Thousands of small businesses are started each year. While every business is unique, business owners have something in common - they all needed capital to launch their venture.
Once a company is up and running, it’s even more important to have low-cost funds to cover stability and growth initiatives. Outside financing helps shore up working capital, keep cash flow steady, hire, launch marketing initiatives, buy inventory and equipment and more.
It’s even more important during the current pandemic and economic downturn to rebuild and meet growth goals. There are no universally accepted “good” or “bad” financing available for funding. The best solution will depend on your needs.
Here are 8 of the most common ways to finance a business, along with some important information to keep in mind. You don’t need to be a financial expert to acquire funding, but it’s a good idea to check with your accountant or bookkeeper to determine the best rates, terms, and loan amount that will be most effective.
Debt vs. equity
Here are the two main ways to finance a small business:
Debt
A loan or line of credit provides you a set amount of money that has to be repaid within an agreed upon period of time. Most debt loans are secured by assets, which means that the lender can take the assets away if you don’t pay.
A loan can also be unsecured, with no specific asset securing the loan.
Equity
Selling a part of your business, also known as selling an equity stake is another type of financing. The new owner of the equity gets all benefits, voting rights, and cash flow associated with the sale so you usually don’t have to pay back the investment.
1. Savings
Personal money can be used to cover startup costs or for working capital if you have an established business. There are options when it comes to funding a business with personal money. You can tap into savings accounts, equity in real estate, retirement accounts, vehicles, and other items you can barter for cash. Don’t forget to account for the money on your business books. This helps you track the amount your business owes you back.
Pros:
- Since it’s your money, you won’t be restricted in the way you want to spend it.
- You won’t have to go through the loan application process.
- There are no payments required.
Cons:
- Combining personal and business funds can lead to accounting and tax issues. (read the best way to structure your finances on the SmartBiz Small Business Blog: Business And Personal Finance: 7 Tips For Separating Your Finances.
- You might not be able to afford losing the money you invest in your business.
- If you operate as a corporation, it's more difficult to use personal money because of the formalities that need to be followed.
- Borrowing from individual retirement accounts and 401(k) plans hurts your retirement planning and you’ll pay taxes and penalties.
2. SBA Loan
The Small Business Administration 7(a) Loan Program is known as the “gold standard” in small business funding. It’s the SBA’s primary program for helping small businesses with financing guaranteed for a variety of general business purposes. The SBA does not make loans itself, but rather guarantees loans made by participating lending institutions.
Pros:
- SBA loans have very low interest rates compared to other types of loans.
- Funds can be used for a variety of purposes including marketing initiatives, equipment purchases, hiring, working capital and more.
- Making timely payments on an SBA loan helps to build good business credit.
- SBA loans have no pre-payment penalty.
- SBA loans have 10-year terms, leading to very low monthly payments.
Cons:
- There may be more documentation required for SBA loans than traditional bank loans because they are directly funded by lenders and backed by the U.S. government.
- You’ll need good credit. For a working capital or debt consolidation SBA 7(a) loan, a personal credit score of 650 or higher is required. For a commercial real estate SBA loan, business owners must have personal credit scores above 675.
- Collateral may be necessary. Review collateral requirements here: SmartBiz University: Collateral Requirements.
3. Bank Term Loan
A Bank Term loan from a bank in the SmartBiz network can provide the funds you need if you need faster funding than with an SBA Loan. With a term loan, you get funds in a lump sum that you pay back monthly.
Pros:
- Bank term loans have an easier application process than SBA loans as you are required to produce fewer business documents.
- Bank term loans can be approved and funded faster than a typical SBA loan.
- The fixed rate for a bank term loan helps you budget because your payments will stay the same throughout the life of the loan.
- There are no prepayment penalties.
Cons:
- Bank term loans generally have higher rates than SBA loans.
- Payments are higher because the terms are shorter than a 10-year SBA loan.
- The interest rate depends on the applicant's credit and financial profile. If you don't have strong credit scores, your rate will be higher.
4. Business Credit Card
A business credit card lets you borrow money to make purchases. If you don't make payments in a certain time period, you'll have to pay interest on top of what you borrowed.
Pros:
- If you have decent credit, applying for and getting a business credit card can be relatively easy.
- Many cards have introductory specials like 0% APR for a specific time period.
- Credit card rewards are a big plus. Travel, cash back, and bonuses can add up to savings and fun perks.
- Using a credit card responsibly will help build up your credit score, important for getting affordable funds down the line.
Cons:
- It’s very easy to pull out a credit card and make a purchase. If you have trouble controlling expenses, you could find yourself in financial trouble.
- If you don’t make a scheduled payment, your credit score can drop.
- Carrying too much credit card debt can make it harder to get another type of loan.
- If you miss a payment, you’ll be responsible for a late fee.
Learn more about business credit cards: Benefits of a Business Credit Card.
