Is Bank or Investor Funding Right For Your Business?
When starting a business, what type of funding should you pursue?
If you're starting a business or thinking about starting one, chances are you have thought about how much money you need to get started. You may also realize that you don't have sufficient capital on your own to get started. So, what do you do?
Fortunately, there are many ways to obtain outside funding to help you get started. Funding options usually involve one of two concepts. One is a loan (i.e., debt), in which the lender makes its money by you paying the loan back with interest over a term or a specific period of time. The other is an investment (i.e., equity), in which the investor is given an agreed-upon percentage of ownership (i.e., number of shares) in the business in exchange for providing the capital. In this instance, the investor is hoping that the business will grow substantially over time so that their shares in the business will appreciate in value, thereby earning a Return on Investment (ROI).
When you write your business plan, you want to keep in mind who your audience is. A loan and an investment are two substantially different things, and the ways that lenders versus investors make money are different enough to require different business plans. To help you plan accordingly to pursue the funding you need, here are the main differences between a bank business plan and an investor business plan.
Return on investment (ROI)
If you are seeking investor funding, prospective investor(s) will want to see an ROI scenario that shows the current valuation and estimated future valuation of the business. A business determines its current valuation via the investment amount requested and the percentage of ownership given in return for the investment (e.g., a $200,000 investment for 20 percent ownership, through simple math, means 100 percent ownership is worth a valuation of $1,000,000). It is important to note that when seeking an investment, especially for a start-up, the valuation is largely based on perception, and potential investors may or may not agree with your perceived valuation.
While there are certified business valuators you can hire to determine a precise business valuation for you, you can also approximate your business valuation without hiring one. The latter is commonly done by taking your EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) from a specific year in your income statement and multiplying it by a multiplier (the recommended number to use for your multiplier varies by industry) to determine your future valuation in the same year. Although EBITDA times multiplier is the most common method, some industries have different recommendations for calculating future valuation.
If you are seeking a bank loan, then an ROI scenario isn’t necessary for your business plan. This is because the bank makes money by having the loan paid back with interest. The amount owed to the bank is determined by three things: the amount of the loan, the term on the loan and the interest rate on the loan. Since none of these have to do with the performance of the business, the amount owed to the bank would be the same, whether your business generates $10,000 or $10 billion in revenue.
If you seek investor funding, prospective investor(s) will want to know all the possible scenarios in which they can exit from having a financial interest in the business. One possibility consists of investors selling their shares back to the company at appreciated values at a future point in time. Others include, but are not limited to, the business failing and the investor losing their investment or the business being successful to the point of having an initial public offering (IPO) and having its shares publicly traded on a stock exchange. An investor plan will state each foreseeable possibility to exit.
If you are seeking a bank loan, then an exit strategy isn’t necessary unless you plan to get out of the business before the term on the loan is up (although many lenders would be wary of lending under this circumstance in the first place). An exit strategy isn’t necessary otherwise because the bank only has a vested interest in the business during the term on the loan. Once the term is up and the loan is paid in full, the bank is no longer concerned about the performance of the business because it has earned its compensation in full and has, therefore, exited at that point.
If you seek a bank loan or other form of debt, the interest expense should be shown in your income statement, while your principal loan repayment would be shown in your cash flow statement. If you are seeking an investment or other equity financing, then the interest expense and principal loan repayment will both be zero.
So, which type of funding should I pursue?
There isn’t a cut-and-dried answer to this. However, banks are more inclined to lend to tried-and-true business models (e.g., restaurants and coffee shops). In contrast, investors are usually more interested in new ideas that can disrupt the business environment in some capacity (e.g., food delivery apps). Another factor to consider is your credit history, as you may have a harder time obtaining a loan if your history is subpar.
Related: 5 Business-Funding 'Rules' to Break
Entrepreneur Leadership Network Contributor