Caught between choosing whether to accept the employment offer were her salary was barely enough to cater for her necessaries and starting up a business after spending 4 years in the university and completing her one-year youth service, Annabel managed to drag herself out of her bed in a bid to get ready for what the day brings. “How can I get funds to start up my shoe business?” – She worried. “No one is willing to help these days seeing the continuous nose-diving nature of the Nigerian economy, maybe I can save up or ask for support from my family and friends” – she also thought.
The issue of funding a business is one of the most talked about in recent times especially for start-ups and small and medium scale businesses in Nigeria. The conventional way of raising money to finance businesses has always been to either take money from savings or at best source capital from family and friends to start up a business. However, the difficulty in relying on the conventional sources of business financing cannot be over-emphasized. Most business ideas have not been able come to fruition because of lack of funding.
The financing options for start-ups if not properly considered may have a long negative impact on a business either in terms of repayment or take-over of business; making an understanding of various options available to start-ups to source funds very imperative. The good thing is, there are various ways businesses can be financed and we will briefly examine such ways.
Basic Funding Options
Typically, there are three broad means of financing corporate establishments
- Debt financing
- Equity financing
- Mezzanine Financing.
Debt Financing:
Debt financing is synonymous to obtaining a loan from a financial institution which ultimately requires a regular monthly payment with a specified interest depending on the terms of payment agreement between the lender and the borrower. It is also possible for private investors to lend money for business purposes with the aim of getting repaid with interest at the end of a specified period.
Obtaining loan at the earliest stage of business is usually not easy. Most times, the financier or the bank looks at the credit worthiness of the business owner and the ability to repay back the loan with a specific time. Given that the success or otherwise of the business cannot be ascertained at the earliest stage, the lender usually asks for security for the loan in terms of collateral.
For businesses that have a more complicated corporate structure or have been in existence for an extended period time, banks usually check other sources. If the bank approves the request to provide capital for the business, the funds are released to the business owner with the antecedent of interest that usually comes with such debt financing.
A most notable advantage of the debt of mode of financing for startup companies is the inability of a lending institution to claim ownership to your company. Upon offsetting a loan, the relationship between the borrower and lender terminates. This is important as your business becomes more valuable. Moreso, the interest you pay on debt financing is tax deductible as a business expense[2].
However, Businesses that have unpredictable cash flows might have difficulties making loan payments. Lenders will typically demand that certain asset of the company be held as collateral as security for the loan, and the owner is often required to guarantee the loan personally or by a third party. More often, only credit worthy companies/individuals are granted loans by the banks. It will be difficult to qualify for loans in huge amounts with unacceptable credit ratings[3]. However, Qualifications for such loans varies from one lending institution to the other. It can very difficult for small businesses to qualify for debt financing during economic downturn.
Equity Financing
For business entities with share capital, funds can be raised by issuing their remaining shares to prospective investors and in returning, the prospective investors paying for those shares either at the value of the shares or at premium, which is higher. Sometimes, existing shares are purchased by existing shareholders or the subscription to new shares created by the company. The investors essentially become shareholders in the company, owning a piece of the company in exchange for the negotiated fee paid into the company as consideration. For other businesses without shares, an arrangement of co-ownership or partnership may be entered between them and an investor to give some stakes to the investor in exchange providing liquidity to the business owner for financing the business. This is a method of raising funds through the sale of the company’s shares.
For Equity Financing, no form of repayment is made, unlike debt financing, your investors are not creditors. They share in the ownership of your company, get dividends in the value of their contributions paid to the company and also share in the company’s liabilities.[5]
While we can boost of no form of repayment under this financing mode, it does not guarantee total control of the business on the owner, it involves giving up ownership of a portion of your company. The larger and riskier the investment, the more of a stake the investor will want. You might have to give up 50% or more of your company. Unless there is a later arrangement were the investor ceases to be a part of the business after a certain period or were the company decides to buy back the shares from a shareholder[6] , that investor will take 50% of your profits indefinitely.
Mezzanine Financing:
This is a hybrid of both debt and equity financing. It is also a broad financing model that encapsulates varying levels of relationships between loans and equity in companies. Mezzanine capital is the combination of equity and debt financing. Although there is no set structure for this type of business financing, debt capital often affords the lending institution the right to convert the loan to an equity interest in the company upon default in offsetting the loan by the borrower. Therefore, Companies commonly seek mezzanine financing to support specific growth projects or acquisitions. From a startup perspective, mezzanine loans could be considered. These types of loans are made available in short periods of time and usually only require minimal or no collateral whilst giving the prospective lenders the right to ownership or equity stake in the company if the loan is either not repaid or not fully repaid, depending on the terms of the transaction documentation.
