Every year, thousands of people start businesses. While their businesses may be different, all of these people have one thing in common: they all had to raise money to finance their company – to get the business off the ground and to cover corporate expenses.
This short guide addresses the most common ways to finance your business, along with some important caveats that you should keep in mind. It is written specifically for small and mid-sized business owners who have no desire to become financial experts but just want the facts – the bottom line.
The basics – Debt vs. Equity
There are two basic ways to finance a small business: debt and equity.
- Debt – a loan or line of credit that provides you a set amount of money that has to be repaid within a period of time. Most loans are secured by assets, which means that the lender can take the assets away if you don’t pay. A loan can also be unsecured, with no specific asset securing the loan.
- Equity – selling a part of your business (known as selling an equity stake). In this case, you don’t usually have to pay back the investment because the new owner of the equity gets all benefits, voting rights, and cash flow associated with that equity stake.
Regardless of the product name, all financing solutions consist of either debt, equity, or a hybrid combination of both. Keep in mind that there are no “good” or “bad” solutions. The best solution for you depends on your specific circumstances and requirements.
Here is an overview of some of the more common methods of financing a business:
Perhaps the easiest way to finance a business is to use your own money. In an ideal world, you should save money for a period of time and use this money to fund your business. This is probably the wisest, most conservative, and safest way to start a company. However, an obvious problem with this type of financing is that you are limited by the amount of money you can save.
Some entrepreneurs take this a step further and take money out of their homes (through a home equity line of credit), their retirement plans, or insurance policies and use those funds to run their businesses. This is a very risky strategy because, if the business fails, you stand to lose your house, retirement, and your insurance. And given that many small businesses fail in the first five years, the odds are stacked against you.
Our take on this: Saving to start or operate a business is a great idea. However, we are against using retirement savings, home loans, insurance loans, and similar sources to finance risky business ventures. You should consider speaking to a qualified financial advisor if you plan to do so.
2. Credit cards
Credit cards can provide an effective way to finance a business and to extend your cash flow. You can use them to pay suppliers and often earn discounts, certain protections, or other rewards. The downside of credit cards is that they are tied directly to your credit score.
Cash advances are another source of funds. Most credit card companies impose limits on their cash advances and charge high rates for them. As such, using cash advances can be expensive, but they can also be useful as a last resort.
Our take on this: Credit Cards can be very helpful in extending your working capital and alleviating cash flow problems, especially if you use to them to pay suppliers. Be careful not to overextend yourself and remember that your credit score is affected by how you use the card.
3. Friends and family
Many entrepreneurs fund their small businesses by getting friends and family to invest in them. You can ask your friends and family to make an equity investment, in effect selling them a part of your company, or you can ask them for a business loan.
There are two problems with using friends and family as a source of business financing. The first one is that if the business fails, you risk affecting the relationship. Understandably, people are often very touchy when it comes to the possibility of losing money. You have to ask yourself if you are willing to risk your relationship for the sake of your business.
The second problem is that you will most likely gain a business partner even if you don’t want one. Once their money is at stake, even so-called “silent partners” can become very talkative and opinionated. You can count on the fact that your friend or family member will want to be involved in your business decisions. This dynamic can affect the relationship, especially if you choose to ignore their advice.
Our take on this: Asking friends and family to make an equity investment can be a good way to finance your company if you are very careful. Be sure to get the agreement in writing and have a lawyer draft it for you. Also, you should spend a lot of time educating your investors about the risks of your business. Lastly, you should consider reminding them to only invest money that they can afford to lose.
4. SBA Microloan Program
The SBA has a little-known but extremely helpful microloan program. The provide business loans for up to $50,000 to small businesses. They don’t provide loans directly; instead, they use intermediaries to fund the loans. Many of these intermediaries also provide management assistance and may require training as a condition for a loan. The advantage of this program is that their training and assistance often increase your chances of success.
Our take on this: This is a great program of the SBA aimed at entrepreneurs who need money to start and operate their businesses. The technical assistance they provide makes this program a great alternative for small business owners.
Accion is on of the largest microfinance and small business lending networks in the US and has offices in every state. In a sense, they are similar to an SBA Microloan. They provide startup financing and they also fund ongoing concerns. To qualify for general financing, you need to have been in business for six months and you must have sufficient cash flow to repay the debt, among other requirements. Accion also offers startup loans of up to $10,000.
Our take on this: Accion is a great source of funding for small companies, especially those that have strong local roots within their communities.
6. Angel investors
Angel investors are private individuals or small groups of executives who invest in businesses, usually by making an equity purchase. They can provide money, expertise, and guidance to help start and grow a business. Getting an angel investment can be very difficult because the investor needs to see growth potential and a viable business plan with a reasonable exit strategy. An exit strategy is a liquidity event that allows the investor to recover their investment and take their profits. Most angel investments have a time horizon of three to five years.
Our take on this: Angel investors can be a good option if you find an angel who can provide industry experience and contacts along with funding. It is very important that you retain a specialized attorney and possibly a CPA to help you understand how to structure the equity sale; otherwise, you could end up with a substantially diluted ownership stake at subsequent funding.
These are well-known products, in which a bank provides financing to run your business. In a loan, the bank gives you a set amount of money that is repaid over a period of years. A line of credit provides a revolving facility that can be used when needed and paid back on a regular basis – much like a credit card.
Getting a loan or a business line of credit can be difficult. The bank’s main interest is in getting paid back. And their preferred way of getting paid is through the cash flow that your business already generates. As a result, they will only provide financing if your company has a proven track record of generating cash and has substantial assets.
Our take on this: Loans and lines of credit are a great way to finance a business. Lines of credit are particularly helpful to handle cash flow shortages. However, getting this type of financing is difficult and is seldom an option for small companies with limited experience.
This type of financing has been gaining popularity in recent years and is now commonplace. Factoring can provide a reliable source of funding if your company has cash flow problems because clients pay their invoices slowly. However, you can only use factoring if you work with commercial and government clients with good credit. When used correctly, the line can improve your cash flow and enable you to take on new clients.
Our take on this: This can be a great option for companies with high gross margins and whose only problem is a lack of cash flow because of slow-paying clients. Getting factoring is comparatively easy and the line is usually very flexible.
9. Purchase order funding
Like receivable factoring, purchase order funding is a specialized form of funding that has been gaining popularity in recent years. It’s designed to help companies that resell goods at a markup and need funds to pay their suppliers. The finance company pays your supplier directly, which allows you to fulfil large orders.
This solution can be very effective for small companies that have received a large order and need funds to cover supplier costs. Given its cost and qualification parameters, it only works for transactions that have high margins and do not require product customization.
Our take on this: This type of funding only works if the transaction is for the resale of finished goods and if gross profit margins are 30% or higher. However, if your transaction qualifies, it’s a great tool to handle large transactions without giving up equity. Like factoring, qualifying for purchase order funding is relatively simple.
Disclaimer: You should always consult a legal and financial expert before engaging in a business financing transaction.