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A Guide to Small Business Financing

 

Guide to Small Business Financing

Faced with the ever-present risk of running out of cash, many small business owners wonder how they can find the money to keep themselves afloat. And while a host of business financing options are available—backed by a wide range of offline and online lenders, from banks to venture capitalists—there’s no shortage of questions about what to expect from each.

According to a federal survey, forty-four percent of small business owners took out loans to cover expenses.

You’re thinking, “No surprise there.” Our doors have been locked for some time now, and not a single cent is coming in for us lately. It’s only natural that small business owners take out loans to maintain their accounts in the black.

This poll is from 2019.

When it comes to making money for your business, there’s no shame. Neither 2019 nor now have we seen this.

Doing business necessitates taking out loans, and loans for business expansion can be a part of a company’s long-term strategy. Small business owners borrowed money in large numbers, with 56% citing expansion or asset purchases as the primary motivations.

Many more interesting facts are in the federal survey of small businesses in the US.

This article will take you through the types of financing available, the evaluation process, the associated benefits, and risks, and more. With a few simple questions to ask the lender, you’ll have all the information you need to decide what kind of financing will best support your new business when it needs it.

What Is Business Financing?

If your balance sheet doesn’t look like Facebook, Apple, or Netflix, you’ll need company finance at some point. To meet short-term obligations, many large-cap firms turn to cash injections. Finding a suitable finance model is critical for small businesses.

It’s possible that taking money from the wrong place could result in a loss or restriction on your company’s growth for many years to come.

General Financing Types

Most small business owners employ a variety of sources of funding, including their personal funds. In terms of outside funding, there are two primary types of finanncing: equity financing (money given in exchange for a stake in the company and the potential for future earnings) and debt financing (money borrowed with the expectation that you pay back the principal with interest).

Equity Financing vs. Debt Financing

Equity vs Debt Financing

If you want to raise capital, you must choose between equity funding or debt financing. Equity financing means giving up ownership of your company in exchange for funds. You retain ownership in part of your company, but you give up a portion to the outside investor.

This type of financing is ideal if you plan to grow your business rapidly. For example, your company has expanded steadily over the past few years. Now, you’re ready to explode into new markets. You have a good idea about where you want to go next, so you hire someone to help with marketing and sales. The person who helps you out is working under contract, not as an employee.

The problem is that you don’t have enough cash to pay him. Instead, you ask friends and family members for a loan. They agree to invest $10,000 each for a percentage of your company. You use their money to cover payroll and other expenses. Your business continues to grow, and in this case, you used equity financing to fund your growth. You gave up some control to others, but you got what you wanted—more resources to grow your business through equity finance.

A line of credit enables you to get money against future revenue. For example, let’s say you need a loan amount of $5,000 to buy a computer system. You apply for a line of credit from a bank, and the bank agrees to lend you the money based on how much you earn in the coming months when you do. If you start making more money than expected, you can pay down the loan quicker.

A line of credit is like a revolving credit card, and both allow you to borrow money when needed. The difference is that a line of credit doesn’t charge any fees outside of interest charges.

When you receive a loan, you sign a promissory note. This document states that you will pay back the amount borrowed plus interest. Interest accrues daily, which means that the total amount you owe could change frequently.

When you take a loan as a small business financing option, you borrow money today and give something valuable in return. For example, if you borrow $1,000 for one year, you pay $1,100, and that extra $100 is called “interest.”

You should always read all documents carefully before signing them. Don’t assume that everything is fine. Make sure you comprehend the nuances of the agreement. It’s important to know what you agree to.

Business owners often find themselves stuck in a financial bind. They need to borrow money, but they don’t have access to traditional sources of financing. Fortunately, there are different ways to get funding for your business.

Business loans aren’t the only option. Several other types of financing are available, and some businesses even turn to crowdfunding platforms like Kickstarter to raise capital.

Companies can apply for a small business grant that does not require repayment. These grants come from government agencies, non-profit organizations, and private businesses.

If a company is developing, it may not be able to secure financing. It’s harder to raise money for a startup because there is no prior business history. Because of this, debt financing may be more challenging to secure than equity financing.

If the business exists and has financial statements to extrapolate from, funding for a developing company will be more readily available. Because of this, mature enterprises will have an easier time securing financing from banks and other lenders.

