A funding gap is the difference between the money required to begin or continue operations, and the money currently accessible. Funding gaps are common in very young companies, who may underestimate the amount of capital needed to sustain production until a workable cash flow has been established. The most common solution is a bank loan, but angel investors or equity sales can also help bridge the gap.
Start-up funding depends upon many factors, including the business plan, the strength of the economy, and barriers to entry for that particular industry. When the economy is strong, investors are more lenient about funding businesses, and may even relax their standards. When the economy is weak, however, many new businesses have difficulty finding the necessary capital. They may adjust their business plan to reflect the minimum amount of necessary funding, making success look more likely to potential investors. A funding gap occurs when reality does not match conjecture.
For instance, if Bob wants to start a company that manufactures tires, he writes a business plan and seeks investors. The economy is weak, and there is a lot of competition from larger, more well-known manufacturers in the tire market, so investors are reluctant. Bob reconfigures his business plan to reflect a need for less start-up funding by assuming more efficient production and earlier strong demand, and thereby secures investors.
Once production begins, Bob finds that it is not as efficient as he had hoped, which translates into higher energy costs, higher employee costs, and a slower turnaround time. He also finds that sales are not picking up as quickly as he had hoped, meaning less money coming in and higher storage costs for finished stock. Soon, the business reaches the point where production must shut down completely and workers must be laid off unless additional funding is found. Bob begins the search for an angel investor.
Angel investors are usually private business owners who invest smaller amounts of money, an average of $37,000, in local businesses. They seek a higher return than traditional investments offer, so they also offer the new business owner the tools necessary for success, like advice and contacts. Angel investors increase the capital available to a new business by an average of 57% by offering personal loans or by guaranteeing outside loans. Although angel investors do take the business’s probability of success into account when deciding to invest, their requirements are not as strict as venture capitalists, and as a result they expect about a third of their investments to result in capital loss.
The other answer to a funding gap is equity sales, in which a business sells its stock to investors and uses the resulting cash flow to continue or improve operations. This can be tricky for new businesses, who may be unproven in the market, making their stocks of very low value. The only way a new business would have stock valuable enough to bridge a funding gap is if it had unparalleled prospects and no competition, in which case other funding avenues would have come through first.