Written by James Ross, Facilitator for North Chilterns & Oxford
A question I get asked all the time is: "What is the best way to raise finance as an SME?" It seems that the area most business owners know and think of first is finding a strategic investor and raising money by giving away equity in the company.
Invariably, this is a bad idea for the following reasons:
Loss of control: You are no longer the sole decision maker, and you have other people to agree with strategic decisions.
Unfavourable Valuation: More often than not, giving away equity at an earlier stage of your journey means you are giving away far more of the company as you are getting investors in early.
Long-term commitment: Once you have an equity partner, you have them for life (unless you buy them out later, which can be very costly).
*The main exception is if the investor can open doors or propel the company forward that you as an owner cannot, in which case it may be a good strategic option.
So, if raising equity is generally a bad idea, how can I raise finance?
Debt Financing
The best way to raise finance is through fixed-term debt, as the interest is often not material (and tax-deductible), and you are still fully in control of the company.
Director Loan: Either using personal funds or if the business is less than two years old, you can get a government-backed Director loan for £25k per Director at 6%.
Friends and Family: Friends and family can be a great source of finance. You can offer them a commercial rate of interest that they would not get from a Bank, and you can parcel it up into smaller loan amounts, which can quickly add up to meaningful finance. Structure the loan for 2 - 5 years with a no-penalty early repayment clause if you want to pay it back early.
Strategic Loan Partner: Many companies have trapped liquidity that they don't want to release for tax reasons. If you perform a circle of influence exercise across business owners, you know and ask around if anyone is looking for a business-to-business loan at commercial rates of interest.
Other forms of Finance
Grants: You may be eligible for rural grants or innovation grants; however, be prepared for plenty of red tape.
Joint Ventures and Partnerships: Form strategic partnerships or joint ventures with complementary businesses to access additional resources, expertise, and financing opportunities.
Invoice Financing and Factoring: Use invoice financing or factoring to improve cash flow by selling accounts receivable to a third party at a discount. This provides immediate access to funds tied up in unpaid invoices.
(Author admission: I am not a huge fan of this idea, but it is still better than giving away equity.)
In conclusion, there are many more ways to raise finance as an SME owner than you may initially think, and this money can make a huge difference to your company if spent wisely. My advice is always to consider your options before giving away that precious equity in your company!
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FAQs
Loss of control: You are no longer the sole decision maker, and you have other people to agree with strategic decisions. Unfavourable Valuation: More often than not, giving away equity at an earlier stage of your journey means you are giving away far more of the company as you are getting investors in early.
Why should you never give up equity? ›
You Lose Control: When you give up equity in your startup, you are giving up control of the company. You will no longer be able to make decisions about how funds are spent, who is hired and fired, or how the company is managed.
Why do SMEs find raising finance difficult? ›
Accessing finance can be difficult for SMEs due to several factors, such as limited credit history, lack of assets, limited resources and negotiating complex lending criteria.
Why should a small business owner opt for equity financing over debt financing? ›
The significant advantage of equity financing is that the investor takes all of the risks. If your company fails, you do not have to pay the money back. You will also have more cash available because there are no loan payments. Finally, investors take a long-term view and understand that growing a business takes time.
What are the disadvantages of giving away equity? ›
Loss of control: You are no longer the sole decision maker, and you have other people to agree with strategic decisions. Unfavourable Valuation: More often than not, giving away equity at an earlier stage of your journey means you are giving away far more of the company as you are getting investors in early.
Can you raise money without giving up equity? ›
Non-dilutive capital is a type of funding that does not require the recipient to give up any equity in their business. This can include grants, loans, and other forms of financial assistance.
Why may a firm prefer to raise finance through equity rather than debt finance? ›
With equity financing, companies avoid adding debt and don't have a payment obligation. Companies may also receive valuable resources, guidance, skills, and experience from investors.
What is a drawback of equity funding? ›
Disadvantages of Equity Financing
Equity financing can lead to a loss of control as investors take a share of the profit and have a say in business decisions. Potential conflicts may arise as different stakeholders have varying interests. Additionally, sharing the profit means less money for the business owner.
What are equity financing pros and cons? ›
The main advantage of equity financing is that there is no obligation to repay the money acquired through it. Equity financing places no additional financial burden on the company; however, the downside can be quite large.
What are SME finance challenges? ›
For starters, they normally have little collateral and no financial history, making it difficult for them to obtain loans from traditional financial institutions. Furthermore, SMEs may lack the resources to develop a detailed business plan or present the requisite financial projections to get investor backing.
SMEs Challenges and Their Solutions
- Rising Costs & Reduced Revenue. Rising costs and reduced revenue are among the biggest challenges SMEs face. ...
- Skill & Talent Shortages. ...
- Managing Expansion. ...
- Attracting New Customers. ...
- Coping with Market Competition. ...
- Securing & Managing Funds.
Many entrepreneurs embark on the process of seeking funding without detailed planning. This is often due to a lack of experience or limited understanding of financial forecasting. Before providing you with finance, investors will expect to see evidence that you understand how you'll reach customers and make money.
Why would a company choose debt instead of equity financing? ›
Reasons why companies might elect to use debt rather than equity financing include: A loan does not provide an ownership stake and, so, does not cause dilution to the owners' equity position in the business. Debt can be a less expensive source of growth capital if the Company is growing at a high rate.
Why might a business owner prefer to raise capital through a loan? ›
why might a business owner prefer to raise capital through a loan rather than through selling shares to an investor? Acquiring a loan allows the owner to retain full ownership of the business instead of sharing profits with investors.
Which is better, equity or debt financing? ›
Equity financing may be less risky than debt financing because you don't have a loan to repay or collateral at stake. Debt also requires regular repayments, which can hurt your company's cash flow and its ability to grow.
Is it bad to take out equity? ›
Home equity loans use your home as collateral. You could lose your home if you can't keep up with your loan payments. Home equity loans should only be used to add to your home's value. If you've tapped too much equity and your home's value plummets, you could go underwater and be unable to move or sell your home.
What is the risk of having too much equity? ›
One of the main risks of using too much equity financing is that it can dilute the ownership and control of the original founders and shareholders.
Why is too much equity bad? ›
In summary, unless your business is growing at a breakneck pace, too many equity investors in a short period of time will dilute any returns you receive. This is a particular problem for small businesses where it's difficult to scale. In these cases, you may wish to limit the amount of equity financing you undertake.
Why not to take equity? ›
Tapping into home equity carries several risks, including putting the property at risk, the potential to fall into significant debt, and the dilution of a valuable asset. The unpredictable nature of the housing market and high interest rates are also reasons not to borrow against a home's worth.
