The Different Types of Small Business Funding
Starting a small business is exciting — whether you’re bringing a new idea to market or wanting to be your own boss, small businesses offer tons of potential.
As you plan for and start your business, it’ll be your job to figure out how to realize that potential. Many times, small business owners discover that in order to make their business dreams come true, they need to seek external funding and financing.
If you’ve never done that before, don’t worry, you’re not alone. As of 2019, there were 30.7 small businesses in the United States, making up 99.9% of all US businesses. Many of these small businesses sought or are seeking funding to help start and run their business.
In this post, we’re discussing why a small business might seek funding and the different types of small business funding options available to you. With this information, we hope you can make an informed choice in the future of the business.
Small Business Funding
Small business owners don’t have small dreams. Across the nation and world, small businesses are addressing vital issues and problems and coming up with solutions for them. Despite having big dreams and big goals, most small business owners don’t have access to big accounts with unlimited resources. Let’s look at some of the reasons why you might want to seek funding for your business.
Reasons to Seek Small Business Funding
Here are five reasons why your small business may seek funding.
- Startup Costs
Starting a business isn’t free — to do so, you need money to cover a variety of expenses. You’ll need funds to pay for your incorporation fees, insurance costs, office or retail space, taxes, website, and a variety of other common business startup costs.
- Working Capital
Capital is another way of saying financial assets. Working capital, as defined by Investopedia, “is the difference between a company’s current assets, such as cash, accounts receivable (customers’ unpaid bills) and inventories of raw materials and finished goods, and its current liabilities, such as accounts payable.” If you have more in liabilities than assets, then you don’t have a positive working capital, which means it can be tough for you to pay back any existing loans and you can even risk bankruptcy.
- Business Growth
After you’ve started and established your business, you’ll want to grow it. Maybe you’re looking to serve a new market, are buying assets, want to increase your sales, or hire additional help. Whatever your needs, growing a business costs money.
- Products and Services
From ideation to execution, product and service development cost money. You’ll need to validate the idea for your new product which could involve market testing, then cover the costs of production, inventory, and shipping. There’s nothing worse than identifying the perfect product or service for your market and not being able to fund it.
- Debt Consolidation and Restructuring
It may seem counterintuitive to receive funds or take out a loan to pay off your debts, but loan consolidation often helps to make your finances more manageable. Loan consolidation can increase your working capital by reducing the number and amount of your monthly payments.
Types of Small Business Funding
Just as everyone’s need for funding is different, so too are your financing and funding options. What may be a great fit for one business isn’t necessarily the solution for yours. Luckily, there are many types of funding to serve a variety of needs and types of business. But before you apply for funds, make sure you know how much funding you need.
Traditionally, there have been two main kinds of small business funding: debt financing and equity financing. Debt financing means that you’re funding your business by borrowing money, whether it be in the form of a traditional bank loan or borrowing from friends and family. Equity financing is a way to gain funds by selling stock or ownership in your company. This type of financing often means you establish a long-lasting relationship with the lender who may also serve as a business mentor.
Let’s explore different types of small business funding so that you can make the best decisions for your business.
When you decide to bootstrap your business, you’re not turning to external sources for help. Instead, you’re acting as your own investor. If you have a 401(k) or savings that you can tap into, and you want to maintain complete control over your business and finances, then bootstrapping may be the best fit for you.
Unfortunately, not everyone has money saved and invested, and that can be due to a variety of reasons outside of their control. If bootstrapping isn’t an option for you, don’t worry, that doesn’t mean you can’t start a small business.
Traditional Business Loans
What are traditional business loans? They’re bank loans, plain and simple. There are different types of bank loans and the terms of your financing can vary greatly depending on the lending institution.
Before accepting any loans, you’ll want to review two things: The loan terms and what collateral you’ll need to obtain it. Oftentimes, banks won’t issue loans for small amounts of funding, so you need to consider the longevity of your business and accept that you may be paying back your loan for a long time to come.
Here are some ways that banks traditionally lend money to businesses:
A revolving loan usually takes the form of a line of credit or business credit card. Instead of a fixed-term installment loan that starts on a specific date and must be paid back by a specific date, revolving loans give you access to funds as you need them. With a line of credit or credit card, you can access money up to a predetermined limit (your credit limit.) As you borrow and pay back the funds, that money again becomes available for use.
When you think of traditional business loans, installment loans are what first come to mind. In most cases, installment loans are secured, meaning that the lender requires some form of security, i.e. collateral, before they’re willing to lend funds. However, if you’re taking out a traditional installment loan for the purchase of a specific asset (like a company vehicle or building), that asset often acts as the collateral.
