Every day thousands of businesses are forced to close their doors. The most common reason given for the high failure rate of small businesses is a lack of adequate capital.
Whether you’re starting a business or expanding one, sufficient ready capital is essential.
But it is not enough to simply have sufficient financing; knowledge and planning are required to manage it well. These qualities ensure that entrepreneurs avoid common mistakes like securing the wrong type of financing, miscalculating the amount required, or underestimating the cost of borrowing money.
There are three typical financing arrangements for any business:
- Self-funding: you put up your own money
- Debt financing: you borrow money
- Equity financing: you share ownership with a partner or shareholder in return for money
Self-funding is often the more popular option for small-business owners. Without substantial physical assets in the business, banks will often be hesitant to offer a direct business loan. Even if you can get a business loan, a lender often wants you to personally guarantee it.
Many business owners also don’t want to get involved in the intricacies of equity financing. This leads to most small-business owners choosing the option of self-funding.
There are five ways to raise funds for your small business without obtaining a business loan.
- Personal savings
- Home equity loans
- Life insurance
- Retirement plans
- Credit cards
Businesses may use debt financing to operate over a period of time. Funds secured through debt financing must be repaid over a predetermined period of time, usually with interest. Short-term (less than one year) and long-term (more than one year) options are available.
Debt financing does not require any change in ownership structure, one advantage of this method. Further, interest paid is deductible as a legitimate business expense. Sources of debt financing include banks, trust companies and credit unions, for example. Other sources include family and friends, suppliers and equipment manufacturers, third-party leasing companies, government agencies and other financing organizations.
Types of debt financing include demand loans, lines of credit, term loans, and leasing and supplier credit. Remember to shop around and compare terms, costs and flexibility.
Equity means ownership. Equity financing describes an exchange of money for a share of business ownership. This form of financing allows you to obtain funds without incurring debt.
Equity financing is good if you don’t want an obligation to repay a lender. The major disadvantage to equity financing is the dilution of your ownership interests and the possible loss of control that may accompany a sharing of ownership with additional investors.
The most basic hurdle to equity financing is finding investors who are willing to buy into your business, especially if you are a new business. No matter how sure you are that your business will succeed, others will not always share your conviction.
Different types of equity funding include:
- Venture Capital (VC)
- Small Business Investment Corps. (SBIC)
- Informal Investors/Business Angels
- Initial Public Offerings
When it comes to financing, you essentially have three options – put up your own money, borrow it from a bank, or secure it through a business partner. While any or all may work, one thing is certain – your business must be properly financed or it will not succeed. While doing your business planning, spend the time necessary to determine your financing needs and sources.
Remember to keep yourself connected to others who may be able to impart the wisdom of their experience unto you. Other business owners, friends, and associates are resource options; remember, too, the Small Business Administration provides helpful information and resources to all small-business owners. Use them.
Finally, work hard to avoid common mistakes associated with financing your business. Ask yourself the right questions, and spend time evaluating and reevaluating your needs on a regular basis. Understanding the intricacies of financing will go a long way towards securing the financial future of your business.
For more on this topic, please check out my book “Secrets of Small Business Success in the San Francisco Bay Area“.