From a transactional perspective, mezzanine loans are traditionally structured to be unsecured and so, prospective lenders usually bargain for preference shares or whatever increased class of shares is permitted by the company’s MEMART.
This type of loan is appropriate for a new company that is already showing growth. Banks are reluctant to lend to a company that does not have financial data. However, a newer business may not have that much data to supply. By adding an option to take an ownership stake in the company, the bank has more of a safety net, making it easier to get the loan. The interest is often higher, as the lender views the company as high risk. Mezzanine capital provided to a business that already has debt or equity obligations is often subordinate to those obligations, increasing the risk that the lender will not be repaid. Because of the high risk, the lender may want to see a 20% to 30% return.
Just like equity capital, the risk of losing a significant portion of the company is very real. mezzanine capital is not as standard as debt or equity financing. The deal, as well as the risk/reward profile, will be specific to each party.
Other various Funding Available to Start-ups.
There are different funding outlets or institutions which start-ups such may from time to time, consider or liaise with in raising capital including the peculiar advantages, disadvantages, impediments, or restraints affecting any of the highlighted model options:
- Financial Institutions: Banks and Other Financial Institutions (“OFIs”)[7] are very well known to offer loans to businesses (small, medium, and large enterprises) to meet their funding needs. In this regard, Microfinance banks in Nigeria (“MFBs”) – financial institutions that provide small loans to individuals or groups – have proven to be very helpful by providing households, entrepreneurs and organizations, access to credit facilities for their businesses. They grant loans to individuals and small- scale enterprises (“SMEs”) to be paid back in small instalments with little interest rates. A necessary prerequisite to obtaining funding from any MFB, would typically be that the company should open a functional bank account serviced with an MFB, with a bank statement showing that the account is operative. Furthermore, the company will be required to provide a genuine reason for the loan, provide collaterals or subject documents relating to its assets and other relevant documents such as its business plan.[8]
- Seed Investment/Angel Investors: An angel investor is any person who is willing to invest capital in a new company either in exchange for nothing at all, in form of a loan or for little equity stake in a start-up company. The funding resources provided through seed investment or angel investors are typically useful for start-ups at the inception of such businesses; having established that the business has prospects in terms of revenue generation and corresponding growth, from time to time. These angel investors may either be professional investors or ordinary personalities who possess a high-net-worth or considerable net worth and willing to commit their resources to financing a business proposal. These investors usually provide finance for businesses in exchange for convertible debts, equity stake or share in the profits of a business (essentially, this could be debt, equity or mezzanine).
- Venture Capital Institutions: These are organized firms where investors provide huge capital to help establish start-up businesses. One enviable feature a venture capital investment institution is that it not only provides funds for business, it also promotes such business enterprise through strategic network opportunities, mentorship, branding, marketing, and entrepreneurial guidance to ensure that the business investment has a greater measure of success. A good number of these firms are industry specific in selecting where they pitch their tent. However, to the advantage of Flutter wave, venture capital firms have been very interested in contributing to innovative technology-based solutions, ideas, and businesses[10]
- Grants: These are funds or capital provided by governments, institutions, foundations, and individuals. Such grants do not accrue interest neither would it be expected to be refunded. In this method of business financing, the grantor has no stake whatsoever in the company, either in equity, shares, or credit obligation. It is more of an opportunity to support and encourage startup ventures without the pressure of debt obligation that such businesses may be prone to as compared to when those funds were obtained from other conventional financiers. It must be stressed that before obtaining business grants, due diligence must have been conducted and a comprehensive assessment of the business have to be undertaken. There are quite a number of grants available to SMEs in Nigeria, each carrying varying eligibility criteria and corresponding preconditions. Instructively, the CBN COVID-19 Intervention Fund for Micro, Small and Medium Scale (“MSMEs”) (the “Intervention Fund”) is still very much available.[11]
- Crowdfunding: Technology has provided a very easy access for businesses, especially startup companies to reach a wide variety of people and institutions towards raising funds to execute a business idea. Crowdfunding simple refers to the public presentation of a business proposal via online media where investors and the general public may invest in such undertaken having been fully persuaded that such business venture portends great potential. Some investors may be keen on getting a significant portion of equity or interest in exchange for their financial support for the growth of the business, from time to time. Generally, the nature and scope of crowdfunding gives your business the right marketing exposure and appeals to a larger audience target which may be an added advantage to the business growth, eventually.[12]
CONCLUSION
From the foregoing, the several sources of funding for start-ups have been highlighted. Depending on the preference and suitability of any of these funding facilities to the business owner, it must be emphasized that careful considerations must be given to the terms, advantages or otherwise of such financing model. Such start-up business must determine how much financial input they require externally; and must exert extreme fiscal discipline to avoid collateral damage. With the right capital investment, a business may just be on track to maximize business opportunities and economic growth. Subject to and depending on how much the company intends to raise from any of the financing models, the most important consideration should be the ease of access to such funds and the corresponding risk the creditor is willing to accept.
