Entrepreneur Corner

Financing Avenues

Financing is needed to start a business and build it up to profitability. There are several sources to consider when looking for start-up financing. But first you need to consider how much money you need and when you will need it. The financial needs of a business will vary according to the type and size of the business.

Debt and equity are the two major sources of financing. Government grants to finance certain aspects of a business may be an option. Also, incentives may be available to locate in certain communities and/or encourage activities in particular industries.

Typically Business Finance can be put into two main categories i.e.

Equity Financing

Equity finance is what the owners of the business invest from their own pocket. This is the best for all times to come. There is no cost to this kind of financing which means you don't have to pay interest on it. However, it becomes a costlier option because now you have to share the profit earned with your financiers if you have them with you.

Raising finance through equity requires much harder efforts as you have to be able to convince the investors that your business proposition will give good returns and has a good market potential. You can get investment in your business once you have run the enterprise for some time and have performed well.

In any case equity, despite requiring profit sharing, is a far better way of financing your business.

Equity under the ordinance can be raised through:

  1. Issuance of right shares to the existing shareholders in proportion to the existing shares held by each them, irrespective of class;
  2. Issuance of further shares by a public company after obtaining approval from the commission without issue of right shares;
  3. A public company with the approval of the commission may raise its capital through issuance of further shares to its employees under “Employees Stock Option Scheme.
  4. Through issuance of bonus shares to the existing shareholders i.e. capitalization of the profits of the company.
  5. Equity can be raised by a public company through Initial Public Offering (IPO) with the approval of the prospectus by the Commission and the relevant Stock Exchange. In this situation, the Company sells stock directly to the public. Depending on the circumstances, equity offerings can raise substantial amounts of funds. The structure of the offering can take many forms and requires careful oversight by the company’s legal representative.
  6. Issuance of Preference Shares: Companies can issue preference shares subject to fulfillment of the requirements of the Companies Ordinance 1984. These shares can of different kinds i.e. Cumulative/non-Cumulative, Participatory, Convertible, Redeemable / Irredeemable, Stepped and Zero dividend preference shares.

Debt Financing

In Pakistan the most popular financing method is debt-structured financing. Debt financing involves borrowing funds from creditors with the stipulation of repaying the borrowed funds plus mark-up at a specified future time. Debt financing may be secured or unsecured.

Secured debt has collateral (a valuable asset which the lender can attach to satisfy the loan in case of default by the borrower). Conversely, unsecured debt does not have collateral and places the lender in a less secure position relative to repayment in case of default. Debt financing (loans) may be short term or long term in their repayment schedules. Generally, short-term debt is used to finance current activities such as meeting working capital requirements while long-term debt is used to finance assets such as buildings and equipment etc. The companies can raise such financing through the following:

  1. From Banks/Financial Institutions:
  2. Banks and other commercial lenders are popular sources of business financing. In this type of financing the money borrowed from a bank or financial institution is to be paid back as principal plus Mark-up.

  3. Redeemable Capital raised through issuance of Debentures/Bonds etc:
  4. It means finance obtained through issuance of securities other than a share, of a company, whether constituting a charge of the assets of the company or not e.g.:

    1. Participation terms certificate (PTC),
    2. Musharika certificate,
    3. Terms finance certificate (TFC),
    4. Sukkuk
    5. Commercial Papers
  5. Friends and Relatives
  6. Founders of start-up businesses may look to private sources such as family and friends when starting a business. This may be in the form of debt capital. However, it should be done with the same formality as if it were borrowed from a commercial lender i.e. creating and executing a formal loan document that includes the amount borrowed, the rate of return, specific repayment terms, and collateral in case of default. The funds borrowed in this way can be converted into equity subsequently.

  7. Government Programs
  8. Federal/Provincial governments have programs designed to assist the financing of new ventures and small businesses e.g. Small and Medium Enterprises Development Authority (SMEDA).

  9. Leasing
  10. Leasing is a method of obtaining the use of assets for the business without using debt or equity financing. It is a legal agreement between two parties that specifies the terms and conditions for the rental use of a tangible resource such as a building and equipment

  11. Credit Sale – Using Book debts
  12. The amounts due to a company from customers, on account of credit sale generally remain outstanding during the period of credit allowed i.e. till the dues are collected from the debtors. The book debts may be assigned to a bank and cash realized in advance from the bank. Thus, the responsibility of collecting the debtors' balance is taken over by the bank on payment of specified charges by the company.

  13. Finance obtained through Certificates of Investment/Deposits from Public
  14. Certain Companies can raise funds through issuance of Certificates or raise Deposits from general public.