Installment loans have specific terms that are covered in something called an installment agreement and can include things like a repayment amount and schedule. Installment loans often take the form of commercial loans or equipment financing, and they fall into the category of debt financing.
Traditional lenders usually require that you have good credit before issuing any type of business loan. If that isn’t the case for you, you may want to seek alternate funding.
Alternative Loans and Lenders
Alternative lending is an umbrella term that describes loans and funding options outside of your traditional bank loans. We’ll list some common forms of alternative lending below.
Friend and Family Loans
There are pros and cons to borrowing money from friends and family, just as there are with every type of funding.
Borrowing money from your familiars can be a great way to save on interest and you already have an established relationship with your lender. However, keep in mind that the success of your business can greatly affect these relationships. If your business does well and your friends and family see a return on their investment then all is well. But what happens if your business is stagnant or fails? That can lead to a relationship turning sour, no matter your original relation to the lender.
A grant is money given to a person or business from the government, a private business, or a corporation. Unlike traditional loans, grants do not need to be paid back. Contrary to popular belief, the U.S. government doesn’t give grants to individuals looking to start a business. Instead, you can turn to private corporations or an entity like the Small Business Administration (SBA) to help with seeking a grant.
Business Cash Advance
A Business cash advance, also known as a merchant cash advance or an account receivables factoring, is when you receive a lump sum of money and in return, you promise the lender a percentage of your future revenue or sales.
Business cash advances are like the “payday loans” of the business world — they’re easy to come by, but the terms are often steep so stay alert and always review the terms and conditions. If you have bad credit but good sales projections, this may be a great solution to your small business funding needs.
Small Business Administration Loan
With a name like SBA Loan, you might think that the SBA lends money directly to businesses, but that’s not quite how it works.
Instead of lending money directly, the SBA has a network of lending partners that they work with to provide loans to small businesses. These partners include “community development organizations and micro-lending institutions.”
Depending on the SBA loan you qualify for, you may also receive education and support to run your business and benefits like lower down payments and no collateral. SBA loans can range anywhere from $500 USD to $5.5 million USD.
You must meet certain eligibility requirements to apply for and receive an SBA loan, so take a look here to get matched with a lender and see if an SBA loan is right for you.
According to Biz2Credit’s July 2020 Small Business Lending Index, only 13.8% of small business loan applications were approved at big banks. That’s not a particularly comforting success rate, and if you can’t get a traditional bank loan, you may want to look for a private investor.
Private investors can be anyone — friends and family fall into this category, along with your professional network and business capital brokers. If you’re looking for a local private business investor, try speaking to your Chamber of Commerce or any relevant trade associations as they may be able to point you in the right direction.
Oftentimes, private investors (you may hear them referred to as angel investors) will give you a lump sum of money (known as venture capital) to invest in your business in return for ownership equity. Private investor terms vary from investor to investor, so do your homework and contact multiple investors to make sure you’re getting the best terms.
Invoice financing can be a great small business funding option for those already open and in business. It’s a way of improving your cash flow (so you can pay employees and stay on top of other expenditures) by borrowing against your open customer invoices.
Depending on your small business structure, you may find that you’re selling goods and services based on credit (invoicing your customers) instead of receiving the money up-front. In this situation, your client is given an invoice that tells them the total amount due and the due date. If you have unpaid invoices, you can approach an invoice financing lender and borrow against those open invoices. In this situation, your open invoices act as the collateral for the funding.
As you’ve perused social media you’ve no doubt seen people crowdfunding money to pay for surprise expenses, like medical bills or funeral costs. But have you ever given serious consideration to crowdfunding your business?
Crowdfunding is exactly what it sounds like — raising funds from a crowd. Instead of having one or two large investors, anyone can contribute a small (or large) amount to a crowdfunding campaign, thereby helping you raise the money you need to launch and maintain your small business.
Crowdfunding campaigns fall into four main categories:
- Donation – when people donate money to your crowdfunding appeal and are promised nothing in return.
- Debt – any money pledged by your supporters is paid back (usually with interest) by a certain deadline. This is a lot like a traditional loan.
- Rewards – in this scenario, you promise a certain reward based on the amount of money someone pledges to your crowdfunding campaign. You can offer services or products as rewards to entice people to donate funds.
- Equity – this is exactly what it sounds like. When you perform an equity crowdfunding campaign, you’re pledging a percentage of ownership in your business in return for funding.
Ready to fund and launch your small business?
We hope this post has helped you understand the different types of funding your small business can leverage. If you have any questions or comments, post them below!
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