A funding gap occurs when a company underestimates the amount of capital needed to sustain production until viable cash flow has been established. Bank loans, angel investors, or stock sales can help bridge the gap. Angel investors invest an average of $37,000 and increase the capital available for a new business by an average of 57%. Stock sales can be tricky for startups.
A funding gap is the difference between the money required to start or continue operations and the money currently available. Funding gaps are common in very young companies, which may underestimate the amount of capital needed to sustain production until viable cash flow has been established. The most common solution is a bank loan, but angel investors or stock sales can also help bridge the gap.
Initial funding depends on many factors, including the business plan, the strength of the economy, and the barriers to entry for that particular industry. When the economy is strong, investors are more lenient when it comes to financing companies and may even relax their standards. However, when the economy is weak, many start-ups have a hard time finding the necessary capital. They can adjust your business plan to reflect the minimum amount of financing needed, making success seem more likely to potential investors. A funding gap occurs when reality does not match assumptions.
For example, if Bob wants to start a company that makes tires, he writes a business plan and looks for investors. The economy is weak and there is a lot of competition from bigger and better known manufacturers in the tire market, so investors are reluctant. Bob reconfigures his business plan to reflect the need for less up-front financing by assuming more efficient production and stronger demand, thereby insuring investors.
Once production begins, Bob discovers that it is not as efficient as he had hoped, resulting in higher energy costs, higher employee costs, and slower turnaround time. He also discovers that sales are not increasing as fast as he expected, which means less money coming in and higher storage costs for finished stock. Soon the business reaches the point where production must be shut down entirely and workers laid off unless additional funding is found. Bob begins his search for an angel investor.
Angel investors are typically private business owners who invest smaller amounts of money, an average of $37,000, in local businesses. They seek higher returns than the traditional investment offering, so they also offer the new business owner the necessary tools for success, such as advice and contacts. Angel investors increase the capital available for a new business by an average of 57% by offering personal loans or by guaranteeing external loans. While angel investors take the likelihood of business success into account when deciding to invest, their requirements are not as stringent as those of venture investors and, as a result, they expect around a third of their investments to result in capital losses.
The other response to a funding gap is stock sales, in which a company sells its shares to investors and uses the resulting cash flow to continue or improve operations. This can be tricky for startups, which may not be market-tested, making their shares very low in value. The only way a new business would have valuable enough stock to close a funding gap is if it had unmatched prospects and no competition, in which case other avenues of funding would have come first.
Smart Asset.
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