Financing sources for your small business

Investigating the applicable options can give you guidance into the types of financing (their advantages as well as their potential downsides) you can realistically expect to obtain. But limiting yourself to a rigid financing "profile" can put a damper on your creative thinking as well as the impression you give to potential financiers.

When it comes time to meet with a potential financier, you must present the most attractive overall portrait of your business by emphasizing its strong points and explaining its weaker traits. Simply saying, "A chart told me equity financing is a good option for my long-term financing needs" won't cut the mustard with a lender.

Remain flexible while considering how the strengths and weaknesses of your business can be presented so that you can have access to as many different sources of financing as possible. And as you polish your proposals, make sure you're familiar with the two umbrella categories nearly all financing: debt financing and equity financing.

Financing basics: Debt versus equity

Thoroughly understanding the basic types of financing can reveal which options might be most attractive and realistically available to your particular business. Typically, financing is categorized into two fundamental types: debt financing and equity financing.

Five key debt financing facts

Although the sound of (more) debt is never appealing, this option is very popular among small business owners, especially owns who want to call all the shots.

Debt financing simply means borrowing money that you'll repay over a period of time, usually with interest. Like any type of financing, this option varies from lender to lender. But you can usually count on a few industry standards, such as:

Short-term loans require payment within less than one year Long-term loans offer repayment over the span of more than one year The lender does not gain any ownership interest in your business Your obligations are limited to repaying the loan For smaller businesses personal guarantees are likely to be required, making your debt financing synonymous with personal debt financing

As you've probably surmised, debt financing is very similar to the loans you've already accumulated, such as student loans, car loans and mortgages.

If you're looking for different financing options that require less (or no) repayment options and you don't mind giving up a little control of your business, equity financing is usually another viable option for small business owners.

Equity financing basics

Rather than making you repay the capital lent to your business, equity financing involves exchanging money for a share of business ownership.

By using this method, you can obtain funds without incurring debt. Of course this method has its "cost" of:

Diluting your ownership interests and

Potentially losing some decision-making power as investors make their voices heard.

Understanding and securing equity financing

Debt and equity financing provide different opportunities for raising funds. To ensure you'll qualify for the most options, you'll need to maintain an acceptable ratio between debt and equity financing.

From the lender's perspective, the debt-to-equity ratio measures the number of assets—or "cushion"—available for repayment of a debt in the case of default.

Many small businesses rely on a mixture of debt and equity financing, balancing this yin and yang of the lending work. As you consider debt financing, keep these ratio concerns top of mind:

Excessive debt financing may impair your credit rating, becoming detrimental to your ability to raise more money in the future.

If you incur too much debt, your business may be overextended, risky and generally considered an unsafe investment.

If your interest rate increases, you may be unable to weather unanticipated business downturns or credit shortages.

Many business owners, realizing these potential hardships of debt financing, turn to equity financing to generate capital. But, like debt financing, equity financing carriers its own concerns you'll need to consider:

If you are not making the most productive use of your capital.

Your capital is not being used advantageously as leverage for obtaining cash.

Too little equity in your business may suggest you're not committed to your enterprise.

Lenders will consider your debt-to-equity ratio when they're assessing if your company is being operated in a sensible, creditworthy manner.

Generally speaking, a local community bank will consider an acceptable debt-to-equity ratio to be between 1:2 and 1:1. For startup businesses in particular, you'll need to guard against cash flow shortages that can force your business to take on excess debt, thereby impairing your business' ability to subsequently obtain needed capital for growth.

Warning

Exercise caution when making equity contributions of personal assets (cash or property) to your business. Usually your rights to that contribution become secondary to the rights of business creditors if your business fails. Alternatives to outright transfers of capital to the business may be secured loans or "straw man" transactions (you loan money to a third-party relative or friend who then loans the funds to the corporation). The insider then takes a secured interest in the property.