[1] https://www.google.com/imgres?imgurl=https%3A%2F%2Fwww.4aep.com%2Fwp-content%2Fuploads%2F2016%2F05%2FCorporate-Finance-978×473.jpg&imgrefurl=https%3A%2F%2Fwww.4aep.com%2Fcorporate-finance%2F&tbnid=SEBMKRyA3GjFgM&vet=12ahUKEwin-bvxxajxAhWNw4UKHZC-By4QMygGegUIARDYAQ..i&docid=c7DtIO3X86eB4M&w=978&h=473&q=corporate%20financing&ved=2ahUKEwin-bvxxajxAhWNw4UKHZC-By4QMygGegUIARDYAQ
[2] interests payable on loans are deductible and this lowers the actual cost of the loan, at least for tax purposes unlike equity financing where tax accrue to dividend payment.
[3] A credit rating is an assessment of the creditworthiness of a borrower.
[4]https://encryptedtbn0.gstatic.com/images?q=tbn:ANd9GcTMORA0ol99lBZQL63w3RyvUfAq9EyKfVOFeA&usqp=CAU
[5] This kind of transaction is usually evidenced in the shareholders agreement executed between the company and the investor.
[6] Section 184 (1) provides for the procedure for the acquisition by a company of its shares and Section 186 outlines the persons from whom a company may buy back its own shares which are: (a) the existing shareholders or security holders on a proportionate basis; (b) the existing shareholders in a manner permitted pursuant to a scheme of arrangement sanctioned by the court; (c) the open market; and (d) by purchasing the securities issued to employees of the company pursuant to a scheme of stock option or any other similar scheme.
[7] Section 131 of the Banks and Other Financial Institutions 2020 (“BOFIA”) defines OFI’ s to mean any individual, body, association or group of persons whether corporate or unincorporated other than the banks licensed under the BOFIA which carry on the business of a discount house, bureau de change, finance company, money brokerage, authorized buying of foreign exchange, international money transfer services, mortgage refinance companies, mortgage guarantee companies, financial holding companies or payment service providers regardless of whether such businesses are operated or conducted digitally, virtually or electronically.
[8] There is a recent publication by the Nigerian Deposit Insurance Corporation (“NDIC”) indicating the intention of the Central Bank of Nigeria (“CBN”) to shut down over forty (40) MFB’s in the country unless they consolidate their share capitals. – https://ndic.gov.ng/notice-of-closure-of-42-microfinance-banks-mfbs/
[9]https://encryptedtbn0.gstatic.com/images?q=tbn:ANd9GcSU5kKWczWuwIzj7Uuj7MRzg0ZQPW823V82Cg&usqp=CAU
[10] Please note however, that a number of venture capital institutions or private equity firms typically do not provide capital for start-up companies. The target fund companies with proven track records, established financial portfolio and clear valuations. There are examples of venture capital firms in Nigeria specially targeting young start-ups. Examples of these venture capital firms in Nigeria include: Growth Capital Fund, Green Tree Investment Limited, Lead Path Nigeria, Spark Capital, Green House Capital, etc.
[11] To be eligible to apply to the NIRSAL Microfinance Bank, which is in charge of the Intervention Fund,
Startups are required to show (a) verifiable evidence that it was severely impacted by the Covid-19 pandemic; or (b) that it has bankable plans that can benefit from the impact of the covid-19 pandemic.
[12] Nigerian law permits crowdfunding for MSMEs under the Securities and Exchange Commission Crowd Funding
Regulations 2021 (the “Regulations”) the Regulation provide, has an eligibility criterion, that interested fundraisers must be entities incorporated in Nigeria and have been in operation or must have been carrying on business20 for at least two years or have technical partners who meet the 2-year operating track record requirement.
