Options for small business funding has never been more diverse; and never more complex. In this guide, we’ll take you through some of the necessary steps that can take your business from start-up to success.
It’s a common enough dilemma facing anyone looking to start a small business. You have a vision. You have the motivation. You have the talent. You have the audience.
But you don’t have the capital.
In the past, it was as simple as having a good credit score and necessary collateral. But times have changed. Risks have never been greater for both private investors as well as banks. Simply having a dream (and some equity!) is no longer enough.
Small business loans and grants may seem like a tricky process to navigate and it can be; particularly if you’re a first time small business owner. But it’s not impossible.
There’s a plethora of resources currently available for small business funding. Traditional bank loans. Government loans. Private investors. But which one is right for you?
To help you find the best loan for you, we’ve compiled a brief overview of some of the options currently available for small business owners. But before you decide, there’s a few things you might want to take into consideration…
What Do I Need This Loan For?
While it’s true that each business will have their own individual need for growth and funding, not all loans are universal. Some may be more appropriate than others. And some may be entirely irrelevant to the focus of your business.
But learning to focus on your business needs and priorities isn’t merely conducive as a preliminary exercise before you obtain funding. It can actually help clarify your goals as a business owner. Streamline them. Sharpen them. Refine them. And in so doing, not only help you strategize business procedures, but redefine who you are as a business owner altogether.
With this in mind, let’s take a look at some of the more common questions you may be asked.
How Much Return Can I Generate From This Loan?
Without a deliverable financial prediction, taking into consideration estimates such as profitability, market demand and need (e.g., expansion, development and saturation) you may not be likely to find an accommodating source—traditional or non-traditional.
Try estimating your revenue return and profitability once a quarter, even if there is no explicit need for funding (for first time business owners from a vantage point of six-month to yearly spans.) Both accountants and commercial advisors can be incredibly helpful in this regard.
How Much Small Business Funding Am I Looking For?
Be realistic. A proposal that doesn’t take into account fluctuations of return in your line of business (for example, a brick and mortar retail outlet or real estate development firm) may result in either too little funding—or too much.
The former is a problem for obvious reasons; chiefly, insufficient capital. The latter, however, can be even more detrimental. Interest rates to banks and lenders are never a welcome surprise—and neither is debt from an inability to pay back private investors. Debt financing (eg, from a bank or lender) works better for smaller loans, while looking at equity financing choices (eg, venture capitals and other private investors sharing partial ownership) are a better route if you plan on raising long term capital for your startup.
What Is My Time Frame?
Traditional bank lenders and government entities are known for being notoriously slow in processing loans as well as responding to any requests. Alternative lending sources have gained in popularity over the last ten years, largely in part due to the need for both immediate capital resources and short term funding needs.
While alternative lenders may often offer interest rates that are higher and at shorter terms than traditional banks, they’re generally much more flexible and responsive to small business needs; particularly for first time businesses who may have a greater need for instant approval ratings than established entities who simply need additional funding. Many alternative lenders also have the added convenience of easy online accessibility and application processes.
Debt Financing and Equity Financing
Generally speaking, when it comes to small business funding there are mainly two resources businesses need to take into consideration; debt financing and equity financing. However, both have very distinct advantages and disadvantages depending on both industry and the size of your business.
Debt Financing
Debt financing is perhaps the most common form of small business funding. Essentially, it involves selling debt instruments, such as bills, bonds or notes to entities—most typically institutions such as banks or lenders—in exchange for a loan. In return, the lenders become creditors with a legally binding promise that principal will be repaid with additional interest.
While debt financing may seem like a more practical decision for many small businesses, it’s not without its drawbacks. For one, many lenders insist the return generated should be substantially greater than the initial cost of financing; which, for many first time businesses, may not be a realistic option. It reasons to show that if you can’t guarantee profitable enough growth during the first few years of operations to pay back both principal and interest, the chances of approval for could be considerably smaller. However, this is not a universal rule as indicated by two examples below:
Long Term Debt Financing
Long term debt financing refers to assets your business is purchasing, where the scheduled repayment and estimated life of the assets extends over several years. Lenders typically require long term loans be secured by the assets to be purchased; which, in instances of failure to pay back, can result in seizure, debt or bankruptcy.
Short Term Debt Financing
Short term debt financing refers to the daily financing of business operations; and typically, scheduled repayment takes place in one year or less. A line of credit is an example; however, these are also secured by the assets to be purchased and can also result in the same penalties.
