Business financing is essential for most businesses. Startups must finance their initial costs, while ongoing businesses need to finance growth and working capital.
It is not uncommon to decide to take on debt. However, financing options will vary depending on the type of business. Its age, position, and performance, market opportunities, staff, etc., are all important. You should personalize your funding search. Let’s talk about how to do a funding search.
Myths about small business financing
Let’s first dispel some common funding myths before diving into the best options for established businesses and startups. Do not be discouraged. It is better to accept the realities you can deal with than the myths that you cannot.
Venture capital is an increasing opportunity to fund businesses
Venture capital financing is rare in reality. It is why venture capital financing is so rare. People often use the term “venture capital,” but they mean “outside investors” and “angel investors” in reality.
For funding a new company, bank loans are the best option
Banks don’t finance startup businesses. Because of the risk involved, banks are not supposed to invest money from depositors in new businesses. While we’ll be discussing this in more detail, you will most likely need to have some monetary traction to obtain a bank loan.
Investors love business plans
Investors won’t be convinced by your business plan that you should invest in your company.
Yes, investors will appreciate a well-written, convincing pitch and business plan. But they are not interested in a plan. It would help if you had a team, has progressed towards idea validation or traction (paying customers). You will need to put in a lot of effort before you can get investors.
No one invests in plans or ideas. Rarely, investors get to know entrepreneurs well enough to be willing and able to invest early in their ventures. They are investing in the entrepreneur and not the plan.
How to prepare your company for funding
Let’s begin with a reality check. Much about financing business depends on you, just like many other things in business. Realism varies from one case to the next, depending on growth stage, resources, and other factors.
Do you run a startup?
Funding prospects will depend a lot on the details of your business.
Many businesses already in operation have access to traditional business loans from banks, which is a benefit that many startups would not have. High-tech, high-growth startups also have access to funding unavailable to established, stable businesses with slow growth.
Your business plan can be improved or developed
You don’t need a business plan. You should.
The most important piece of the funding puzzle is your business plan. It will explain how much money you require, where it will go, and how long it takes to get it back.
Investors will first look at a summary and then a pitch. But if they pass that screening, they will want to see your business plan to do their due diligence. Even before they do, investors will expect that you have a business plan for your reference during the initial stages.
A business plan is required by most commercial banks to be submitted with a loan application. For a Small Business Administration (SBA) loan, a plan must be submitted.
Everybody you meet will expect you to have a business strategy. While they may not ask for your business plan before starting your conversation, they will still want to see it.
How to get funding for your business
You must be able to match the company’s needs when looking for money. The company you are looking for money and searching for it will determine where and how much you can afford. For example, a high-growth internet company seeking second-round venture capital funding differs from a local retailer looking to finance a second store.
We’ll be discussing six types of lending and investment options in the next sections. It will help you decide which funding options are feasible for your business and which options to pursue first.
1. Venture capital
Venture capital is often misunderstood. Startups often criticize venture capital companies for failing to invest in risky or new ventures.
Venture capitalists are often referred to as sharks because of their predatory business practices. Or they can be called sheep because they think like a flock and want the same deals.
However, this is incorrect. Venture capitalists are business people who invest other people’s funds. They are responsible for minimizing risk. They shouldn’t take on more risk than required to meet the return/risk ratios requested by their capital sources.
Who should pitch venture capitalists to?
Venture capital should not be considered a source of funding for all but the most exceptional startups. They cannot afford to invest in startups unless they have a rare combination of product opportunity, market opportunity, and proven management.
Venture capitalists look for businesses that could see a significant increase in business value in a matter of years. These high-risk ventures are often unsuccessful, so they look for winners who can win enough money to cover all the losers.
They tend to focus on newer products or markets that are likely to increase sales in a relatively short time. They only work with established management teams that have worked with successful startups in the past.
You probably already know what it takes to be a potential investor in venture capital. Your management team has experienced this. With the help of a group of smart people, you can convince yourself that your company will grow tenfold in three years.
You should not ask your new company if it is a potential venture capital opportunity. Venture capital is something that most people are familiar with.
2. Angel investment
It is more common than venture capital, is more accessible to startups, and is available at earlier stages of growth.
Angel investment can be confused with venture capital, but there are important differences. Angel investors are individuals or groups that invest their capital. It is more likely to invest in companies during the early stages of growth. On the other hand, venture capital tends to wait until after several years of growth and after startups have had more experience.
Businesses typically obtain venture capital as they mature and become more financially successful after receiving angel investment. Angel investors are similar to venture capitalists and usually focus on high-growth businesses in the early stages of their development. Angel investors should not be considered for funding established, stable, low-growth businesses.
The 2012 JOBS Act, which loosens some restrictions and allows crowdfunding, also affects angel investment. Angel investment was previously restricted by U.S. securities regulations and exchange regulations to those who met certain minimum wealth requirements. These individuals were called “accredited investors” in legal terms. Crowdfunding refers to individual investments in startups made by individuals who do not meet the legal wealth requirements.
Startups and small businesses with low growth can seek investment from more investors if they meet certain conditions. Many details are still unclear, so consult a lawyer if you have any questions.
How to find angel investors
The next question is how to find “angels” who might be interested in investing in your company. You may be connected to investment communities in your local area by government agencies, business incubators, business development centers, and other similar organizations. First, contact your local Small Business Development Centers (SBDC), as they are most likely affiliated with your local community college.
