are written in a negotiated agreement; however, the terms will rely on the relative negotiating positions of the parties involved.
Advantages and disadvantages of Venture Capital investment include:
| Advantages | Disadvantages |
|---|---|
| Funds provided along with knowledge, guidance and access to networks. | Lose some ownership of the business. |
| The funds are repaid through an exit strategy, rather than through a defined amount. | Lose some control of the business. |
| Business owners/managers are not personally responsible for repayment of investment. | Can lead to unfavorable terms in negotiating agreement. |
| Increased reporting and disclosure responsibilities. | |
| Can create pressure to create business opportunities which sustain a yearly specified return on investment. |
Approaching venture capitalists: You should have a prepared business plan with: a very concise but catchy executive summary; financial forecasts; business strategies; management experience; and a detailed exit strategy. The pitch is also very important for not only outlining the technology but also highlighting the business opportunity with specified markets and how a customer need is being met. Remember a venture capitalist will see many hundreds of business opportunities in a year so your opportunity will need to “stand out in the crowd”.
It should also be remembered that venture capital is usually the most expensive way to fund your business. This is because the expected returns from the investment will be many times the original venture capitalists investment as opposed to debt funding which will be a percentage interest rate return.
Links to subsections of this topic
How much funding do you need?
What are the sources of funds?
What is the Optimal Funding Source for Your Needs?
Programs and Services