Small business owners know there are many important financial relationships to make when starting out—with your small business bank, with your vendors, and potentially with your business lenders and investors.
Business financing is crucial for any company. As any small business owner knows, It costs money to start a business. Determining how to fund a new business is one of the first — and most important — financial choices most business owners make. For example, knowing how much to borrow and deciding which lender to work with are two of the biggest considerations. There are many factors to consider to make sure you make the right financing choices for your business.
This straightforward and comprehensive guide walks through the basics of business financing and breaks down the most common ways to finance your small business, along with some important tips to keep in mind.
What Is Small Business Financing?
Small business financing is the process of finding and securing any additional money needed to start your business. Owners might use these funds for a bunch of reasons, like business expansions, equipment purchases, stocking inventory, and corporate and employee expenses. When current cash flow isn’t enough, owners will turn to business financing to get the funds they need.
Business Financing Basics: Debt vs. Equity
Apart from cash, financing your small business falls under two categories: debt and equity.
Financing through debt is a small business loan. It happens when a business gets money from a lender to be used as working capital or capital expenses. Many loans are secured by assets, which means a lender can take your assets if you don’t repay the loan. A loan can also be unsecured, with no specific asset securing the loan.
Equity financing is where a business offers a percentage of the company, known as shares, in exchange for money. In this case, you don’t usually have to pay back the investment because the new owner of the equity gets all benefits, voting rights, and cash flow associated with that equity stake.
All financing solutions consist of either debt, equity, or a hybrid combination of both. Keep in mind that there are no “good” or “bad” solutions. The best solution for you depends on your specific circumstances and requirements.
10 Ways to Finance Your Business
With many business finance options available to small businesses, it’s difficult to know where to start looking for funds and how to find the best option that fits your needs. There are many factors to consider when choosing the right financing solution for your business. From loans and grants to crowdfunding, these are the top 10 most common financing choices.
1. Traditional Bank Loans
The first type of financing most of us think of is a traditional bank loan. Bank loans are available in many forms (short-term or long-term) and for a wide variety of purposes (working capital, expansion, equipment purchasing, or commercial real estate). Many brick-and-mortar banks offer savings opportunities for existing business checking and savings account customers.
2. SBA Loans
Small Business Administration (SBA) loans are a popular subtype of bank loans. These loans are made through banks, but the SBA guarantees a large portion of the loan, which makes banks more likely to lend to small business owners than they otherwise might be. SBA loans are attractive to many small business owners; however, the SBA has stringent loan qualifications on top of the actual lender’s requirements, and the application process can be lengthy.
3. Credit Card Financing
Credit cards can provide an effective way to finance a business and extend cash flow. You can use them to pay suppliers and may even earn discounts, certain protections, or other rewards for doing so. However, credit card financing can be risky and should really only be used for short-term needs. If you decide to go this route, make sure you can pay off the entire balance before the due date to avoid hefty finance charges and a weak credit score.
4. Angel Investors and Venture Capitalists
Angel investors are individuals who invest their own money in a new business in exchange for partial ownership. They typically invest in businesses that would otherwise be overlooked by traditional investors.
Venture capitalists (VC) typically invest in high-growth companies and are provided shares in the company or an equity position that allows the VC to be active in the business.
If your business already has a proven business concept or a record of success, these two options might be your best way to get large sums of financing quickly.
5. Merchant Cash Advance
A merchant cash advance sometimes referred to as an MCA, is a sum of money a provider gives you upfront. In return, the provider gets a predetermined amount of your future earnings. Daily payments are made automatically by Automated Clearing House (ACH) transfer and are typically based on a percentage of that day’s credit card transactions. The provider will continue to take a cut of your sales until the entire advance they gave you has been repaid in full.
6. Invoice Factoring
Factoring turns your unpaid invoices into working capital. Invoice factoring is the practice of selling your invoices, at a discount, to factoring companies in exchange for cash. The factoring company buys your accounts receivable invoices and then pays you immediately for a percentage of the invoices (typically about 80 to 90 percent). Once the factoring company collects on the invoices, they give you the balance of the invoice amount, minus a flat fee. This might be a great option for newer businesses with good revenue projections but not a long revenue history.
Grants are “free” money in that they don’t have to be paid back. Because of this they are very sought after, and competition for even the most generous grant programs is tough. Government grants are the most popular type of grant, but they aren’t the only option. Many private companies, community organizations, and nonprofits have grant programs that range from a few hundred to tens of thousands of dollars. The requirements vary by group, so do your research to see if you qualify.
Microloans are small loans, generally with a limit of around $50,000. These are usually geared toward businesses that have the staffing, working capital, inventory, or equipment needs. Many online lenders and even traditional banks offer some form of these smaller startup loans. Increasingly, nonprofits and community organizations are acting as microlenders, using grants and funding initiatives to help inject cash into their communities through qualified businesses.
Crowdfunding raises funds for a business from a large number of people, called crowdfunders. The money isn’t a loan, but a donation in return for something from your business, such as early access to your product or service. Crowdfunding is also popular because it’s very low risk for business owners. Not only do you get to retain full control of your company, but, if your plan fails, you’re typically under no obligation to repay your crowdfunders. Every crowdfunding platform is different, so make sure to read the fine print and understand your full financial and legal obligations.
10. Friends and Family
While mixing relationships with business can get messy, many of our loved ones are just the people to support our business ventures with some financial backing. Keep in mind that when you turn loved ones into creditors, you’re risking their financial future and jeopardizing important personal relationships. Make sure to have a formal business plan and contract in place that clearly explains the repayment terms (amount to be paid, the timeline for payment, and any interest or fees.) Spend a lot of time educating your investors about the risks of your business, and consider reminding them to only invest money that they can afford to lose.
Weighing Your Small Business Financing Options
With so many different types of financing to explore, you’ll need to weigh your options carefully. You should also be sure to compare the application process, rates, fees, and requirements for each lender you consider. Your choice of financing can impact the future of your business, so use these tips to help you thoroughly evaluate all of your options.
Determine How Much Funding You’ll Need
Every business has different needs, and no financial solution is one size fits all. Your personal financial situation and vision for your business will shape the financial future of your business.
Start by listing out reasons you need funding and how it will be allocated. You’ll want this list to be specific, as sometimes lenders will ask for a comprehensive list before they loan you the money. Are you seeking funds for expansion? Are you refinancing a loan? Are you purchasing more inventory? You’ll also want to create a detailed list of the items you’ll purchase and the estimated cost.
Once you know how much funding you’ll need, it’s time to figure out how to get it.
Know the Minimum Requirements of Each Financing Type
Some of the most important criteria for business financiers typically include revenue, time in business, your credit score, and your industry type. But requirements can vary widely, depending on the lender you work with and the type of financing you’re applying for. The higher the loan amount or the lower the rates, the more requirements you’ll need to meet.
Meeting a lender’s minimum qualifications and requirements will make you a stronger applicant. Some lenders may offer some flexibility if you’re underperforming in one area but overperforming in another, but your best chance of getting approved is meeting or exceeding all of their minimums.
Understand the Rates, Cost, and Fees
Taking time to understand how small business financing rates and fees work puts you in a stronger position to choose the best loan option and save money as a business owner.
Here are some of the most common costs you should consider when it comes to borrowing money:
- Interest (fixed vs. variable)
- Annual percentage rate (APR)
- Factor rates
- Application fee
- Origination fee
- Draw fee
- Wire transfer fee
- Check processing fee
- Servicing and maintenance costs
- Late payment fee