Websites that connect angel investors can allow you to post your business plan. These are the two most trusted sites in this field:
- Gust Angel Network
- AngelList
If you are looking for startup investment, be careful. These are dangerous waters.
While I know of some legitimate business plan consultants, it is harder to find them than the sharks. Real angel investors prefer to deal directly with founders of startup teams, not finders or brokers. Although finders’ fees were once a part of startup investment, they have been largely eliminated.
3. Commercial lenders
Venture capitalists are less likely to invest in or lend money to startups than banks. However, they are the most likely source for financing established small businesses.
Small business owners and entrepreneurs quickly criticize financial institutions and banks for failing to finance their new ventures. Federal banking laws restrict the ability of banks to invest in businesses.
Because society doesn’t want banks to make savings from depositors or invest in risky ventures, the government prohibits banks from investing. Bank depositors are at risk if those ventures fail. Would you allow your bank to invest in other businesses than yours?
Banks should not lend money to startups for the same reasons. Federal regulators expect banks to keep their money safe by making conservative loans backed up with solid collateral. Bank regulators don’t consider startup businesses safe enough, and they lack sufficient collateral.
Why do I believe that banks are the best source of small-business financing? Because banks lend to small businesses. If a business has been in existence for several years, it will have enough assets and stability to be used as collateral. Small businesses are often backed by inventory and receivables. Usually, formulas determine how much money can be lent, depending on how much inventory is available and how much in accounts receivable.
Small business financing can be achieved through bank loans that are based on personal collateral such as homeownership. Home equity could be considered the best source of small-business financing.
4. The Small Business Administration (SBA)
SBA guarantees loans for small businesses, as well as startups. SBA does not make loans directly, but it guarantees loans that commercial banks will make. They are usually applied for and managed by local banks. During the application process for an SBA loan, you will normally work with a local bank.
The SBA requires that the startup owner contribute at least one-third of the capital required for loans. A good business or personal asset must guarantee the rest.
The SBA only works with banks called “certified lenders.” The approval process from the SBA takes as little as one week for a certified lender. Ask your banker to refer a nearby bank that is certified if your bank is not a certified lender.
5. Alternative lenders
An established small business can borrow against its receivables, in addition to standard bank loans.
When working capital is not available, the most common use of accounts receivable funding is to support cash flow.
If your business sells to distributors who take 60 days to pay and the outstanding invoices (but not late) total $100,000, you can likely borrow more than $50,000.
Although interest rates and fees can be quite high, this can still be a great source of small-business financing. The lender does not take on the risk of payment. If your customer doesn’t pay you, then you must pay the money back. These lenders may review your debtors and decide to finance some or all the outstanding invoices.
Factoring is another related business practice. Factors are buying obligations. For example, if you owe $100,000 to a customer, you can sell the paperwork to the factor for a percentage of that amount. The factor assumes the risk of payment in this instance so that the discounts can be quite high. For more information on factoring, ask your banker.
6. Friends and family funding
If I had to make one point for budding entrepreneurs, it would be this: Know how much money you have and know your risk tolerance. Be aware of how much money you’re betting and avoid losing it.
I will always remember a conversation I had with a man trying to make his sailboat manufacturing company work. He had spent 15 years trying and only succeeded in aging and accruing more debt. He said that he could only tell you one thing: you shouldn’t ever take money from your family or friends. You will never be able to get out of this trap. Sometimes businesses fail, and you have to be able to close it and walk away. “I was unable to do that.”
This story explains why U.S. securities laws discourage business investments from those who aren’t wealthy and sophisticated investors. They don’t understand the risk involved. Your parents, siblings, close friends, cousins, and inlaws are very generous to invest in your company. In that instance, please make sure you are clear with your family about how easy it is to lose this money and make sure you explain that to them.
While you shouldn’t rule out investing in your family and friends, it’s important to consider the potential disadvantages. Be open to this type of relationship.
Perhaps your idea and situation make crowdfunding more appealing. It is why you should create a profile on Kickstarter and pitch your product or business idea. This method of raising funds has grown so popular that many crowdfunding sites are available, each offering different terms and benefits.
Before you apply for business financing, here are some things to keep in mind
Unfortunately, investment and financing involve money. Money can also breed predatory business practices and scams. Here are some tips to help you avoid these pitfalls.
Be careful who you source funding
Do not consider friends, family, angels, private placements, or other sources of capital as reliable sources of investment capital. While some investors can be a great source of capital, others are not. These sources of capital should be treated with extreme caution.
It must be written
Spending money from someone else’s pocket is not a smart move. Get the paperwork done by professionals and ensure that they are signed.
Spend before you get funding
Never spend money you have not received. Many companies sign investment contracts and contract for expenses, and then the investment is canceled.
When you are in a difficult spot, don’t rush to your family and friends
It is not always a good idea to turn to family and friends for investment. When your business is in trouble, it is the worst time to lose the support of family and friends. Your business, friends, and family could all be affected.
Finance is difficult
Most businesses are financed by home equity or savings as they start–bootstrapping. Only a handful of high-growth startups can attract outside investment. Venture capital deals are rare. The collateral and guarantees required to borrow money will be the only criteria, not business plans or ideas. Business borrowing is a common option for established businesses, but it is not for new startups.
Your business will determine what the next steps should be. High-tech startups may first look into angel investment, friends, and family, while ongoing businesses with steady growth should ask their banker. Remember that your business is unique.
Disclaimer. The opinions and views expressed in this article are the authors Shalom Lamm.
