How To Finance Your Small Business
For any small business, there are numerous ways to finance the business. It can come from personal savings, stocks and bonds, banks and other institutions, debt financing or taking out loans.
The way in which you finance your small business will depend on the type of industry that you are in as well as on your personal financial situation and goals. Knowing what is available to you will help guide your decision of how much cash flow you need for the company now, versus how much growth potential it might have in the future.
This informative post dives into all aspects of small business financing by explaining what different types of funding sources a company may use and when each one might be appropriate - stocks vs. bonds vs. bank loans, and more.
Small Business Financing Strategies: An Overview
The first thing to understand when looking at financing options is that there are four main types of financing strategies to use as you grow your company: equity financing, debt financing, owner financing and hybrid financing. Here are the basic definitions of each type of strategy:
Equity Financing
You can finance your business by selling a portion of it in the stock market. Equity is an ownership position in a company that represents the value of that percentage ownership. For example, if you own 50% of a business worth $2 million, then your equity stake is worth $1 million ($2 million x .5). Your company could be worth much more, of course, depending on how successful it is and what happens to interest rates. Equity financing is used by investors when they want to buy a piece of a company and also by companies that want to raise capital from the public in order to expand their business or pay off debt.
Debt Financing
When you borrow money, you are incurring a debt for some period of time, but you are not selling a percentage of ownership in the company. When you take out debtor financing, all you have done is bought yourself time (or "a bit of breathing room" as one investor put it) from your creditors until a later date when you will repay them. Debt financing is used by companies that are in need of quick money to expand their business.
Owner Financing
When an owner puts money into their business, it is considered owner financing. It is a tool that can be used to fund an expansion or some other major cost for a company. An owner might also use this type of financing strategy as a way to get a stake in the company back if another party takes it over or wants to buy them out. When owners incur personal costs for their business, it does not count as debt and does not create any sort of liability for them personally.
Hybrid Financing
A hybrid financing strategy includes elements of both debt and equity. It's an ideal approach for businesses that are just starting out because it allows them to use the flexibility of a short-term loan (where you would pay interest on the amount borrowed) while still retaining some ownership stakes in the company. For example, if you want to expand your business in order to compete in a larger market, a hybrid approach would allow you to access funding quickly while owning some shares as well. A hybrid bank loan will also include future sales proceeds and cash flow-based repayment options that can be based on interest or percentage of sales or profit in order to help make your payments more affordable.
The type of hybrid financing you choose will depend on the amount of money you want to raise and your own personal financial situation. Banks are more likely to offer a convertible loan that's combined with common stock if you have a good credit score and collateral. If you have an installment loan, you would be using the money for business purposes only and would get a set payment schedule for up to five years. That type of deal is suitable for those who need less money than other options, like bank lines of credit or venture capital.
For more, check out this informative article about Using Hybrid Financing for Small Business.
Equity, Debt, and Owner Financing: Some Things to Consider
There are a lot of things to consider when you're deciding which type of financing option is ideal for your business. First and foremost, you'll have to figure out how much debt you need versus how much equity you need in order to finance your company. There are some general guidelines on what types of businesses look at which financing options the best, but it's important to know that there is no magic formula that will help you decide the right way.
If your business is just starting out and you want to make a major purchase, then you may want to consider looking at both debt and equity financing options at the same time. This can help you get the amount of money that you're looking for without having to give up any ownership in the company that you've worked so hard to build.
Start out by checking with your local bank, who might require equity stakes or collateral in order for them to be willing to offer a line of credit. That said, banks aren't always the best place to look when choosing an equity or debt financing option because they usually require that you have some form of collateral in order for them to make a loan. This usually means that your company's accounts would have to be liquidated in order for the bank's money to be transferred and that can be a huge hassle.
The other main thing to remember when you're looking at equity and debt financing options is that they can take different forms, so it's important to know which type of financing has what type of interest rate attached to it. You'll want to check if the interest rate is fixed (however little) or variable (however much). Variable rates change frequently, so there are often great deals when they are lower than they were in the past.
When it comes to owner financing, you then have the option of using different types of interest rates as well. If you decide to use this type of financing option, do you want an interest rate that's based on principal and not revenue? Or would you prefer a percentage-based loan that is based on revenue but is fixed?
If you're uncertain about which type of financing will be best for your business and your particular circumstances, it's always a good idea to talk to a loan officer at your local bank before making a final decision.
Conclusion
There is a variety of financing options, including debt and equity, that can be used by different types of businesses. It's important to know what type of financing method you are using and how that impacts the various terms of your agreement. When you're not sure which type of financing will be best for you or your business, it's a good idea to consult with an expert before making a decision.