Demystifying 11 Fundamentals for Financing Your Business
Starting a new business can be an exhilarating time.
Eventually, though, you may reach a point where you will require some outside help.
Most entrepreneurs have to consider the issue of financing, whether it arises when they're starting their company or expanding it.
According to The Kauffman Firm Survey, 50 to 75 percent of young firms use capital injections, most of which comes from owner investments or sources other than banks, while 19 percent use bank loans.
While chasing down funding for your venture can seem difficult, there are more options than ever available today for small business financing. From angel investors to crowdsourcing, there's no shortage of opportunities.
If you've hit a point where you need some help, don't let a lack of funding discourage you. Here are some traditional and alternative financing options that are available to you as a small business owner.
1. Credit cards.
Credit cards are an extremely popular form of financing for small businesses, and account for roughly seven percent of all startup capital.
A report by the National Small Business Association puts credit cards as third most popular financing choice, after retained earnings and bank loans. Using credit cards to fund a venture is an attractive option -- especially for startups that may not have a lot of cash flow. Still, using credit cards isn't without its risks. Should you run into trouble or the business fail to take off as planned, and you're unable to pay back the balance on time, you'll be stuck with high interest rates.
2. Venture capitalists.
Venture capitalists can invest in startups or growing companies -- however, it's worth noting that the number of businesses funded by venture capitalists has gone down in recent years.
Historically, less than one percent of U.S. companies have raised capital from venture capitalists which means that your chance of getting VC is very low. VCs are notoriously careful about which companies they choose to invest in, however, if you're in a fast-growth industry, and you have a solid exit strategy in place, a VC may be interested in funding you.
3. Angel investors.
Angel investors fill in a gap in startup financing, stepping in to fund companies that need help that they can't get from friends and family, or venture capitalists.
Unlike VCs, angel investors normally invest their own money, rather than managing pooled funds. Angel investors normally provide capital for start-ups or businesses in the early stage of growth in exchange for equity, or in some cases, convertible notes, that converts into shares or cash value at a point later on.
Companies that have been helped by angel investors include Google, Yahoo, and Costco. Since this form of investment generally carries more risk, angel investors generally expect a higher return on their investment -- usually between 20 to 25 percent. One advantage of using an angel investor is that they often have strategic experience, and can often provide valuable guidance with key decisions.
4. Small Business Loans (SBAs).
A popular source of funding, SBAs are loans that are backed by the U.S. Small Business Administration and they are a hot item.
SBA-backed loans are open to any small business but there are specific criteria that you have to meet first. First, you have to meet the government's definition of a small business in your industry. You'll also need to have already been turned down for a loan by a bank. Depending on the loan, there may be additional eligibility requirements that you'll have to meet as well. You can apply for SBAs through banks that processes SBA loans, the SBA itself doesn't provide loans directly.
5. Bridge loans.
Bridge loans are short-term funds that can be brought in to help fill the gap between an immediate need for funding and a future, pending investment. Small business owners can obtain these loans from the bank. You'll have to prove though, that you have sufficient cash-flow, and the bank will want to feel confident that your monthly sales are adequate. These loans are designed to be relatively quick to obtain. Unfortunately they're usually expensive, so expect to pay a higher interest rate or fees.
6. Convertible notes.
Also known as convertible debt, convertible notes are used primarily for seed funding, and are useful for situations where you may be hesitant to set an equity valuation too soon. This is often the case where setting a valuation too early can negatively impact subsequent funding from other investors. Convertible notes convert to equity according to predefined terms at a future point.
7. Cash flow financing.
Cash flow financing is a loan that's backed by your projected cash flow. This is different from an asset-backed loan, where collateral is based on your business assets. With cash flow financing, your expected future income will impact the repayment schedule.
8. Hedge and private equity funds.
With banks becoming more stringent on loan criteria since the recession, hedge funds and private equity funds are stepping up and filling the gap, becoming lenders for many businesses that are in need of funding. Although they offer quicker funds, and usually greater flexibility, the downside is that private funds charge high interest rates, usually nearly double those of conventional lenders.
9. Equipment financing.
In a way, equipment financing works in a similar way to a car loan. The equipment that you purchase works as collateral for your loan, which means that you won't usually have to put up additional collateral. While equipment financing can be a relatively easy form of funding to obtain, the amount that you're eligible for will vary based on things like your business history and credit rating. These factors will also impact how much interest you'll have to pay -- usually between eight to 30 percent.
With the rise of crowdfunding sites like Kickstarter and Indiegogo, crowdsourcing has become an increasingly popular form of financing for individuals who are short on cash, but have big ideas that are going to revolutionize an industry.
In 2014 crowdfunding campaigns raised $9.46 billion in North America, and the industry experienced an annual growth rate of 145 percent, according to a study by crowdsourcing research and advisory firm, Massolution. Successful crowdfunded projects include the smartwatch Pebble, The Dash, smart earbuds and Oculus Rift, a VR headset for gaming that was later acquired by Facebook.
Finally, for some companies, bootstrapping -- starting a business with very little capital, and building it with income that it generates -- is a great alternative to outside funding, especially in the beginning.
Seeking financing is often essential for some companies that require a high influx of capital to get off the ground, or for organizations that are looking to take advantage of fast growth in certain sectors. But for many companies, particularly web-based companies or businesses where startup costs are low, bootstrapping is a viable alternative.
Bootstrapping is an extremely low-risk way to scale your company, and an extremely safe way to test the waters to see how the market will respond to your product. It may be less trendy than some of the other flashier ways to get cash, but it's nothing to laugh at. Companies like Dell, FaceBook, eBay, and TechCrunch, just to name a few, all started out as bootstrapped ventures.
No matter what industry you're in, you'll want to carefully consider your company's individual circumstances when determining which financing option is best for you. Identify solutions that will help you to grow, while at the same time allowing you to maintain enough control over your company. Then choose your funding source accordingly.
Which method of funding do you prefer? Bootstrapping and self-funding, loans, or backing from outside sources such as angel investors and venture capitalists?
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