Types of finance for business can typically be put into two broad categories i.e.
In Pakistan the most popular financing method is debt-structured financing. In this type of financing the money borrowed from a bank or financial institution is to be paid back as Principal + Mark-up (or profit or interest). It is usually payable in installments on a monthly basis..
These can be long term or short term financing. We can understand a bit more using the terminology in use by financial institutions.
Lease financing is used for buying or acquiring equipment and ranges from 3 years to 5 years tenor. Lease finance can be of two type i.e. Finance Lease or Operational Lease. In case of lease finance arrangements the asset or machinery or equipment or vehicle continues to belong to the financial institution till such time that the lease has been repaid.
Finance Lease is more or less like a debt finance with the only difference being that the ownership is not of the user of that asset. The lessee (who takes the lease) pay a rental on a monthly or quarterly basis which includes part of the principal amount and part as a profit payment. Once the tenor of the lease is complete it matures and its ownership is transferred by the Lessor to the Lessee.
In case of an Operating Lease the ownership remains with the lessor and the lessee takes that asset on rent and has to return it at the end of the lease period or even before in case of his requirement for a replacement.
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 sponsors/financiers if you have them with you. For women owned enterprises with smaller initial capital outlay, this works out very well with friends and family members either contributing towards the business or by lending.
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 Pakistan there are very few institutions from where venture capital can be raised for start-ups.
In any case equity, despite requiring profit sharing, is a far better way of financing your business. So as your business grows larger and you need to recapitalize it with more money and are ready to share in the profit in a big way...go for an IPO!!!
IPO stands for Initial Public Offering which, simply put, means that you take the business for listing on the Stock Exchange....you can raise huge amounts of money by doing so and also provide the flexibility of exit for any of the co-owners who want to leave the business and take their money out. What you do is create wealth for your share-holders.
However, before you go for an IPO you should have established your business quite strongly in the market and on firm business systems because as you list your company on the stock exchange, the regulatory requirements will increase and if you fail to comply there can be heavy penalties. (More on Corporate Governance in another segment).
Financial Institutions lend against cash flow but always require a tangible security that they can sell in case someone is unable to pay the loan back. This is also called collateral which is used as a security against default.
However, do not assume that if you offer a good security the bank will provide any type of finance or raising finance would be easy as you still have to show your income to pay back the loan. Banks first want to recover their money loaned to you through your income and only as a last resort use security to recover any defaulted amount.
When to raise which type of finance - Raising finance through any option depends on the age of the business. As the business grows the needs of the enterprise increase and more funding is required to fuel its growth, as shown graphically in 'Raising Finance', a graphic description of when to obtain what type of finance gives an understanding of the various stages of the age or stage of the business and what type of finance would be most suitable and which financial institutions to approach.
A unique way of raising the required funding in Pakistan is through BC or 'Beneficent Committee'. Women form their own groups and pool-in their own resources where one person is in charge of collection and payment while members pay a fixed amount each month and then each month one of the members gets the full amount. There can be 20 or 30 members and per person monthly participation can be from PKR500 to PKR50,000 depending on the size of the Committee and the payment capacity of the members. It can be a Committee for PKR100,000 going up to PKR2.50 million. In that way they do not need to borrow from anyone and manage to save efficiently.
State Bank of Pakistan (SBP) offers various types of finances to suit the needs of the borrowers specifically in the SME sector through subsidized lines through banks and DFIs. These consist of various schemes as follows:
In some developed countries a mode of financing called 'Grants' also 'Government Grants' are in vogue to help start-ups or on-going business ventures, whereby the Government provides financial assistance on soft terms for such businesses. These are usually for small businesses and women owned or minority businesses. As Pakistan does not, as yet, have such facilities, visit here Government Grants to have a look as to how it works and maybe, one day, we can bring it to our country as well.