Financing for start-ups, the myth and the reality

The financing of start-up businesses is popularly imagined as being like Shark Tank or Dragons’ Den. In those television series, groups of hopeful entrepreneurs pitch their ideas to impress a panel of hardnosed investors. Unfortunately, while such shows provide good entertainment they don’t reflect the reality of how the majority of business start-ups are actually funded.

The births and deaths of new business ventures

To understand the process of start-up financing, we first need to understand the dynamics of new venture creation and survival. Each year hundreds of thousands of new businesses are created across Australia, and each year a similar number of businesses are shut down.

This can be seen in Figure 1, where the total number of new business start-ups over a five-year period was broadly matched by the total number of business exits. In fact, the average percentage change in the total number of businesses over this period was minus 0.1%.

This rate of churn in the total pool of Australian businesses is a pattern found across most industries and remains fairly steady over time. The reason for this trend is that the chance a newly created business will survive beyond its first three years of life is only 50/50.

As shown in Figure 2, the likelihood that a start-up created in any given year will still be trading at the end of its first year is about 74%, but this falls to around 60% in the second year, and 50% by the third year. That is why the overall stock of businesses in the country remains fairly steady at around 2.1 million.

Given the attrition rate of newly established businesses, it is very unlikely that professional venture capitalists will consider investing their money into start-up firms. This creates what has been termed the financing gap, which is a lack of both equity and debt financing for early stage firms.

The financing gap is found around the world and is caused by different factors depending on the country. For example, in some countries it is due to structural weaknesses in the banking sector, which is common in developing economies. In other countries, the problem is a lack of venture capital financing.

Sources of financing for start-ups

The financing for start-up and young firms comes from three primary sources. The first and most common source is bootstrapping. This comprises a combination of the founder’s savings, credit card debt and retained profit from cash flow. Bootstrap financing is very important and this is why the management of cash flow, and the ability to set the correct prices to generate profit is so critical.

Debt finanacing

A second source of funding is debt financing, which is typically borrowed from banks and other financial institutions. It can be short-term, such as credit cards, or long-term via mortgages. However, this typically requires the business owner to have collateral, such as a house, against which to secure the mortgage.  An issue for many small businesses is the interest costs associated with debt financing. These were quite high during the peak of the mining resources boom and have declined in recent years. However, small business debt financing is considered higher risk than that provided to large firms and often attracts a higher interest rate from banks.

As shown in Figure 3, bank interest rates for small business loans in Australia have been relatively high over recent years with an average of 7.5%. This compares favourably with New Zealand, but remains high compared with many other countries. In particular, the United Kingdom which has had an average rate of 5.41%.

Peer-to-peer lending

A recent trend in debt financing is peer-to-peer (P2P) lending. This is still relatively immature as a source of financing, but is growing in the United States where it provided US $8.9 billion in P2P loans in 2014 alone.  In Australia, P2P lending is less developed and was worth less than A $25 million in 2015, but it is anticipated to grow.  It usually takes place via online brokers and can be run either by auction or posted prices for set interest rates.  P2P lending in Australia has yet to be completely regulated.

Equity financing

The third source of funding for start-up and young firms is equity financing. This involves investors taking ownership of a proportion of the business’s share capital in order to secure a return on investment from growth. It is much higher risk than debt financing and is provided by a range of informal and formal sources.

Informal equity investors are what are commonly referred to as The Three F’s, meaning family, friends and fools. Such equity is usually provided in a largely informal manner, often with limited due diligence by the investors. However, this type of equity financing is usually the most common for start-up firms. 

Business Angels

Another source of equity financing is that provided by Business Angels, who are high net-worth private investors. They are predominately middle aged men, although women and younger people are emerging within this area. The United States has the largest and most active Business Angel market with an estimated 316,600 business angel investors whose average investment portfolio is around US $328,500. Their combined investments over the period 2012 to 2014 was estimated to be US $24.1 billion.

Formal venture capital financing involves much larger amounts of money and is provided by professional funds managers. It is also very difficult for start-up firms to secure. In Australia, there are an estimated 121 active venture capital and late-stage private equity managers operating 210 investment funds.

In 2015 these venture capital firms had investments worth an estimated A $19.95 billion.  Most (68%) of this money is sourced from domestic investors and 42% is provided by superannuation funds.   However, to put this into perspective, the United States venture capital market is worth US $60 billion and is 14 times the size of all the venture capital investments made in Europe. 

Crowdfunding

A new source of equity financing is crowdfunding. This type of funding does not have to involve investors taking equity. In many cases, it has been a source of funding for charitable projects with donations. It has also been a way to fund new businesses by pre-selling products or services to customers. In other countries crowdfunding is now a common way for business angels to find investment projects. Although many such investors are less experienced than their more traditional counterparts.

How crucial is investment capital for a start-up business?

As can be seen from this brief discussion of the different sources of financing for start-up businesses, there are many options but each has its own costs and benefits. Some, like equity financing, will be difficult to secure unless the sources are informal and largely friendly investors. Others, such as bank loans, may only be available to business owners who can leverage existing assets such a family home.

Whatever the source, the start-up entrepreneur will need to realise that the amount of funding they will need is going to be dependent on their ambitions. Where they seek to create a fairly modest, low-growth business with low overhead costs, such as a home-based business. All they will need is bootstrapping.

However, if they want to establish a business with high upfront costs, such as a retail store or restaurant, much more money will be required. Further, the faster they plan to grow the business the greater the need for money. In this case the business will most likely need either a high amount of debt funding, or the ability to source equity financing supported by some debt.