- Small Business Funding – Grants, Loans, Equity, or Bootstrap (Maybe All of the Above)
Business funding is broken into two broad categories; debt or equity. A third category, grants, could be added as well. Debt financing is borrowing, or going into debt for the funds or assets. Equity financing is trading a part of the ownership, or equity in your business in exchange for the funds or assets. Which route you decide to take will be determined by many things, not the least of which is your personality. Many business decisions, especially at the home and small business level are dictated in large part by the personality of the owner, and where to get money is certainly no different. In a perfect world the decision on how to finance your small business would be made purely on an analytical level, but that's rarely the case.
From a business standpoint, which financing route makes the most sense? Which will enable your business to get the capital it needs at the lowest cost while retaining the highest level of flexibility? In many cases the business owner will self finance, or bootstrap to get the company off the ground. In bootstrap financing, additional capital is generated by business operations and no additional capital is required. The advantage with this funding approach is that the business has no debt and 100% of the equity stays with the original ownership group. The disadvantage with bootstrap financing is that there will probably be insufficient funds to maximize the growth potential of the business. Some business owners are willing to make this trade off in order to retain 100% ownership and control. Others would rather maximize profit potential and so will take on additional sources of funds.
Often the decision on which direction to take is dictated by the type of business as well as the desires of the ownership group, weather that group is a single owner, a family or some other mix of individuals. For example, some business are more capital intensive than others. If you are running a small consulting or marketing business out of your home, you may not need too much additional capital. On the other hand, you may be running a construction, small manufacturing company, or a business such as a bakery, in which case you'll likely need additional funds for capital assets, employees and marketing.
It is possible to bootstrap a very large company, and I personally know a couple who grew a construction business that they started right out of college that they later sold for $200 million. They bootstrapped the entire thing, never taking on any debt, over the course of almost 30 years. That is obviously the exception, but it does illustrate the possibilities of bootstrap funding. Weather or not they could have grown the business larger, faster, or both by getting additional financing is a question that will never be answered.
If you either don't want to wait 30 years, require additional funds for capital expansion, or are experiencing operational cash flow problems due to growth in your business you'll have to make the choice on how to finance.
Debt Financing – Credit Cards -
Probably the most common source of small business financing, is debt financing in the form of credit cards. While easy to get and flexible, there are disadvantages to credit cards as a source of business funds. The primary disadvantage is that, as unsecured credit, they tend to be expensive. Another disadvantage is that, depending on the level of funding required, it may not be possible to get sufficient funds by going this route. If you run a landscaping business and you'd like to outfit a few additional crews, a credit card is probably not the best solution. The advantage is that it is fairly easy to get credit card(s) in the business name, even if the owner will have to personally guarantee the card. Credit cards definitely have their place in business, however. In many cases, credit cards are perfect for financing some day to day operations such as fuel, web hosting, Internet advertising, and so on.
Debt Financing – Small Business Lines of Credit -
This is another flexible financing alternative for small or home businesses. The advantage to a line of credit over a credit over a credit is that it is usually less expensive and has a higher limit. It is not uncommon to get small business line of credit, especially for a business with a solid track record, of $250,000 or higher. This is sufficient capital to fund expansions and smooth the cash flow issues that can be created by a growing and/or seasonal businesses.
Debt Financing – Small Business Loan
The most common small business loan is a loan that is guaranteed through the Small Business Administration. Think of it as a student loan for your business. As a student loan is guaranteed by, but not taken from, a government agency, so is an SBA loan. You will receive your funding through a conventional lending institution, such as bank. Because the government guarantees they will repay the loan if you default, the interest rate is very favorable.
You may think that because the government is guaranteeing the loan you won't need collateral, but you'd be wrong. You'll typically need security for the loan, which in most cases turns out to be the deed of trust to the borrowers house. Default on the loan and the government owns your home. I speak on this from personal experience. I was a principal in a firm that had a $250,000 SBA loan. We foolishly entrusted the repayment of the loan to an employee that turned out to be inadequately supervised. Needless to say, that employee didn't have the same priorities as those in the ownership group who had their homes as collateral for the SBA loan. In short we had to come up with $92,000 in cash in 30 days to repay the balance of the loan. We did so, but it was a frightening time. In short, don't mess with the government.
If your business is advanced to the point where you have sufficient assets and revenue, you may be able to use part of your business for security on your SBA loan. In the case of using assets for security, you'll be required to complete a UCC1 form. This form gives ownership of the pledged assets to the lender until such time as the terms of the financing agreement are fulfilled. As a side note, you should be using UCC1s as well if you extend credit to your customers for product you've sold them. You can use the funding for many things, such as plant and equipment, real estate, inventory, leasehold improvements, and additional staffing.
You can also get a non-SBA business loan, but usually the interest rate will be higher and the loan will be more difficult to get unless you have truly impeccable credit or a healthy amount of security. A loan can be a great source of funds of your business. A loan can allow your business to grow and reach the goals you've set without giving away ownership, which may be just as you'd like.
Debt Financing – Vendor Financing-
This is an extremely common source of funding for small and home businesses. It is normal for distributors, manufacturers and other vendors to extend credit terms to businesses to finance their inventory or services. You will usually receive some sort of incentive to pay early, or with cash. The terms will be stated in terms such as 2/10, n/30. This simply means that the invoice net is due in 30 days, and you'll get a 2% discount for paying tit within 10 days. The advantage of vendor financing is that it is usually free and easy to get. The disadvantage is that it's very short term, and can only be used for financing from the specific vendor.
Equity Financing -
Equity financing is a very common source of funds for small and home businesses. The normal progression of equity financing, even in businesses that are now very large, begins with what's known as the “friends and family” round. These investors will receive some level of ownership in the business for their investment. A round of financing is simply an instance of acquiring capital. The next round is typically used by businesses that will be growing to the point where ownership in the business is attractive to investors. The second round is usually made by small investors or investor groups based on current and expected future revenue. Sometimes this is referred to as the “angel” round because the investors are termed angel investors.
The third round, if your business gets that far, (if it is a home business, it won't be any more), is the series 'A' round. This is usually funded by private equity and VC firms. They'll look at your business with a fine toothed comb during a process known as due diligence. These rounds are usually in the multi-million dollar range and will be based on many things, including your business plan, current and expected future earnings, business model, the expected market for your products and services, and more. They will receive series A preferred stock for their infusion of capital.
You may use any, all, or none of these sources of small business funding. One thing's for sure though, if you provide no funding, you'll probably get no return.
