What is a funding gap? (with photos)

Initial investors are a type of angel investors who contribute funds and provide other types of support during the early stages of launching a new business or entrepreneurial project.

A funding gap is the difference between the money needed to start or continue operations and the money currently available. Financing gaps are common in very young companies, which may underestimate the amount of capital needed to sustain production until a viable cash flow has been established. The most common solution is a bank loan, but angel investors or stock sales can also help fill this gap.

A funding gap is the difference between the money needed to start or continue operations and the money currently available.

Seed funding depends on many factors, including the business plan, the strength of the economy, and barriers to entry for that specific industry. When the economy is strong, investors are more lenient about financing businesses and may even relax their standards. When the economy is weak, however, many new companies struggle to find the necessary capital. They can adjust their business plan to reflect the minimum amount of funding needed, making success seem more likely to potential investors. A funding gap occurs when reality does not match conjecture.

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, better-known tire manufacturers in the tire market, so investors are reluctant. Bob reconfigures his business plan to reflect the need for less upfront funding, assuming more efficient production and strong past demand, and thus protecting investors.

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Once production starts, Bob finds that it is not as efficient as he expected, which translates to higher energy costs, higher employee costs, and a slower turnaround time. He’s also found that sales aren’t increasing as quickly as he’d hoped, which means less cash coming in and higher storage costs for finished inventory. Soon, the business reaches a point where production must be completely shut down 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 provide the new entrepreneur with the tools necessary 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 guaranteeing external loans. While angel investors consider the likelihood of business success 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 a loss of capital.

The other answer to a funding gap is equity 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 new businesses, which may not be proven in the market, making their inventories of very low value. The only way a new company would have shares valuable enough to fill a funding gap is if it had unparalleled prospects and no competition, in which case other avenues of funding would have come first.

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