Start Up Financing Issues and Challenges

One of the most daunting challenges that Start Ups companies face is the financing of their business. In fact, most of the Start Ups, even though having a good prospect, failed due to issues of financing. The importance of funding is justified by the need of Start Ups to start business and survive in difficult times, when profits are low and expenses are high.They seldom have standby financing waiting to fill any gaps before and after the venture starts in operation. Hence, ensuring that the right funds are available for use at the right time is often the distance between success and failure for a Start Ups. 

Followings are the few important issues that every Start Ups need to consider for financing their business. 

Financing for Start Ups

Most Start Ups begin with an idea for a potential product, service, or process. The feasibility of an idea is first put on trial during the development stage. Therefore, they have to go through the typically five stages i.e. Development Stage, Start UpStage, Survival Stage, Rapid Growth Stage, and Maturity Stage. Each stage has its own financing need.  During the development stage of a venture’s life cycle, the primary source of funds is in the form of seed financing to determine whether the idea can be converted into a viable business opportunity. The primary source of funds at the development stage is the entrepreneur’s own assets, family and friends.

In the Start-Up stage, the entrepreneur’s own assets, family and friends, business angel and venture capitalist are the sources of the financing. Start Up financing is usually targeted at firms that have assembled a solid management team, developed a business model and plan, and are beginning to generate revenues. Depending on the demands placed on the entrepreneur’s personal capital during the seed stage, the entrepreneur’s remaining assets, if any, may serve as a primary source of Start Up financing. Family and friends may continue to provide financing during the Start Up. 

However, the Start Up venture should begin to think about the advantages of approachingother, more formal, investors. Although sales or revenues begin during the Start Up stage, the use of financial capital (out flow of cash) is generally much larger than the inflow of cash from the sales. Therefore, entrepreneur’s own capital or asset may not be adequate to cope up with the growth at the starting phase. Thus, most Start Up-stage ventures needexternal equity financing. This source of equity capital is referred to as venture capital, which is early-stage financial capital that often involves a substantial risk of total loss. The flip side of this risk of total loss is the potential for extraordinarily high returns when an entrepreneurial venture is extremely successful. 

Two primary sources of formal external venture capital for Start Up-stage are business angels and venture capitalists. Business angels are wealthy individuals, operating as informal or private investors, who provide venture financing for small businesses. They may invest individually or in joint efforts with others.  While business angels may be considered informal investors, they are not uninformed investors. Many business angels are self-made entrepreneur multimillionaires, generally well educated, who have substantial business and financial experience. Business angels typically invest in technologies, products, and services in which they have a personal interest and previous experience.
Venture capitalists(VC) are individuals who join in formal, organized venture capital firms to raise and distribute capital to new and fast-growing ventures. Pension funds, insurance companies, and wealthy individuals invest in real estate, stocks, and other assets. They allocate certain amount of their money into riskier investments with higher returns, likeStart Ups. VCs will typically invest a third of the fund in the first three years. Depending on the VC’s preference, the money can be invested anywhere from the seed stage (or early stage) to the growth stage. 
t from these two sources, crowd funding is also coming up as a radical new way to raise fund. It involves raising funds in a small denomination from large number of individuals by using internet. It can be in a form of donation, equity participation or loan. Success of crowd funding is depends upon the entrepreneur’s ability to reach the targeted individuals, key features of the project, campaign and the characteristics of the owner. Some of the popular crowd funding platforms are Kickstarter and Indiegogo.
The Start Ups can also explore peer to peer lending to finance their business. This is a process whereby a group of people comes together to lend money to each other and seems very popular in our context. However, entrepreneur needs to look out for a successful entrepreneur peer willing to fund similar new ideas. At the same time, entrepreneur can also use their personal loan to fund the Start Ups but this may not be sustainable in the long run. Therefore, they must have a clear plan to convert their personal loan to business loan once the Start Ups reach a Survival stage (early growth stage).   

Financing has a cost

The most important issue in Start Up financing that most of entrepreneurs do not realize is; it is not only the source of financing but also the cost of the financing. For example, VC’s typically ask for more than 40% of return of their investment. Business angel asks for around 30% of the return. The return largely depends upon the risk of the project. Similarly, the initial seed money invested by the entrepreneurs themselves also has a cost which is known as an opportunity cost. For example, if the entrepreneur has not invested his/her money in the Start Ups, he/she would have invested that money in the banks with 8% interest. The 8%, in this example, is the cost of their initial investment. As a rule of thumb, a higher expected return requires higher level of risk. As a result, entrepreneurs will have to take higher risk in their operation to meet the required return as expected by outside investors which may result in loss in the future. Therefore the goal of the Start Ups is to minimize the cost of financing as low as possible by actively involved in the negotiation.    

Equity financing is more costly than debt financing from banks and financial institutions. Even though it may be difficult for the Starts Up to get bank loan in the initial stage, they need to actively start exploring the debt finance once they reach early growth stage. This will lower their overall cost of capital. 

Cash is the King

Start Ups often underestimate the amount of cash needed to get their ventures start, up and running. In fact, one of the main reasons Start Ups fail, is that at some point they run out of cash. Therefore, they need to supplement traditional accounting measures—such as profit and return on investment—with measures that focus on what is happening to cash. Cash burn (use of cash) measures the gap between the cash being spent and that being collected from sales. It’s typical for Start Ups to experience a large cash burn (cash outflow is higher than cash inflow), which is why they must seek additional investment from outsiders. Ultimately, to create value, a venture must produce more cash than it consumes. Cash build measures the excess of cash receipts over cash disbursements, including payments for additional investment. Therefore, Start Ups must balance between long term and short term financing. 

Conclusion 

Financing Start Ups can be difficult and stressful. The success is largely depends upon the solid business plan along with the background and characteristics of the owners.Some of the institutions in Nepal are working as a Business Incubator (For example: Idea Studio Nepal Pvt. Ltd). They are acting as a bridge between Start Ups and the potential investors along with providing mentoring service. It may be good idea that Start Ups seek their support in the initial stage.