Every year, thousands of people start companies. While their businesses may be different, all of these people have one thing in common: they all had to raise money to finance their company – to get the business off the ground and to cover corporate expenses.
This short guide addresses the most common ways to finance your business, along with some important caveats that you should keep in mind. It is written specifically for small and mid-sized business owners who have no desire to become financial experts but just want the facts – the bottom line.
The basics – Debt vs. Equity
There are two basic ways to finance a small business: debt and equity.
- Debt – a loan or line of credit that provides you a set amount of money that has to be repaid within a period of time. Most 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 (known as selling an equity stake). 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.
Regardless of the product name, 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.
Here is an overview of some of the more common methods of financing a business:
Perhaps the easiest way to finance a business is to use your own money. In an ideal world, you should save money for a period of time and use this money to fund your business. This is probably the wisest, most conservative, and safest way to start a company. However, an obvious problem with this type of financing is that you are limited by the amount of money you can save.
Some entrepreneurs take this a step further and take money out of their homes (through a home equity line of credit), their retirement plans, or insurance policies and use those funds to run their businesses. This is a very risky strategy because, if the business fails, you stand to lose your house, retirement, and your insurance. And given that many small businesses fail in the first five years, the odds are stacked against you.
2. Credit cards
Credit cards can provide an effective way to finance a business and to extend your cash flow. You can use them to pay suppliers and often earn discounts, certain protections, or other rewards. The downside of credit cards is that they are tied directly to your credit score.
Cash advances are another source of funds. Most credit card companies impose limits on their cash advances and charge high rates for them. As such, using cash advances can be expensive, but they can also be useful as a last resort.
3. Friends and family
Many entrepreneurs fund their small businesses by getting friends and family to invest in them. You can ask your friends and family to make an equity investment, in effect selling them a part of your company, or you can ask them for a business loan.
There are two problems with using friends and family as a source of business financing. The first one is that if the business fails, you risk affecting the relationship. Understandably, people are often very touchy when it comes to the possibility of losing money. You have to ask yourself if you are willing to risk your relationship for the sake of your business.
The second problem is that you will most likely gain a business partner even if you don’t want one. Once their money is at stake, even so-called “silent partners” can become very talkative and opinionated. You can count on the fact that your friend or family member will want to be involved in your business decisions. This dynamic can affect the relationship, especially if you choose to ignore their advice.
4. SBA Microloan Program
The SBA has a little-known but extremely helpful microloan program. The provide business loans for up to $50,000 to small businesses. They don’t provide loans directly; instead, they use intermediaries to fund the loans (get the list here). Many of these intermediaries also provide management assistance and may require training as a condition for a loan. The advantage of this program is that their training and assistance often increase your chances of success.
Accion is on of the largest microfinance and small business lending networks in the US and has offices in every state. In a sense, they are similar to an SBA Microloan. They provide startup financing and they also fund ongoing concerns. To qualify for general financing, you need to have been in business for six months and you must have sufficient cash flow to repay the debt, among other requirements. Accion also offers startup loans of up to $10,000.