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When you are seeking to meet the firm’s capital needs, you generally first use non-institutional funding sources. The most popular are personal resources, including friends and family. When available personal funds and resources of friends and family have been exhausted, a small business turns to alternatives that provide the benefits of institutional debt or private equity.
These alternatives include Personal resources, supplier financing, seller financing, business incubators, franchising, joint ventures and co-branding, but the business may not yet be eligible for direct support from a financial institution.
Personal resources, including friends and family as funding sources
Most entrepreneurs found their business by investing their own resources, such as personal savings and the equity in their homes. This is often supplemented by “borrowing” from family members and friends or, alternatively, by giving them a stake in the business. You face two major issues when using your own funds. First, are those funds sufficient for the business’s needs? Second, can you withstand their potential loss? When you borrow from family and friends,you also must consider whether the family members or friends can afford the potential loss and what the impact of the loss may be on the personal relationship. In addition, you must deal with the family members or friends who may want a say in the business as a condition of investing. This arrangement can be a welcome one, but it also can be potentially troublesome.
Supplier financing as funding source
Once your business is going, you can often use financing from your suppliers but seldom from your employees. Many suppliers will provide financing either through very generous payment terms or through direct loans.
KEY POINT: Supplier financing has the advantage over financing by family and friends because it is not tinged with emotion. It can be costly, however, unless payment is stretched well beyond the due date. You are usually wise to substitute institutional financing as soon as possible so supplier discounts can be taken.
Suppliers want your business to succeed. They often can provide a range of non-financial assistance besides the financing itself. This non-financial assistance can range from providing informal management consulting to providing introduction to potential customers.
Seller financing as funding source
You can also often obtain financing from companies selling you equipment or from sellers of commercial real estate you purchase for the business. Equipment sellers will finance a sale by allowing payment over time and taking a lien on the equipment. Or, they may have a leasing alternative. Many equipment manufacturers have specialized subsidiaries to finance their customers’ equipment purchases. Equipment vendors, like suppliers, want your business to succeed and often can provide a range of non-financial help as well as the financing. Commercial real-estate sales are frequently financed by sellers’ providing first or second mortgage loans on the property. These sellers, however, will be unlikely to provide non-financial support.
Finally, if you buy an existing business, the seller will often provide term financing for part of the purchase price. In this circumstance, a major consideration may be the seller’s tax situation, a topic much too complicated to explore here. The seller also may want to remain involved in the business for a period, usually as a paid consultant. The terms of this association also need to be carefully drawn.
Business incubators as funding source
For start-up companies, particularly in technology areas, business incubators can be an attractive source of financial support. Business incubators typically provide physical space to small businesses at a nominal or no charge. They can also provide other services, such as secretarial support, telephones,and office machines. In addition, by placing several fledgling businesses together, the business incubator provides you with a forum of peers for joint problem solving, support from others facing similar problems, and exchange of information and discussion of common commercial interests. Established by universities or nonprofit organizations, business incubators are intended to help the growth of small, fledgling enterprises that lack cash to pay full price for office space and services. Information about business incubators can be obtained from the National Business Incubation Association.
Franchising as funding source
Franchising provides small, successful businesses with an attractive way to enter a new geographic market without having to raise large sums of capital. It is particularly attractive to retailing consumer non durables and services. A small business can sell a franchise to an individual or organization that wants to market the product or service the small business owns in a geographic area the small business is not currently serving. In the typical franchise arrangement, for an initial payment, the small business sells the right to market its products or services in a specific geographic market. The franchise grantor (franchiser) thus does not have to raise the capital to support an expansion of its reach. This is the responsibility of the franchisee.
The franchiser will also often receive periodic payments from the franchisee for the rights to continue the franchise. The franchiser also may be paid for goods and services provided the franchisee. Franchisers, however, typically must provide support to their franchisees. This is usually advice about the product and the business. General marketing support is often required if the franchiser provides a brand that relies on advertising to draw customers to the franchisee.
Joint ventures and strategic alliances as funding source
Joint ventures and strategic alliances provide ways for successful small businesses to use the resources and skills of another company without merging with it. They also can allow a small business to share the risk associated with a new business initiative. There are several reasons a joint venture may make sense for a small company including:
- Developing a new market
- Developing a new product or technology
- Sharing complimentary technology
- Accessing a distribution network
- Sharing in the execution of a contract
- Accessing capital
In the typical joint venture, a partnership, newly formed LLC, or a corporation is set up to bring the parties together to achieve a specific objective. The relationship between the parties is spelled out in the ownership agreement for the legal entity. This arrangement is common in the pharmaceutical industry.
Co-branding as funding source
Co-branding is a form of informal partnership between the owners of two brand names, such as a resort and an airline. They combine to add value to each brand through increased consumer name recognition and economies of scale in functions such as advertising. Co-branding can be arranged through a variety of legal entities. It can be particularly valuable for a small business if it can partner with a larger business that has a large advertising program, a broad product line, and a well-recognized brand name. The advantage for the larger company is to round out its product line without the expense of creating its own product or buying an established brand.