As you consider equity financing, you'll need to determine which business organization structure makes the most sense for your financing needs.

The three sources of finance

Funding is essential for all businesses. Without funding, a business can not pay for overheads, purchase stock or even set itself up

No business can be carried without funding. In identifying suitable sources of finance, there are three broad categories. These are short, medium and long-term.

Short-term refers to funds that generally have to be paid back within a year. Medium-term financing usually requires funds to be paid back between one and five years; whilst long-term finance is generally anything that is paid back after five or more years.

Let us now look at examples of each of these to gain a better understanding of their uses.

1. Short-term financing

Short-term financing may be in the form of a bank overdraft, where the bank allows a business to take out more money than is present in their account.

This is not uncommon, because businesses often operate on a tight cash flow where they have to wait for the sale of products before being able to pay their bills. The rate of repayment for overdrafts tends to be higher than a more long-term loan.

Trade credit

A supplier may also lend money to a business in the form of trade credit. The business will not always pay for its stock immediately because it needs time to sell it and make money first.

If a business has a good record of making repayments under these terms; suppliers are often willing to offer trade credit.

Personal savings

Personal savings of business owners can also be a source of short-term finance, where the owner lends money to the business and is repaid after a short period of time. This is different to buying shares as the money given is usually written into a loan contract.

2. Medium-term financing

In relation to medium-term sources of finance, a business may take out a bank loan. The repayment terms on bank loans are usually quite strict but banks can offer significant amounts of funding to a business.

This provides businesses with the opportunity to expand and grow.

Venture capital funding

Venture capital funding may also be a viable option for growth. Unlike with a bank loan, venture capital funding may not need to be repaid.

Instead, the venture capital firm is actively looking for businesses they can invest in with the hope of making a return through profits a business makes. They will normally look to cash out within 2-5 years.

3. Long-term financing

Longer-term funding offers the cheapest borrowing terms for businesses. However, they tie a business into a contract for a longer period of time.

Banks can offer such loans to a business but will require more significant collateral as security for the money they are lending.

Debentures

A company may also raise long-term finance through more creative means such as issuing debentures. A debenture is where a business makes a request for funding that is secured against assets and yields a fixed rate of return for the lender for a specified period of time.

Unlike a bank loan, the terms of the debenture can be set by the business looking to raise finance.

At the end of the loan period, a debenture holder may have the opportunity to convert their debenture into shares in the business. In this situation, the business would not have to pay back the remaining amount of the debenture loan. However, this option is not always made available with debentures.

Selling ordinary shares in the business is another way of raising finance without having to repay the amount of money raised.

Limited liability

The shares can be sold privately to individuals or publicly if the business decides it wants to be listed publicly on a stock exchange and become a PLC. This option is also only available to companies with limited liability. Companies with unlimited liability will have to change their legal structure before they can offer shares for sale.

The purpose of the loan

Deciding on the source of finance depends very much on the purpose of the loan and the amount being borrowed. For example, for paying a bill or employee wages, a business will use its own profits or look at other short-term sources of finance such as overdrafts.

It does not make sense to take out a 5-year bank loan to pay a monthly bill. If a business wishes to expand and requires an amount of capital that exceeds what it is capable of generating through sales; a longer-term option may be preferable.

The level of risk

The level of risk involved is also a factor in deciding how to finance the business. If a business is perceived as too risky, this may limit where they can raise finance from and would have to depend on personal sources.

The owners themselves may not want to lose control over a business and would therefore be reluctant to issue shares. However, at the same time, they might welcome advice that could come from a venture capitalist.

It is always a good idea to carry out a full assessment of options before deciding where to go for finance as there are a number of factors to consider.

5 Common Funding Sources For Startup Businesses & Growth [2022]

If you want to be successful in business, it is crucial to determine when, where, and how to obtain the startup funding you need. Whether you need $1,000 or $1 million to start or expand your business, if you can’t raise money, you can’t build the business you want.

