Becoming funding ready

As a bank specifically geared for SMEs (Small and medium-sized enterprises), we work with small and mid-sized business owners every day and the struggle is real. There is an added element as well. When you are building a business, do you want debt finance or equity finance? In reality, you want both – but the balance is essential.

Getting started

An overwhelming majority of SMEs in South Africa are ‘bootstrapped’ or self-funded. This happens in several ways. Some business owners approach the famous 3Fs – friends, family and “fools” – for some seed funding. Some start a side hustle and use their jobs to fund their living expenses until the business can support them. Others cash in pensions or investment accounts.

Whatever the method, the result is generally the same – the business starts small with one focus: bringing in clients and moving towards break-even. The path to breaking even varies according to  several factors. A business that sells a service instead of a physical product is generally easier to get off the ground, particularly if the entrepreneur is selling their own expertise. But eventually, whether it is time that the business is selling or physical goods, supporting the business growth requires constructing a relevant and robust framework. Like it or not, that framework, or operationalizing the business in a sound and principled manner, requires cash.  If the business starts producing or purchasing goods, those costs often increase substantially.

At this point, business owners start looking for external sources of funding, which is where things get tricky.

The barriers to accessing finance

There are many reasons why start-ups and small businesses struggle to access finance, whether it is from a bank or an investor, but in a nut-shell, it comes down to risk:

• If a business does not have assets or stable cash flows, how does it prove it will not default on a loan? Banks in particular have a fiduciary duty to invest their money wisely. Investors will also want to see some evidence that the business is stable and will be a good investment.
• Operational experience. Many entrepreneurs either come from survivalist backgrounds with no business experience, or from corporate jobs that have focused skill sets, but also no broad business experience. The result is someone who may be extremely passionate and skilled but lacking in basic business experience. These businesses are easy to spot because they lack financial, compliance, legal and operational frameworks – it is these frameworks that banks and funders review to ascertain whether the business is a risk worth the funding or not.
• Debt and equity mix. The debt-to-equity ratio measures the amount of debt versus equity being used in a company. It is calculated by dividing a business’ total liabilities by total shareholders’ equity. For example, if shareholders have put a lot of equity into a business to invest in assets, it is predominantly equity funded. As we have seen, most start-ups are equity funded. If a business has too much debt, it is considered highly leveraged, and this can potentially cause problems of its own. Understanding your business sector’s healthy ratios (beyond just debt to equity ratio) and getting the balance right is key to running a successful business. This will also help SMEs understand their own funding requirements and affordability, and stand out (or be more attractive) to potential funders. Remember, selling money is a business of its own and funders want the confidence that they will get their money back plus a return on it.

Debt or equity?

There is an ongoing debate whether debt or equity funding should be used to fund small businesses. On the one hand, debt funding has monthly interest repayments. On the other, if used well, it can be used to invest in growth, build the business, increase revenues and profits and ultimately make the business more money. In this scenario, debt funding makes more sense – provided you can access it.

Equity funding can appear to be ‘free’ if an outside investor invests in the business, but they receive an ownership stake for that funding and will often become very involved in the decision making of the business (This can have a positive impact if it is a good equity partner). Down the line, equity funding is often considered to be significantly more expensive than debt funding should the business be successful and the business owner realizes how much value they have lost through owning a much smaller percentage of their company.

Ultimately, I believe the balance is important and provides a way to balance out funding risks. Every type of finance has a unique role to play, which is why it is so useful to work with a banking relationship partner to understand the best solutions for your business.

First things first

Do not put the cart before the horse. Whether you have invested your pension, tapped into the 3Fs in your network or you have got some money put aside, you ultimately want to grow your business which will involve debt and equity funding down the line.

Therefore it is critical to lay the right foundations for your business. This does not need to be expensive. Start with your financial framework. One of the reasons why we have invested so heavily into building our B\\YOND banking platform is because we want SMEs and start-ups to have a clear view of their financials.

The ability to invoice clients correctly and on time, have a snapshot of your cash flow and profit margins, and a dashboard that keeps everything in one place forms part of the foundation of a successful business. Not only does this give any potential funders a clear view into well-organised finances, but it helps the business owner get clarity on the lifeline of their business, understand their cash flows which will help them stay true to their funding partners and access more funding as the business grows.