On the other hand, mature companies may have a more difficult time obtaining equity financing because either the industry or the company has reached a point where growth is unlikely.

To develop a financial strategy, entrepreneurs can leverage industry standards from the same or a related industry and financial information from a publicly traded company in the sector.

If you’re looking for a way to finance your business, consider these alternatives first. Then, look at your options carefully. Be aware of the risks involved with each type of funding. Only then can you decide which source is best for you.

Equity Financing

Equity Finance

Equity financing is a form of financing with the money of others. These are the company’s investors. If a company or an individual decides to put money into your business, you are not required to repay that investor.

Raising capital for a small business through equity financing entails finding investors willing to put money into your venture. You can raise money through equity financing by selling a portion of your company, or “shares,” to investors.

When a business owner employs equity financing, they essentially sell a stake in the company to the lender, and the investor now owns a portion of your company.

Mezzanine capital combines debt and equity. This option often allows lenders to convert unpaid debt into stock stakes in the company.

The ABC show Shark Tank may provide you with a rough concept of equity funding. “Angel investors” and “venture capitalists” are two standard terms for these investors.

It is more common for a venture capitalist to be a company than an individual. The firm does due diligence on all potential investments by the firm’s partners, teams of attorneys, accountants, and investment consultants. Due to the significant sums of capital involved in venture capital deals, the procedure tends to be lengthy and complicated.

On the other hand, Angel investors are typically well-off individuals who want to put their money into a particular product rather than starting a company. To finance their product development, software developers might take advantage of these loans, and Angel investors are in a hurry and want plain language contracts.

Initial Public Offering

Initial shares in a publicly traded market, such as the New York Stock Exchange, are offered in an initial public offering (IPO). The term “going public” indicates a company’s transfer to the stock market.

Small Business Investment Companies

Venture capital financing for small firms is licensed and regulated by the Small Business Administration (SBA) through a program called Small Business Investment Companies (SBIC).

To invest in high-risk, start-up companies, venture capital firms pool their investors’ money. Investors include everyone from high-net-worth individuals to private pension funds to large investment firms.

Royalty Financing

Royalty Financing

Royalty financing is an equity investment in the future sales of a product; it refers to “revenue-based financing.” Unlike angel investors and venture capitalists, royalty funding requires that you have already made a profit.

As a result of the agreements established with the lender, investors can expect to begin receiving payments immediately. In exchange for a share of the product’s sales, royalty financiers provide the startup capital it needs to get off the ground.

Think about Shark Tank’s Kevin O’Leary.

An investor rather than a traditional lender is involved in equity financing. You don’t owe anything to the investor if your company goes bankrupt. The investor loses their investment in bankruptcy as a part-owner of the business.

Equity Financing Advantages

Funding your business with equity and investors has several advantages:

The most significant is that, unlike a business loan, you do owe anyone money. If your business goes belly up, your equity partners are not creditors. Investors, like you, are owners of your company, and they lose their money along with your equity stake.

Due to the lack of monthly payments, more money is typically available for day-to-day needs.

Investors are mindful of the fact that starting a business takes time. You won’t be under any pressure to see your product or company succeed in a short period to receive the money you need.

Equity Financing Disadvantages

Equity funding has many drawbacks, including the following:

In terms of having a new partner, how do you feel that you lose a piece of your ownership when you accept equity funding?

Riskier investments necessitate more significant stakes for their investors. To survive, you may have to give up half or perhaps more of your business. If you don’t come up with a plan to buy the investor’s portion later, that partner will keep 50 percent of your income in perpetuity.

You must also consult with your investors before making decisions. If the investor(s) own more than 50% of your company, you are no longer in charge of the financial decisions, and you may only be responsible for the day-to-day operations and not the company’s success.

Evaluation based on the business profile

To increase your company’s value, you should do extensive market research before providing equity. This way, you can determine whether you can afford to provide stock in your company and its potential value.

Your profile aggregates business pitches, financial statements, financial projections, product viability, etc. Raising money through an equity offering is best with businesses with disruptive, attention-grabbing products/services.

If not, consider applying for a loan or debt financing.

