Negotiating the finance maze can be a confusing and overwhelming exercise that takes up a lot of valuable time. The type of funding you seek out will depend on the needs of your company, the stage at which your company is at and the milestones you hope your business will achieve.
Understanding the most common funding options available to your business will help you to create a fundraising strategy and boost your chances of success Here’s an overview of the most common funding solutions for small businesses.
1. Self finance
Even if you have the greatest, most innovative business idea, it’s unlikely to take off without solid financial backing. The best form of finance can frequently be your own money because it gives you complete control of your company and the independence to do what you want. In fact, many entrepreneurs finance their businesses in this way through savings or personal debt, such as a second mortgage or credit cards, the latter, however, can be one of the most expensive ways to self finance. Alternatively, you can generate cash for the business by selling personal assets that have some value, such as a boat or second home.
2. Family and friends financing
Surprisingly, the most common type of debt financing for small businesses isn’t commercial lending, but family and friends. Who better to borrow from than people who you are close to and who know your character and circumstances inside out? Nevertheless, borrowing from family and friends can be sensitive and to avoid problems at some point in the future, it’s critical to approach this sort of loan as you would a formal lender. Don’t just verbalise the terms of the loan, formalise the process with legal documentation.
It’s also important to be as transparent as possible about the risks of their investment in your business. Any misunderstanding about the loan could cause irreparable damage to your relationships. Family and friends may demand the money back when it suits them, but not the business. They may also want to get involved in the business when this is not wanted. Before accepting the loan, be clear about your expectations, confirm the repayments that you can afford, and be clear on what they will receive; stocks in the company and/or profit.
3. Debt financing
One of the many benefits of conventional lending is that you don’t have to give up a slice of your company, but if you take on too much debt, it could easily hold back business growth. The advantages of debt financing are that repayments can be short, medium or long term, depending on the individual circumstances of the business and the interest repayments are tax deductible. As the principal and interest are predictable, it’s much easier to plan for debt finance in a budget. In addition, the bank has absolutely no say in how to run the business and isn’t a legal partner. A note of caution is to check the T&Cs for any small print that may give them authority.
Nevertheless if you take on too much debt it can cause cash flow issues as you struggle to make the repayments. Debt isn’t cheap and the high cost of loan repayments can make it tough to grow the business.
4. Equity financing
This involves raising capital through the sale of shares in your enterprise. Unlike conventional lending, equity finance doesn’t involve repayments or interest on the capital received. Instead the business can use its profits to exploit growth opportunities. In addition to funding, investors provide businesses with expertise and management skills to safeguard their equity investment in the company. Equally, the business can benefit from the investor’s knowledge, expertise and contacts list within the market and sector, which is an invaluable resource.
There are situations where equity finance is more appropriate than other types of finance, such as bank loans, but it puts different demands on you and your business and it can take a more time and preparation to secure. The major disadvantage is that you have to consult with investors once stocks in the company have been sold. They may not agree with you about the direction the business should take. This is why you need to consider this option carefully as funding your business from the wrong source can lead to frustration and you may be forced to cash in your chips and leave investors to run the company.
This is an increasingly popular way of raising finance for small businesses. It can take two forms: equity crowdfunding and rewards-based crowdfunding. The first is essentially the sale of shares in the company whilst rewards-based crowdfunding offers benefits in return for money.
There are many online platforms that facilitate campaigns. The disadvantages of crowdfunding is that if you don’t have a compelling story to tell to potential investors, then the crowdfunding bid may well fail. Sites typically won’t collect money until a fundraising goal is reached, so this could involve a lot of wasted time that could have been spent on other goals to grow your business. The worst-case scenario is if you reach your goal, but realise that you have underestimated how much money you will need to take your business to the next level. A business can get sued if it promises perks for finance and fails to deliver.
These five funding options are the most common routes to growth for small businesses. Once you’re ready to take the business to the next level, you should start by creating a plan. Ask yourself: where are we now and where do we want to be in one/five/ten years? What goals do we hope to achieve? Then use these goals to create financial projections that can be used to calculate how much funding you’ll need and what source is the best.
Bio: This article was written by Tony Smith. Director, Business Expert