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How to Finance Your Small Business
By Lee Huffman
There comes a time for nearly every business when it needs additional money to finance business expenses. When you decide to buy new equipment, hire additional people, or carry a large order, where will the money come from? Many small business owners try to fund their business expenses out of their own pockets, a method known as bootstrapping, but that option has its limits. In this article, we’ll cover why outside money may be necessary, the types of business financing available, and the pros and cons of the different financing options for small business owners.
Should you rely on sales alone to finance your business?
How to Finance Your Business Growth
There are two primary options for small business financing: borrow money or find investors. Both of these financing methods have pluses and minuses. As Ethan Senturia writes, “Financing costs come in many forms with many names, and it is important to know how to spot them and how to understand them so that you can compare apples to apples when being given financing options.”
When you borrow money, also known as debt financing, your business must pay it back over time and with interest. These debt payments will reduce your cash available for other business needs until the debt is paid back. A major advantage of borrowing money is that debt allows you to retain ownership of your business.
Investors provide money to a business in exchange for a share of ownership. This is called equity financing. You negotiate how much influence the investor has in your business and how much of the company they are buying. In most cases, your business does not need to make payments to the investor, so more money is available to fund operations and future growth.
Six Ways to Borrow Money to Finance Business Growth
There are many ways for you to finance your business with debt. Debt can be a great tool for growing your business. Loans may be secured or unsecured, and have fixed or variable interest rates.
Secured loans are backed by an asset, such as a building or piece of equipment, whereas unsecured loans are based on your credit and business financials.
Fixed rate loans have interest rates that do not change. Variable rate loans have interest rates that are based on an index and may go up or down depending on economic factors.
1. Business Credit Card
Even if you don’t need to borrow money right away, it is a good idea to apply for a business credit card. Keeping your personal and business expenses separate is critical for tracking where you spend your money. Some business owners take advantage of 0% APR card offers to finance startup or expansion costs.
2. Term Loan
A term loan is used to borrow a lump sum of money that is repaid over a specified period of time.
3. Business Line of Credit
A line of credit performs like a credit card. Your business is approved for a specific amount, and you can borrow up to that amount as you need it. When the amount borrowed is paid back, your available credit increases, which allows you to borrow more again in the future. When the balance is zero, a line of credit charges no interest and your business doesn’t owe a payment. Unlike a credit card, there is no grace period on borrowed money: Interest accumulates immediately.
4. SBA Loan
The U.S. Small Business Administration, or SBA, is a government entity, not a bank. However, it will guarantee a large portion of your loan, which gives a bank more confidence in your loan application. According to the SBA website, these loans “can be used for most business purposes, including long-term fixed assets and operating capital.” However, “some loan programs set restrictions on how you can use the funds,” so it’s important to check with the lender about loan restrictions.
This method of business financing focuses on your assets. You can borrow money from a third-party financial company, called a factor, against your inventory, accounts receivable, and even purchase orders. Interest rates are often higher than other options due to the risk involved for the lender, but money is available very quickly.
6. Merchant Cash Advances
For businesses that accept credit cards, a merchant cash advance is an option. This lending product provides an up-front lump sum, which is then repaid by a daily portion of your credit card sales. This financing can be expensive, but approval is fairly easy if you have a track record of consistent sales.
Three Options for Raising Equity to Finance Business Expansion
There are three primary options when you want to find investors for small business financing: friends and family, angel investors, and venture capital.
1. Friends and Family
When a business needs money, friends and family are generally the first choice for the business owner. They know you and believe in your concept, so they are often willing to invest in your business. Keep in mind that your personal relationships could interfere with business agreements and vice versa, so any friends and family investment should be treated as a business transaction.
2. Angel Investors
This class of investor focuses on small business investment opportunities. Angel investors are often former business executives who can offer their capital and expertise to help your business grow. When searching for an angel investor, look for one who has experience in your industry.
3. Venture Capital
As your business grows, it may become appealing to venture capitalists. These investors are looking for rapid growth and will invest for a short time frame before cashing out with a sale of the business or public offering.
Three Alternative Methods to Finance Business Success
Beyond debt and investors, there are additional options to finance business growth that are becoming more common.
If you have an idea, but not the money to make it a reality, look into crowdsourcing. There are several crowdsourcing platforms, including the popular Kickstarter, where you can presell your product or service to your followers. On some sites, you only receive the money if you meet your funding goal. With others, you can opt to only take the money you raise if you meet your funding target, which increases the chance that your backers will receive what they paid for.
2. Small Business Grants
Grants are funds that are neither loans nor equity investments. Instead, they are one-time payments from the government, nonprofits, and other organizations that are designed to help businesses grow. The Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) are excellent resources to help small businesses find grants that are geared toward their industries.
Some grants are for specific groups of people to help them succeed. The SBA dedicates a whole section of its website to funding opportunities for women-owned businesses, for example. And the U.S. Department of Commerce's Minority Business Development Agency provides "business consulting, procurement matching, and financial assistance" to minority-owned businesses.
3. Cash-Value Life Insurance
Business owners often turn first to their savings, credit cards, and home equity when funding their businesses. If you have a cash-value life insurance policy, the insurance company may offer loans against the money saved inside the policy at attractive rates. Keep in mind that if something happens to you with a loan outstanding, your death benefit will be reduced by the loan amount.
How to Prepare Your Business for Raising Money
Before approaching a lender or investor, follow these tips to improve your chances of getting a small business loan or find the right equity partner.
Boost Your Credit Score
As a small business owner, you are a major component in the business’ success or failure. In most cases, a lender will factor your credit score in their decision. Focus on improving your credit score right away by paying down debts, disputing incorrect items, and avoiding unnecessary credit inquiries. Download all three credit bureau reports for free once a year at AnnualCreditReport.com.
File Your Tax Returns
You must file your tax returns each year. Whenever possible, file them early so that the latest returns are available for a lender or investor to review when making a decision. Keep in mind that while aggressive tax planning may reduce your taxes owed, it also reduces your income that a lender will use to determine your ability to repay a debt.
Start the Process Early
Funding a loan or securing an investor can take time. Start the process at least 60 days in advance so you're not rushed into making a decision. Remember that the best time to apply for a loan is when you don't need one. Lenders and investors prefer businesses that are financially strong and thriving.
Determine Your Funding Need
Before applying for a loan or pitching to an investor, determine exactly how much you need to finance your business and include a small buffer for the unknown. You don't want to ask for too little, then have to come back for more. On the other hand, asking for too much risks being turned down, extra interest paid on a loan, or giving up too much ownership to an investor.
Assemble Your Business Plan
Maintaining good records is key to business success. This also shows a prospective lender or investor that you are organized and reliable.
Most lenders and investors will review the current year’s business financial statements, such as your income statement and balance sheet, as well as recent bank statements and a business plan. Your business plan is your opportunity to document your expertise, strategic vision, SWOT analysis, and financial projections to show how the money will benefit the company.
The Bottom Line
Borrowing money or attracting investors is an opportunity to grow your company. Each business finance option has its pros and cons, and there is at least one method that is right for every situation. Prepare your credit and business financials before you start looking for money to increase your chances of success and to improve the rates and terms that you receive.
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