Sources of finance are not created equal. They have different characteristics, different priority areas, different investors, different target markets, different requirements for financing, different motives for financing, etc. It is important to know these and other variables about funding sources. However, surprisingly few entrepreneurs seeking finance for their business take the time to research the various sources of finance to discover their raison detre and their outlook along some of the dimensions just mentioned. Going blindly from one source of finance to another does not pay. The more knowledge one has about sources of finance, the better placed they will be to approach the right sources of finance and to precisely address the requirements for funding and that way raise their chances of securing funds considerably.
When searching for external sources of finance it is essential not only to evaluate each source of finance and their selection criteria and processes, but also to evaluate yourself in the context of an ideal profile of candidates for funding from each source. Contrary to the belief held by many, the availability of collateral is not the only criteria required of borrowers. Each source of finance has a scoring sheet that they use to evaluate applicants. Broadly speaking, the scoring sheets cover the following general headings commonly referred to as the 5Cs, albeit the terminology used and the emphasis placed on each element may differ from one institution to another:
Previous borrowing record and personal integrity. It is very important for entrepreneurs to establish credibility with representatives of the institution so that they can act as champions for the application as it goes higher up the approval processes. Therefore, how one appears, how they present their business etc are essential. Trust is the foundation of all business relationships. A record of borrowing and paying back should be established. Full disclosure of all information including any previous default judgements and reasons for them, and why that is no longer expected to happen again, are all important. The character of the entrepreneur is the single most important vatiable that lenders use. Essentially the question is: can this applicant be trusted?
Evidence of capacity in cash flows & coverage ratio [Earnings/debt service]. Managerial capabilities and experience. Lenders want to be certain that the entrepreneurs that they are lending money to know what they are doing and therefore, will be able to pay back the money given to them. Where a track-record and experience in the industry cannot be established for the applicant and key members of their management team, then, the risk perception becomes too high to overcome. Nobody is keen to lend depositor or investor money for business experiments.
How much long-term equity has been put in by the owners & is the debt/equity ratio in line with the industry average or that of similar businesses? It is not reasonable to expect third parties to put money into a business that you the owner have not put any money into or have put in less money than you are asking for. Third parties cannot be expected to bear a higher risk for the business than the entrepreneurs themselves.
How attractive is the market for the product in question? How differentiated is the product? What is the economy, industry, politics like, where are things going, what are the risks – what can go wrong and what happens if it does?
What form of security is available? Physical assets or financial assets such as shares, life-insurance policies and guarantors. Physical assets are generally preferred but financial assets can often be accepted in lieu of physical assets providing that the financial institution is open to such a proposal.
It is important to remember that default risk increases with increased borrowings from multiple sources. For that reason, it is important to narrow or consolidate your borrowing with a few sources of finance or preferably just one source. It also has the added benefit of creating stronger ties with the institution which makes future applications easier. At the same time, it should also be remembered that lenders can place restrictions [covenants] on applications for funding from other sources, or on the use of cash flows and on the use or disposal of property and equipment purchased with borrowed funds. The objective for lenders doing this, is to safeguard their funds or to increase the prospect of loan repayment.
Funds from government or donor sources are often attractive to entrepreneurs because they are either cheap or free of charge. That is, they either have a low interest charge or that they do not need to be repaid at all. However, it is important to realise that government or donor funds generally come with intensive reporting requirements that can take up a substantial amount of an entrepreneur’s time away from their core business. In fact, reporting requirements from these sources can be quite burdensome and distracting. Therefore, what may first appears as cheap or free funds, may be neither after all.