Every year, thousands of people start companies. 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:
1. Savings
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 (get the list
here).
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.
5. Accion
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
fundings. You can find angel investors at the
Angel Capital Association.
7. Business loans and lines of credit
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.
8. Factoring
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. You
can see how it works
here and get a quote
here.
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 (learn
how it works).
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 po funding is relatively simple.
Disclaimer:
We provide factoring and purchase order funding, so our view on these
products may be biased. You should always consult a legal and financial
expert before engaging in a business financing transaction.
