Finance plays a critical role in every aspect of a business. It constitutes the basis for strategic planning, budgeting and managing the daily operations of an organization.
People in their multitudes start businesses every year. Although their businesses may be different, all of these people had one thing in common: they all needed to raise funds to fund their business – to get the company off the ground and to cover corporate expenses.
This short guide discusses the most common ways of financing your company, along with a few important caveats you should keep in mind.
It’s written specifically for small and medium-sized business owners who don’t want to become financial experts but only want the truth – the best.
There are two main ways a small company can be financed: debt and equities.
- Debt – a loan or credit line that provides you with a fixed sum of money that has to be repaid within a specified time period. Most loans are secured by assets which means that if you don’t pay, the lender will take away the assets. A loan can also be unsecured, without the loan being backed by any particular properties.
- Equity– selling part of your business (known as selling a stake of your business). In this case, you usually don’t have to pay back the investment, as the new equity owner gets all the benefits, voting rights, and cash flow associated with that equity interest.
Regardless of the name of the company, all funding options are either debt, equity or a hybrid blend of both. Note there are no “good” or “bad” solutions.
Based on the unique circumstances and conditions you will have to choose the best option for you.
Here is an overview of some of the most common financing methods for a company:
The best way to finance a business is through the use of your own money. You save money for a period of time , and use this money to finance your business.
This is probably the wisest, most conservative and most secure way to start a company. An obvious problem with this kind of financing, though, is that you’re limited by how much money you can save.
Some businessmen take this a step further and take money out of their homes (through a credit line for home equity), their pension accounts, or insurance schemes, and use those assets to finance their companies.
This is a very risky strategy as you stand to lose your home, savings and insurance if the company fails. And the odds are stacked against you, considering that many small companies fail in the first five years.
My personal advice : It’s a great idea to save on starting or running a company. We are, however, against using retirement funds, home loans, insurance loans and the like to fund risky business activities.
You will have to employ the services of a financial adviser if you still want to go ahead with it.
Credit cards can provide an efficient means of financing a business and expanding its cash flow. They can be used to pay vendors and also receive discounts, certain security or other incentives.
The downside of credit cards is that they are being directly related to the credit score.
A further source of funds are cash advances. Most credit card companies are putting caps on their cash advances and charging them high rates.
As such, it can be costly to use cash advances but it can also be useful as a last resort.
My advice: Credit cards can be of great help to extend your working capital and alleviate cash flow problems, especially if you use them to pay suppliers. Be careful not to overstretch yourself, and note that how you use the card affects your credit score.
3. Family and friends
A lot of entrepreneurs finances their small businesses by having friends and family invest in them. You can ask your friends and family to make an investment in equity, in effect selling them to a part of your business, or you can ask them for a loan.
There are two questions about the use of friends and family as a source of business funding.
The first is that if the company fails you risk having an effect on the relationship. Understandably, when it comes to the risk of losing money people are still very touchy.
If you are willing to sacrifice your relationship for the sake of your company, you must ask yourself.
The second challenge is that even though you don’t want one, you’ll most likely obtain a business partner.
Even the so-called “silent friends” can become very talkative and opinionated until their money is at stake.
You can count on your friend or member of your family wanting to be involved in your business decisions.
This dynamic, particularly if you choose to follow their advice, can affect the relationship.
My personal opinion: If you are very cautious, asking friends and family to make an investment in equities can be a good way to fund your business.
Make sure to get the document in writing and have it written up for you by a lawyer.
You should also spend a great deal of time educating your investors about the risks of your business. Finally, you should consider reminding them to spend only money which they can afford to lose.
The SBA has a microloan program which is not too recognized can be very be helpful.
They lend business loans to small companies for up to $50,000. They don’t directly provide loans; instead, they use intermediaries to fund the loans (see list here).
Many of these intermediaries may offer assistance to the management and may include training as a condition of a loan.
The advantage of this program is that their preparation and support also improve the chances of success.
My take on this: This is an excellent SBA initiative targeted at entrepreneurs who need money to start and operate their businesses. The professional assistance they offer makes this initiative, for small business owners, a perfect alternative.
5. Finance your business through Accion
Accion is one of the largest networks in the US for microfinance and small business lending, and has offices in every state. They’re similar to an SBA microloan, in a way. They provide support for projects, as well as finance an ongoing business.
You need to have been in operation for six months to apply for general funding and you must have adequate cash flow to repay the loan among other conditions. As well, Accion provides business loans up to $10,000.
My take on this: Action is a great source of funding for small businesses, especially those with strong local roots in their communities.
6. Angel investors
Angel investors are private individuals or small groups of executives who invest in businesses, usually by making a purchase of equity. They can provide resources, experience and guidance to help start a business and finance it and grow it.
This can be very difficult to get an angel investment, as the investor wants to see growth potential and a realistic business plan with a fair exit strategy.
An exit strategy is an event of liquidity that enables the investor to recover their investment and to take their income. Most Angel investments have a three to five year time horizon.
My personal opinion : Angel investors can be a good choice if you consider an angel who along with funding can have business expertise and connections.
This is very critical that you retain a qualified attorney and probably a CPA to help you understand how to arrange equity sales; otherwise you can end up with a significantly diminished interest in the ownership of subsequent financing. Angel investors can be listed on the Angel Capital Association.
7. Business loans and credit lines
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.
My opinion :Lending and credit lines are a great way to fund a company. Credit lines are particularly helpful when coping with cash flow shortages.
However, this can be a difficult way to finance your business. It is rarely an choice for small companies with minimal experience.
In recent years, this method of funding has gained prominence, and is now commonplace.
Factoring will provide a stable source of finance for your business if it has cash flow issues, because buyers slowly pay their invoices.
You can only use factoring though if you work with good credit with commercial and government clients.
The line will increase your cash flow if used correctly, and allow you to take on new customers. Here you can see how it works, and get a quote.
Our take on this: It can be a perfect choice for high profit margin firms, whose only concern is a lack of cash flow due to slow paying customers. Factoring is comparatively fast, and not rigid.
9. Purchase order financing
Purchase order financing , like receivable factoring, is a specialized way to finance your business. This form of financing has gained popularity in recent years. It is designed to help companies reselling goods at a markup and requiring funds to pay for their suppliers.
The financing company pays directly to your supplier which enables you to fulfill large orders.
This approach can be very useful for small businesses who have received a large order and need funds to cover the costs of the supplier. Given its cost and qualification parameters, it works only for high-margin transactions and does not allow product customisation
My opinion :This form of financing works only if the purchase is for the resale of finished products and if the gross profit margin is 30 percent or greater. However, if your transaction works, the handling of big transactions without giving up equity is a great tool.