Year in year out, thousands of people start companies. And while their businesses may be different, all of these people have one thing in common similarity is that they all had to raise money to finance their company and to kick the business off the ground and to cover corporate expenses.
This article is a short guide that addresses the most common ways to finance your business, along with some important caveats that you should keep in mind. Also, it is written specifically for small and mid-sized business owners who have no desire to become financial experts but just want the facts and also understand the rudiments to sourcing for business funds.
Debt vs Equity
We have two basic ways to finance a small business: debt and equity.
- Debt: This a loan or line of credit that provides you a set amount of money that has to be repaid within a period of time. And most loans are secured by assets, which means that the lender can take the assets away if you don’t pay. However, a loan can also be unsecured, with no specific asset securing the loan.
- Equity: This is selling a part of your business (known as selling an equity stake). And in this case, you don’t usually have to pay back the investment because the new owner of the equity gets all benefits, voting rights, and cash flow associated with that equity stake.
And regardless of the product name, all financing solutions consist of either debt, equity, or a hybrid combination of both. Also keep in mind that there are no “good” or “bad” solutions. And the best solution for you depends on your specific circumstances and requirements.
Here are some of the more common methods of financing a business:
Usually the easiest way to finance a business is to use your own money. And in an ideal world, you should save money for a period of time and use this money to fund your business. And this is probably the wisest, most conservative, and safest way to start a company. Even though, an obvious problem with this type of financing is that you are limited by the amount of money you can save.
Most entrepreneurs take this a step further and take money out of their homes their retirement plans, or insurance policies and use those funds to run their businesses. And this is a very risky strategy because, if the business fails, you stand to lose your house, retirement, and your insurance. Also given that many small businesses fail in the first five years, the odds are stacked against you.
Therefore, saving to start or operate a business is a great idea. And we are strongly against using retirement savings, home loans, insurance loans, and similar sources to finance risky business ventures. And you should consider speaking to a qualified financial advisor if you plan to do so.
2. Credit cards
Also, credit cards can provide an effective way to finance a business and to extend your cash flow. As you can use them to pay suppliers and often earn discounts, certain protections, or other rewards. However, the downside of credit cards is that they are tied directly to your credit score.
Also, cash advances are another source of funds. This is because most credit card companies impose limits on their cash advances and charge high rates for them. And as such, using cash advances can be expensive, but they can also be useful as a last resort.
The use of credit cards can be immensely helpful in extending your working capital and alleviating cash flow problems, especially if you use to them to pay suppliers. Also be careful not to overextend yourself and remember that your credit score is affected by how you use the card.
3. Friends and family
Numerous entrepreneurs fund their small businesses by getting friends and family to invest in them. Also, you can oblige your friends and family to make an equity investment, in effect selling them a part of your company, or you can ask them for a business loan.
Howbeit, there are two cogent problems with using friends and family as a source of business financing. One crucial issue is that if the business fails, you risk affecting the relationship. And understandably, people are often very touchy when it comes to the possibility of losing money. You therefore need to ask yourself if you are willing to risk your relationship for the sake of your business.
Also the second problem is that you will most likely gain a business partner even if you don’t want one. And once their money is at stake, even so-called “silent partners” can become very talkative and opinionated. As you can count on the fact that your friend or family member will want to be involved in your business decisions. And this dynamic can affect the relationship, especially if you choose to ignore their advice.
4. Business loans and lines of credit
Conclusively, these are well-known products, in which a bank provides financing to run your business. And in a loan, the bank gives you a set amount of money that is repaid over a period of years. And a line of credit provides a revolving facility that can be used when needed and paid back on a regular basis just like a credit card.
It is no news that getting a loan, or a business line of credit can be difficult. Even though the bank’s main interest is in getting paid back. Also note that their preferred way of getting paid is through the cash flow that your business already generates. And as a result, they will only provide financing if your company has a proven track record of generating cash and has substantial assets.
Business loans and lines of credit are a great way to finance a business. However, lines of credit are particularly helpful to handle cash flow shortages. Even though, getting this type of financing is difficult and is seldom an option for small companies with limited experience.