Business Financing via Loans or Debt Financing

Business Finance

You’re probably more familiar with debt finance than you realize as a business owner. Do you have a home or car loan? Both options reflect you personally borrowing money as debt financing.

These types of loans are the same for your company. A bank or lending institution lends money to businesses in the form of debt. Some private investors will do this for you, but it is not the norm.

Here’s how it all goes down. You go to the bank and fill out an application when you need a loan. The bank will evaluate your personal credit history if your company is still in its infancy.

Make sure your company’s records are structured and complete before you apply. If your loan request is approved, the bank will specify the terms of payment, including interest. You are correct if the process reminds you of applying for a bank loan, something you have likely done countless times.

When a financial institution offers debt financing, the borrower is often required to make regular monthly payments until you repay the principal and interest. Financial products such as credit cards are in this category.

Financial institutions may be willing to lend money at low interest rates (for example, 0%) for a while. But at the end of the loan, the rate can increase significantly. In many cases, lenders require collateral, such as real estate, equipment, inventory, accounts receivable, and other assets.

Fixed interest rates, repayment schedules, and penalties for late payments are standard in bank loans, lines of credit, and credit cards.

Financing Options for Small Businesses

If you’ve ever tried to open a small business, you know how hard it can be to secure financing. Banks and other large lenders won’t give you a loan unless you have a lot of collateral or personal guarantees. And many people don’t have those kinds of assets.

Fortunately, business funding comes in a variety of ways.

Here are twelve popular methods:

Business Credit Cards

Using a business credit card—or, in a pinch, a credit card cash advance—to make purchases for your small business can save you from asking for a small business loan.

Credit card financing, on the other hand, can be dangerous. Therefore, you should limit your use to urgent, short-term requirements only. Avoid exorbitant interest costs by paying off your credit card in full before the due date and opt for reward cards that give you cash back or airline miles.

Business Lines of Credit

To be eligible for a business line of credit, you must have a healthy cash flow and a high credit score (a business line of credit functions more like a credit card with a set credit limit than a small business loan, but they are not the same).

To avoid paying interest on funds you are not using, don’t draw on the line of credit until you genuinely need it. After borrowing from it, you’ll have to start paying back the amount you borrowed immediately. Your credit line will replenish as you repay the borrowed monies (meaning you once again have access to the money).

Merchant Cash Advance

This method of financing involves receiving a lump sum payment in advance of future credit card purchases. Daily payments are issued automatically by ACH transfer and are on a percentage of the day’s credit card or debit card sales—so if you have fewer transactions on a given day, you’ll pay less. Credit requirements and time in business are less restrictive, and funding is usually the same day or the next business day.

Invoice Factoring

Invoice financing is a type of business financing in which a third-party ‘factoring’ company buys your unpaid invoices at a lower price (typically, around 80 – 95 percent of the value of the invoices).

The factoring company takes care of collecting the overdue invoices from your clients as part of their pre-negotiated fees.

Suppose you offer net 30 – 90 days to your customers. You might benefit from factoring since it helps small firms to get paid quickly rather than waiting until the payment is technically due.

Invoice factoring’s most significant drawback is that you will not receive 100% of the invoice amount. However, it might assist and reduce worries about cash flow in other circumstances.

Term Loans

A business term loan is a terrific way to obtain working capital, grow your business operations, buy equipment, employ additional staff, or do whatever else you need to accomplish.

Entrepreneurs have relied on this form of finance for decades. These loans aren’t the most eye-catching, and this product has been a great seller for decades because of its dependability.

There are loan sums ranging from $10,000 to $2,000,000, and the money can be in your bank account the same day or within 24 hours after the application and approval.

Expect a repayment period of one to five years for your company term loan. The interest rates are as low as 6% to get you started. Because the interest rate or fee on these loans is at a predetermined level, the payments will remain stable throughout the loan term.

It’s easier for you to figure out how much money you can afford to borrow, and it’s less stressful to pay it back, thanks to this type of loan.

Bank Loans

Bank Loans

In some cases, applying for a traditional bank loan or credit line can take longer than simply using a credit card. With a bank application, you’ll need to demonstrate that you’ve successfully repaid your loans in the past. You will need to provide a business strategy or plan and a financial forecast to the bank or credit union.

