Finance is a crucial aspect of the business; it is no news.
Every business operation falls back to the availability of finances. Having a decent working capital helps run day-to-day transactions and enables one to buy products and services required to run a business.
Oftentimes, a person is new to the regime, starting their career post studies, has brilliant business ideas but no savings.
Not everyone has an inheritance to fall back to; hence look for resources outside the family.
This is when financial and lending institutions in the country come into the picture. But what goes on in financing a business? There is a lot to learn before you take a loan.
In this post, we will be discussing:
- Predominant ways to finance a business,
- Types of loans, and
- Pros and cons of each method.
It will help you in identifying what works best for your business. Moreover, you can go through the list of financing options available for you.
So, let’s get started!
Common Small Business Financing Options
For small businesses to prosper, they may require some financing. There are various options of loans that help give a jump-start for new and small businesses.
If you’re planning to start a small business, you need to know the financing options available at your disposal. Here are some common options:
Often opted, this is the safest, most favored way to start a business. There are a lot of easy ways to save money. Saving up the money takes some time, but it gives full autonomy to the businessman.
Loans from Friends or Family
It comes with some strings attached, often equity. They may be a silent partner; having a loan from friends and family comes with the perk of the flexibility of deadline. That said, there is a downside to this method, too.
Here are some examples:
- Depending on the financial position of the individual(s), you may not be able to generate sufficient finance.
- There’s always a probability that they may request you to repay the loan urgently due to financial constraints at their end.
- If your business starts to generate revenue, your friends or family members may ask you to share your profit, to return a favor.
Therefore, it’s always wise to find people who are financially stable and have no interest in your business. To avoid the above situations, you must explain your point beforehand.
These may offer some ease in paying vendors, salaries, and buying products and services. Anyhow, if you fail to pay back, it will impact your credit score. Credit cards have their own benefits. They increase your purchasing power.
Non-bank Small Business Lender
Non-bank SME lenders are gaining popularity due to their fast-paced loan qualification process, less paperwork, and easy and flexible installments. You can get flexible small business loans by meeting their eligibility criteria.
The eligibility criteria vary from lender to lender and depend upon several factors, such as:
- Your ability to repay the loan in installments
- Your personal credit rating
- The nature of your business
- The legality of business (it must be registered and lawful)
- Evidence showing your business is generating (or will generate) revenue
You need to submit some documents specified by the lender. If you meet their requirements, you’ll qualify to get the loan and repay it at your own pace, which favors most small businesses.
They can set deadlines as well as the amount to be paid per installment. They can also set the frequency according to their ease.
You can pitch your business idea to an angel investor who will likely help if the idea seems attractive. An angel investor can be an individual or a group ready to finance aspiring entrepreneurs.
They offer capital to the business. In return, they want an equity position to see whether your business is moving in the right direction. A decision-making position in exchange for business capital secures their interest as they can intervene anytime.
That said, their involvement often helps startup companies. Angel investors may have good insight and opinions on business plans and they can offer expertise in managing business smoothly.
Depending on good credit scores, you can choose to pay back the vendors’ payments over 30-90 days. It helps with cash flow and acquiring profits on sales.
The Basics of Business Financing
The above-discussed options are the derivations of the two basic concepts: debt financing and equity financing. Businesses may choose either of the two or both, depending on multiple factors that you’re going to learn about in the following lines
It is the most common form of financing a business. Usually, a person heads to a lending institution or bank to apply for the loan. In order to acquire the loan, these institutions evaluate the potential of the business, credit scores, or assets.
Also, Debt Funding (also referred to as debt financing or debt lending) is a way for a business to raise capital through means of borrowing.
For the process to go smoothly, make sure to have all the documents and requirements asked by the lending institution. Moreover, read through the terms and conditions of duration, returning loans, and interest on loans.
Loans are one of the easy ways to finance a business. Often banks offer flexible small business loans that facilitate new and emerging companies to find their footing to run the day-to-day finances of businesses.
These flexible loans for small businesses come with some strings attached. First, there is a deadline when the loan has to be completely paid back. Second, the bank charges a small fee for its facilitating in the form of interest.
Sometimes interest can be in the form of equity in business but primarily a percentage to be paid each month. If you get a loan from a friend or family, you can avoid the interest, and deadlines can be a little flexible.
Line of Credit
As the name suggests, it is the opportunity that enables the business to acquire a loan from a lending or financial institution to manage business finances.
The great thing about this form of lending is that it comes with a roadmap. Returning loan, how much to pay each month, and interest rate are outlined and easy to follow.
Pros of Debt Financing
- Debt financing doesn’t impact how you control your business. You’re free to make your own decisions.
- With the funds available, you can plan your monthly, quarterly, semi-annual, or annual budget accordingly
- Although it can be a long-term liability, once you repay the debt in full, your relationship with the lender ends.
- The interest on the loan is an expense. This means your net obligations are reduced to some extent.
Cons of Debt Financing
- You ought to have a sound credit rating
- You need to have good financial judgment to manage your cashflows and repay your installments on time. In doing so, you may need to put restrictions on excessive expenses and cut down withdrawals to stay disciplined.
- Providing business assets as collateral means putting these assets at risk. Other than that, you may be asked to provide your personal assets as a personal guarantee.
Equity financing is one great way to source funds for your business. In equity financing, one can bring an entrepreneur like an investor on board who shares equity or percentage in business profits and losses.
Investors come in various names like angel investors, venture capitalists, or initial public offerings.
While in some cases, it can be family or friends having faith in your business, inducing money to make financial operations smooth, and sharing the bounties of the business.
To apply for equity financing with angel investors, venture capitalists, or initial public offerings, the company must:
- Show a business plan outlining its manifestation, and
- It’s potential to grow in the future (say, in five to ten years).
Pros of Equity Financing
- There is no burden of repaying the loan; it’s good for startups that are not generating profits in the growth stage.
- You can focus on channeling resources to get more funds for your business
- For businesses with a poor credit history or no financial track record, equity financing is a suitable option.
- With equity financing comes business knowledge, financing advice, and management experience. Angel investors, for example, offer good insight allowing you to use their experience and expertise to grow your business
Cons of Equity Financing
- You have to share your profit with the equity financers
- By sharing the control of your business, you can’t implement your own decisions freely
- Shared ownership can bring about tension and conflicts
Equity Financing Vs. Debt Financing: Which Method Is Better?
There is one basic difference that sets these two types of finances apart.
Debt financing comes with a deadline and no equity in the business. Meanwhile, there is no rush of the deadline of returning a loan in equity financing, but the investor or lender has some or significant equity in your business.
It’s not that small business structures are not supportive of equity financing. However, venture capitalists and angel investors are looking for higher returns in a short time. That may be difficult for a small business.
Moreover, small business loans have become quite easy to acquire. They’re found to be more effective and doable solutions for small business owners.
Having cash flow to run business functions smoothly is a blessing for any business. It helps the business recoup its energies and focus on the business’s main goal.
Ideally, having a family or friend who can bail you out of finances is great. Otherwise, if you adhere to rules and regulations, financial institutions will be a great way to finance your business.
For starters, it requires opening a bank account online to run operations and calculate the credit history. With that, one can always apply for one of the options discussed above.
Knowing which kinds of financing opportunities work well for your business and how much time you will need to return will help determine your decision.