5. Crowdfunding
Crowdfunding is where you get a lot of people to invest in your idea. Kickstarter is probably the most popular crowdfunding platform for those who want to raise money to launch a new product or service. Some sites will collect all the money as it comes in; others won’t collect it until the goal amount is reached.
Pros:
- Crowdfunding campaigns can be great for PR. They help gain visibility and generate buzz.
- You can secure advocates and ambassadors who have an interest in your success with a crowdfunding campaign. This type of word-of-mouth promotion can be invaluable.
- With rewards-based crowdfunding, you're raising money through donations for your project or business without selling off an equity stake in your business.
Cons:
- Between 69 and 89 percent of projects, depending on the crowdfunding platform used, fail to reach their targets.
- If you want to safeguard your intellectual property, crowdfunding probably isn’t the way to go.
- An entrepreneur with rudimentary financial skills might not have the experience to process funds correctly and legally.
- During an economic downturn, fewer people will want to invest.
6. Angel Investor
Angel investors are individuals or groups of individuals who invest money or equity financing in start-up or early-stage small businesses. Angel investors often invest amounts ranging from $25,000 to $50,000. Three of the most famous companies that got their starts with angel investing are Amazon.com, Starbucks, and Apple.
Pros:
- Even if rejected, you may make excellent contacts for getting funding in the future.
- Going through the process of giving presentations about your business to potential angels is great practice for the future.
- Angels with small business experience can offer valuable business advice.
Cons:
- It is a reasonably complicated and time-consuming process to secure angel funding.
- An in-depth business plan is required.
- Angel investors conduct due diligence and perform competitive analysis, eventually dismissing up to 90% of applications.
- Some angels want to be involved in the companies in which they invest.
7. Microloan
A microloan is a small sum of money lent at low interest to a new business. Generally, microloans are for less than $50,000 and used for early expenses for small businesses and nonprofits.
Pros:
- It can be easier to qualify for a microloan than for a traditional business loan.
- The SBA offers microloans with up to 6-year repayment plans.
- A microloan can help you build credit so you can get lower interest rates from a later loan.
Cons:
- You may need more money to achieve your business goals.
- SBA Microloans come with spending restrictions.
- The microloan process can take longer than many alternative loan programs.
8. Factoring
Factoring financing allows business owners to access a cash advance from outstanding invoices. In short, it’s selling your outstanding invoices to a third-party for about 80% of the total invoice value. Once your customer pays, the factor finance provider will collect the invoice value, deduct their fees, then forward the leftover amount to your business.
Pros:
- Business loan approval can take months. On the other hand, invoice factoring gives you access to cash quickly.
- You'll be spared the headache of chasing down customers for payment.
- Collateral and good credit scores aren’t required.
- Typically, a factoring company is most concerned with your customer’s payment history.
Cons:
- The longer your customer take to pay, the more expensive this type of funding becomes.
- Factoring financing is usually only available for B2B companies.
- Short terms and high fees can make factoring much more expensive than other forms of financing.
For more details, review Factoring Receivables: Everything You Need to Know.
Tips When Searching for Small Business Funding
1. Calculate Affordable Business Funding
Do you have the cash flow to support a loan? That’s the most important question you need to ask yourself. Understanding loan details and payments can be confusing. Work with a lender who is available to answer any questions you have about rates, terms and payments.
SmartBiz Loans has a sliding calculator to help determine monthly payments for an SBA loan through our bank partners.
2. Make a Financial Plan
A financial plan is a section of your existing business plan that includes financial statements indicating where your company stands currently and where it expects to be in the near future. A financial plan helps you determine how much financing your business might need in the future. A financial plan also helps lenders determine if lending you money is a wise use of their funds and can indicate the net worth of your business at the end of a certain time period.
If you don’t have a financial plan, create one with our guide: How to Make a Financial Plan in 6 Steps.
3. Manage Your Business and Personal Credit Scores
This is key. You simply won’t get favorable rates and terms if you have low credit scores. The SmartBiz Small Business Blog has a wealth of resources to help you build and manage credit. Check out the following article for actionable ways to keep your scores high: Personal Credit Score vs. Business Credit Score.
What are Business Credit Scores and Why are They Important?
Before you apply for a business loan or another option, it’s a good idea to speak with a financial professional. They can help you decide what type of funding is best for your unique business and the amount you need to reach your goals. If you need to improve your scores, more information can be found here: Ways That You Can Help Improve Business Credit Score.
The Bottom Line
Finding a way to finance a small business for rebuilding or growth can be challenging. It can be one of the most difficult things that most small business owners will ever do on their entrepreneurial journey. Do your homework and don’t be afraid to hire a financial expert to assist you. It will pay for itself in the long run. Here are guidelines to help you find the right fit: How to Hire an Accountant for Your Small Business.