Equity Financing
Equity financing, on the other hand, is defined principally as funding obtained through an outside private investor, frequently by selling partial ownership and control in the company by offering shares of its common stock. Generally speaking, private investors tend to prefer either established businesses or businesses that have substantial growth potential based on market trends. Startup companies in healthcare, technology and life sciences, for example, have historically had high success rates with private investors because of exponential growth over the past two decades.
One of the chief disadvantages to equity financing is that private investors generally tend to be more apt to high stakes investment of significant amounts of capital. The more significant the investment, the greater amount of control in day to day operations a private investor will be likely to have; which is another reason why investors are less willing to fund small businesses with minimal or slow growth potential (it goes without saying that with private investors, you are legally indebted; and subsequently, they could insist on the option of purchasing the majority share in your business.)
Two of the more common types of private investors include:
Angel Investors
In the past, angel investors were frequently friends, family or referrals to business owners. But more recently, a new breed has developed consisting of interested parties who are willing to invest relatively small amounts (typically under $500,000) with favorable terms to business owners, and generally prefer to have no involvement in management or control of the company after repayment.
Venture Capitalists
Perhaps the most well known source of equity financing, venture capitalists typically are quite selective in their choice of businesses. They tend to focus on businesses that either have already been established, been well publicized or otherwise have a substantial competitive advantage. They’re among the most high risk sources of equity financing (typically, amounts in excess of $1 million); but subsequently, the most adamant on having a larger stake in management of a company. Typically, their goal is to invest in a private business in order to transform it into a public company by offering shares via an Initial Public Offering (IPO); thereby maximizing their initial investment.
Advantages & Disadvantages
As mentioned earlier, one of the fundamental advantages that debt financing has over equity financing is the control a small business owner has over their daily operations. But there’s also an additional benefit; debt interest is fully tax deductible as a business expense. In instances of long term debt financing, the repayment period can be extended over multiple years at a reduced expense.
However, also as noted both long and short term debt financing requires collateral in the form of tangible assets. And in the absence of tangible business assets, failure to repay a loan can default to the seizure of personal assets; including vehicles, homes, personal investments and bank accounts.
Many private investors prefer to see an initial contribution from first time business owners as seed funding towards their enterprise. While more often than not it will be minimal in comparison, they frequently do like to take it as a sign of good faith and commitment to your business. You may also find the process of equity funding to be time consuming, as shareholders generally need to be assured of stability and return on their investments and will take no small advantage of requesting regular updates, reports and predictions.
Types Of Small Business Funding
Business Credit Cards
For the first time business owner, credit cards are one of the most effective and simplest solutions for financing. Unlike personal credit cards, their interest rates are significantly lower and offer higher spending limits.
Business Lines Of Credit
Also referred to as a revolving line of credit, a business line of credit is an alternative to a business credit card uniquely suited for already established companies. They provide a set amount of capital that can be drawn on only when you need to; the only interest paid is on the amount used. Because access to credit is automatically renewed upon repayment, it’s perfect if you find your monthly operating expenses to be consistent.
Equipment Financing
If you’re a business owner that finds yourself in need of regular machinery and equipment—for example, vehicles, computers and other specialty machines—many lenders offer equipment financing both as a lease and a loan. Keep in mind that both are considered asset-based financing; which means the equipment can be secured as collateral.
SBA Loans
One overlooked small business loan source comes from incentives offered by the Small Business Administration (SBA), a federal agency designed to assist small businesses and entrepreneurs take advantage of developing opportunities by accessing affordable funding. While the SBA is not a lending agency, they incentivize lenders to approve small businesses by guaranteeing the majority of their capital; meaning a much lower risk for lenders. This solution, however, is probably better suited for established businesses with a high credit rating.
Term Loans
As discussed in the section on debt financing, a term loan is probably the most common—and popular—form of small business lending. Like a personal loan, a fixed amount of money is borrowed for specifically designated business purposes and paid back over a set period of time at an interest; with business or personal assets used as collateral. Keep in mind that, as with SBA loans, the better your credit rating and success rate, the greater your terms are in flexibility.
Conclusion
There’s no doubt that starting your own business can be one of the most rewarding—and challenging—experiences of your life. At times, it can be frustrating; and in many ways, enriching.
The last thing any small business owner wants to think about is paperwork; much less financing. But whether you’re looking to expand your operations, are in need of an additional line of credit or finally ready to launch that idea you’ve had bubbling in the back of your head, you’re going to need funds to do so.
Luckily, there’s a host of options to choose from these days to ensure it’s you who’s the one steering your vision.