The bank, understandably, needs to know it’s getting its money. Lending options offered by banks include those by the Small Business Administration (SBA). In most cases, you will put up collateral or assets and personal guarantees, and the PGs make these secured loans.

SBA Loans

A low-cost government-backed SBA loan from the Small Business Administration (SBA) entices business owners. SBA loans, as a financing option, on the other hand, have a reputation for a lengthy application process that can delay the funds. For the loan to be approved and delivered, it may take up to three months. SBA loans can be a fantastic alternative if you don’t need money quickly and want to take advantage of cheaper interest rates and costs.

Equipment Loans

A business equipment financing loan may be an option if you need to buy significant equipment but lack the funds. You can utilize these loans to pay for high-priced machinery, vehicles, or equipment that retains its worth, such as computers or furnishings.

The lenders make assumptions about your ability to repay a loan. If you cannot repay the loan, the equipment you acquire will serve as security.

Real-Estate Loans

A commercial real estate loan can finance the purchase or refinancing of commercial real estate, such as a warehouse, retail store, or office building. You can use a real estate commercial mortgage to buy new business property, expand a location, or refinance an existing loan.

Microloans

You can apply for microloan financing when you’re looking to start a small business. Loan amounts are usually between $500 and a maximum loan of $50,000, and they can help you fund the startup costs of a new venture. They come with higher interest rates than traditional loans, but they offer more flexibility. The terms of the loan are typically shorter than other types of financing.

Working Capital Loans

Do you need working capital? You can use a short-term loan to cover cash flow problems until you raise additional funding. Working capital loans are generally available through banks and credit unions.

Some lenders require collateral to secure the loan, while others do not. The interest rates on this loan program tend to be higher than those associated with other forms of financing. However, they are still lower than the interest rates on personal loans.

Alternative lenders, like Sunwise Capital, offer unsecured business loans up to $2 million to cover your cash flow needs.

Short-Term Loans

Short-term loans are quick and straightforward to obtain, requiring little in the way of documentation. If your application is accepted, you’ll receive the money as little as 24 hours after submitting it.

The time it takes to binge-watch an entire season of your favorite TV show is about the same as it takes to get a loan. Between $10,000 to $500,000 are available for these loans. Fast funding is the objective.

You’ll also have to pay it off within 6 to 18 – 24 months. Rates can range from low teens to 40% or more, depending on whether there is a guarantee.

Many small business owners turn to short-term loans when they need immediate solutions to pressing problems. You can use a short-term loan to pay for unforeseen expenses, hire new employees, weather a sales slump, replace damaged equipment, or seize an exciting business opportunity.

These types of small company loans don’t have a lot of stringent requirements for obtaining them—at least six months in business and a 500+ credit rating.

Advantages of Debt Financing

Taking on debt to fund your firm has several advantages:

There is no ownership by the lending institution over how you conduct your business.

Once you’ve repaid the loan, you’re no longer obligated to the lender. As your firm grows in value, this becomes more critical.

Debt financing interest can be a business expense on your taxes.

It is possible to effectively incorporate the monthly payment into your forecasting models because it is a well-documented expense.

Advantages & Disadvantages

Disadvantages of Debt Financing 

There are, however, several drawbacks to using debt finance to fund your company:

The assumption that you will always have the revenue or cash flow to satisfy all business expenses, including the loan payment, is implicit in adding a debt payment to your monthly expenses. That’s not often the case for tiny or early-stage businesses.

During a recession, you may find a curtailment of small business lending. Debt finance can be challenging to obtain in harsh economic times unless you are an overwhelming candidate.

Debt funding for small enterprises might be more difficult during economic downturns.

Conclusion

The good news is that funding for small enterprises rose by 27% in 2021. For this reason, startups, small businesses, and entrepreneurs must be more creative than ever before when it comes to raising finance and taking advantage of the funding options in the marketplace.

Check to see whether you qualify for a short-term business loan. If you don’t meet the requirements, you may want to investigate other non-traditional financing options.

 

Mark J. Kane is a successful entrepreneur spending the last 16 years lending money to business owners. Beginning his career as a psychologist, at the age of 23 he became the youngest Hospital Admin running a 100+ bed facility. He built two businesses to over 500 employees and a business from scratch to over $18M in revenue in 18 months before selling. This experience led him to begin Sunwise Capital.

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