Before You Look For Funding

Before you look for funding, you need to create a solid business plan. In addition to explaining your business and your strategy for success, your plan must determine how much money you need and for what it will be used.

If you’d like to quickly and easily complete your business plan, download Growthink’s Ultimate Business Plan Template and complete your business plan and financial model in hours.

Also, it’s very important for you to understand the timing of the funding. For example, do you need all the funding now (e.g., to build out a location), or can you receive your funding in stages or “tranches.”

The amount of funding you seek will affect the source of funding you approach. For example, if you require $250,000 in funding, angel investors are more applicable then venture capitalists. If you need $5 million, the opposite is true.

The 5 Most Common Funding Sources

While I have identified 41 sources of funding for your business, below are the 5 most common.

1. Funding from Personal Savings

Funding from personal savings is the most common type of funding for small businesses. The two issues with this type of funding are 1) how much personal savings you have and 2) how much personal savings are you willing to risk.

In many cases, entrepreneurs and business owners prefer OPM, or “other people’s money.” The four funding sources below are all OPM sources.

2. Business Loans

Debt financing is a fancy way of saying “loan.” Credit unions and banks offer funding that you must repay over time with interest. This can come in the form of a personal loan, a traditional business loan, or different loans based on the type of asset you need to purchase (e.g., for equipment, land, or vehicles).

You must prove to the lender that the likelihood of you paying back the bank loans is high, and meet any requirements they have (e.g., having collateral in some cases). With a bank loan, you do not need to give up equity. However, once again, you will have to pay interest along with the principal.

3. Friends & Family

A big source of funding for entrepreneurs is friends and family. They can provide funding in the form of debt (you must pay it back), equity (they get shares in your company), or even a hybrid (e.g., a royalty whereby they get paid back via a percentage of your sales).

Friends and family are a great source of funding since they generally trust you and are easier to convince than strangers. However, there is the risk of losing their money. And you must consider how your relationship with them might suffer if this happens.

4. Angel Investors

Angel investors are generally wealthy individuals like friends and family members; you just don’t know them (yet). At present, there are about 250,000 private angel investors in the United States that fund more than 30,000 small businesses each year.

Most of these angel investors are not members of angel groups. Rather they are business owners, executives and/or other successful individuals that have the means and ability to fund deals that are presented to them and which they find interesting.

Networking is a great way to find an angel investor for your business.

5. Venture Capital

Venture capital funding is a suitable option for businesses that are beyond the startup period, as well as those who need a larger amount of venture capital for expansion and increasing market share. Venture capitalists and VC firms are professional investors that are more involved with business management, and they play a significant role in setting milestones, targets, and giving advice on how to ensure greater success.

Venture capitalists invest in new businesses and medium-sized businesses they believe are likely to go public or be sold for massive future business profits. Specifically, they want to fund companies that have the ability to be valued at $100 million or more within five years. They also go through an expensive and lengthy process of deciding on the best business to invest their venture funds. Hence, the application process and approval usually takes several months.

The Bottom Line

As you search for the best funding options for your start-up business or to expand your existing business, you will discover that some sources are more complicated and time-consuming while others may offer a very small amount. While the five sources mentioned above are the most common, there are other ways of obtaining the financing you need including government programs including grants, crowdfunding sites, business credit cards, or a line of credit from a bank just to name a few.

Choosing an inappropriate type of funding can lead to unfavorable outcomes such as feuds between the lender and business owner, shift of control, waste of resources and other negative consequences.

With this in mind, you should study the benefits and drawbacks of each financing option and select the ideal one that will help you meet your business goals. With the right sources of money, the sky’s the limit for your business.

Raise Funding Quickly & Easily If you’re struggling to raise money, it’s probably because your funding strategy is broken. Here’s how to do it right As I explain when you click, the key is to start at the bottom and work your way up the Funding Pyramid. Click here to learn how to do it yourself

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