November 25, 2014

What Type of Financing Is Right For Your Business?

When the 2008 financial crisis hit, it spawned a widespread freeze in lending. Many small businesses who once were able to get financing suddenly found themselves cut off from credit. We’ve seen the impact over the past years, as many small businesses have cut back on hiring, been forced to lay off employees, or even shut their doors altogether.

stack of money

The good news is that small business lending is at a 4-year high. According to a report from Thomson Reuters, lending to small businesses increased 18% between November 2010 and November 2011.

And the good news doesn’t end there. Legislation currently moving through Congress is designed to make it easier for small businesses and startups to raise capital and enable small-scale investors to more easily put their money into promising new ventures. The JOBS Act, whose acronym stands for Jump-start Our Business Start-ups, stands to be one of the few bipartisan bills to pass Congress this year.

The JOBS Act is aimed at companies with revenue under one billion dollars. If you’re a local merchant or solo business, you know there’s a big difference between your capital needs and those of a multi-million dollar company.

When it comes to securing money to start, expand, or just continue your business, you’ll need to choose wisely. Some options will be too complex, others too risky. Some will provide too much, and others not enough. Here’s a snapshot of the various financing options that might fit your needs:

Debt Financing: Institutional Lending

You can apply to many sources for debt financing, including banks, credit unions, savings and loans, commercial finance companies, and the U.S. Small Business Administration (SBA). State and local governments also offer programs to assist in the growth of small businesses.

Banks are the primary funding source for small business owners, and can provide you with a line of credit that comes with a repayment schedule and an interest rate. During the application process, a bank will look closely at your company’s cash flow, collateral, and the liquidity of your assets. It also helps if you’ve already established a relationship with the bank, including personal banking, before asking for the loan.

Debt financing is attractive to small business owners, since it can be easier to obtain than equity financing and you don’t have to give up any equity in your company. On the downside, you’ll need to pay back your loan with interest, and may need to provide personal collateral (such as your home) to guarantee the business loan.

Debt Financing: Friends & Family

Many entrepreneurs borrow debt financing from family members and friends. This funding typically comes in small amounts without a lot of hassle or paperwork. Be advised that while this approach lets you avoid all the legal red tape, it’s not without its own personal strings. Any business has its risks and things can get ugly when you lose a friend’s money or can’t pay them back.

Grants

If you’re involved in technology, you can consider applying for competitive grants from the U.S. government’s Small Business Innovation Research (SBIR) program. This program provides more than $2 billion annually from 11 Federal agencies (such as the NIH and USDA) to small businesses to spur R&D and high-tech innovation. SBIRs are highly competitive. In addition, there are numerous state, regional, and minority grant opportunities available. Grants are free money that should not be overlooked.

Equity Financing

While debt funding is the most common form of financing for small businesses, many companies are financed each year by private or institutional investors in exchange for an equity ownership stake in the company. There are three common types of equity financing:

  • Family and friends: in this arrangement, a family member or friend will provide you with capital in exchange for an appropriate stake (i.e. stock) in your company.
  • Angel Investors: these are high net worth private investors. In addition to money, angels often impart their business wisdom, guidance, and networking opportunities. While angels do invest in tens of thousands of companies each year, this funding source if difficult to find for the average small business.
  • Venture Capitalists (VCs): These professional investors are serious players in the investing world. They invest in companies with the expansion potential to grow into major businesses with high profits for shareholders. As a result, they look for young companies that are beyond the startup phase, are ‘fast growth’ companies, and are willing to go public in the near future (approx. 3-5 years).

Should VC funding be an option for you, be aware that different venture capitalists take different approaches to managing their investments. Most prefer to maintain a passive influence, but will react strongly if the business does not perform as expected and may insist on changes in management or strategy. This need to relinquish some of the decision-making and some of the potential for profits are the main disadvantages of equity financing.

Final Words

Remember that the impression you make on the financiers you approach is all-important. If you already have a good relationship with your banker, that might be your best option. If you will be approaching a new source for the first time, be sure that you make a professional impression. Although your financial application is the bottom line, making a positive impression can help tip the scales in your favor.

More business owners are seeing opportunities to invest in their business’s growth. Since the lack of available small business financing was a leading cause of many businesses folding during the worst of the recession, perhaps the recent lending data is a good sign that the economy is getting better for small businesses.


Financing Photo via Shutterstock

7 Comments ▼

Nellie Akalp


Nellie Akalp Nellie Akalp is CEO of CorpNet, her second incorporation filing service based on her strong passion to assist small business owners and entrepreneurs in starting their business. Free guides, advice and videos on small business legal topics are available at her Small Biz Corner.

7 Reactions

  1. Nellie has done a great job here in explaining the difference between debt and equity financing. I am always caught off guard by business owners, some have been in business for years, who only think of their local bank or the SBA when they seeking financing. Both are great sources but not the only venues to acquire financing. There are many financial intermediaries such as Business Money Source.com which offer a wide range of financing for almost any phase of business development, from start-up, growth and expansion.

  2. Nellie, great work. Really enjoyed your advice.

    To springboard off your point about making a good impression, NEVER go in and lay bare your financial woes for a lender. That will crush your hopes faster than anything else you can do.

  3. I really like that you explained debt and equity financing separately, most don’t know the different. Seriously great article!

  4. @ Jim – thank you so much for the kind words and support!!
    @Dave – Thank you also! Great addition and advice! :)
    @meredith – Why, thank you! Yes, I thought it would be a better read that way. :)
    – Nellie

  5. Another one that many forget about is invoice financing (sometimes known as factoring). This is where you sell your accounts receivables to a factor at a discounted rate. The advantage is that you get your money faster and the factor takes over collections. It can save you a lot of hours in chasing down payments.

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