Sources of innovation funding
Funding sources available to businesses may include seeking equity finance, applying for government or university funding, and considering an initial public offering. It is imperative that startup businesses plan for growth in order to be able to meet their commercial objectives.
Financial success is the major goal of business. In order to achieve this goal, businesses must:
- have realistic financial plans
- monitor and review costs
- gain support of bankers, investors and venture capitalists.
Some important sources of funding for innovation activities include:
- your own funds
- government grants
- family and friends
- business angels
- venture capital
- crowd funding.
Your own funds
You need to have enough confidence in your business to invest in it yourself or you can't expect anyone, including government sources or banks, to invest in it. When you approach investors, whether they are family and friends, government sources, banks, the general community or equity investors, one of the first things they will ask is how much money you have put into the business.
You may have assets in the form of savings accounts, equity in real estate and vehicles, valuable collections, and investments. You can sell some assets to get cash for your business and use others to get collateral in order to get a bank loan. It is advisable to track how much you have invested, including opportunity costs, such as foregone salary.
Grants can be obtained from different levels of the government for a variety of purposes and industries.
The eligibility criteria, amount of funds available, funding conditions and activities differ from grant to grant. More information on grants and assistance programs is available from the Australian Government and Advance Queensland.
Learn more about innovation grants.
Family and friends
Asking family members for a loan can result in flexible payment arrangements, and the finance can become available quickly. Put your agreement in writing, as you could harm family relationships if things go wrong. In agreeing to a loan, the arrangements should be made in a businesslike manner.
Financing through debt means sourcing funds from a third party, and agreeing to pay the money back, with interest, by a future date. Most commonly, debt arises through loans from financial institutions and credit unions.
- The business retains equity
- Fixed interest rates
- Flexible repayment options
- If the business is based on early stage IP, the cash flow may be insufficient to repay debt finance regularly
- If the business fails you may be personally responsible for the loan
- Investors may not invest if the debt to equity ratio is too high
- Lenders are usually less likely to take security in intangible assets, such as IP, rather than tangible assets, such as real property, due to the difficulties in valuation and an unpredictable market
- Liabilities are created that must be managed
Financing through equity is the sourcing of funds from a third party with an agreement to give the investor a share of the business. Equity financing can come from many sources, most common of which are family and friends, business angels and venture capital investors.
Through equity investment, the investor is granted a certain percentage of equity (shares or units) in the business. As security for this equity investment, the investor will generally want some influence over business decisions. A venture capitalist is likely to want at least one representative on the board of directors and other contractual concessions. However, some investors, such as family or friends, may wish to be silent investors and contribute nothing more than capital due to a lack of knowledge or time.
- You obtain funds without having to repay a specified amount of money
- You own less of the business and may lose some management control
A business angel is a high net-worth individual who invests directly into entrepreneurial businesses for equity. It is usually 'smart money' where, in addition to capital, expertise adds value to the investee business. In providing 'angel financing', they are not being a charity or pursuing a hobby. They want solid returns on investments either by profits or a share in the ownership of the successfully commercialised business. The most useful angels are entrepreneurs who have been successful and wish to give back to the industry from which they created their success.
Angels are usually willing to wait longer for returns than venture capital investors as they generally invest in early stage businesses. The investment usually ranges from $20k to $500k. Experienced angels can also invest knowledge into the business, as well as capital, having usually been through the business development process before.
- The angel may wait for a longer period before returns are realised
- An angel can bring a large amount of experience and knowledge to the business
- An angel may try to take over the business because they believe they know more
- An angel can be difficult to locate and attract, especially in Australia
- Angels have limited funds and may not be able to provide necessary follow-on funding
Venture capitalists are fund managers who invest other people's money into private businesses in return for equity in the business. This equity is later released through an exit strategy, such as floating the business on the stock exchange, which can create the substantial return on investment required by the fund manager. Venture capital is most commonly sought to finance high-risk projects, such as the commercialisation of early stage IP. A venture capitalist does not require the investee to repay the invested funds if a profit does not eventuate, provided part of the investment is not in the form of debt. Such funding of early stage IP is often called 'seed capital'. Venture capitalists usually have access to networks which can provide recruitment, potential customers, other investors and partnering opportunities.
Venture capital funding is often acquired with tighter restrictions than funding provided by angels. This is because the venture capital fund is required to make a return on investment by a specified date to the owners of the investment money (e.g. 2-4 years). In particular, they want to see how their investment or original equity is protected.
Conditions of investment can include the running of the business in a predictable way, and the implementation of control mechanisms in case events threaten the investment. The rights of both parties are written in a negotiated agreement. However, the terms depend on the relative negotiating positions of the parties involved.
- Funds are provided, as well as knowledge, guidance and access to networks
- Funds are repaid through an exit strategy, rather than through a defined amount
- You lose some ownership of the business
- You lose some control of the business
- It can lead to unfavourable terms in negotiating agreements
- Business owners/managers are not personally responsible for repayment of the investment
- There are increased reporting and disclosure responsibilities
- It can build pressure to create business opportunities that sustain a yearly specified return on investment
Approaching venture capitalists
When approaching venture capitalists, you should have prepared a business plan with:
- a concise but catchy executive summary
- financial forecasts
- business strategies
- management experience
- a detailed exit strategy.
The pitch is important for outlining the technology, highlighting the business opportunity with specified markets and how a customer need is being met. A venture capitalist will see many hundreds of business opportunities in a year, so your opportunity will need to 'stand out from the crowd'.
You should also remember that venture capital is usually the most expensive way to fund your business. The returns expected from the investment will be many times the original venture capitalist's investment, compared with debt funding, which will be a percentage interest rate return.
Crowd funding is the practice of funding a project or venture by raising money from a large number of people. It enables entrepreneurs to gain market validation and avoid giving up equity before going all out and taking a product concept to market. It is commonly done through crowd funding websites.
Optimal funding sources for innovation
The funding sources that are right for you depend on your business needs and can be complex. Seek advice from a professional, such as your accountant, before embarking on any particular option.
As a rough guide, sources that are generally pursued are outlined in this table:
Funding source key
- PR: Personal resources, family and friends, crowd funding
- G: Government grants
- A: Angels
- VC: Venture capital
- F: Financial institutions, banks, credit unions
- MB: Merchant banks
- SE: Stock exchange