Table of Contents
- Equity Financing 101
- Debt Financing 101
- Equity Financing vs. Debt Financing
- The Equity Advantage
- How to Attract Investors
- Funding a Small Business Through Grants
- How Much Funding Does Your Business Need?
- Alternative Forms of Business Financing
If you have the next big business idea, you’ll need to invest a lot of time and energy to turn the idea into a profitable enterprise. That includes assembling a team, buying equipment and real property and setting up a website and marketing funnel. All of that takes serious coin to finance, so “how to fund a business?” is the first question aspiring entrepreneurs must answer.
There are few, if any, ways to launch a small business without startup capital behind you. Entrepreneurs from all walks of life often ask us how they can take their idea and turn it into a money-making venture. The answer, universally, is to secure financing to get the ball rolling and start generating revenues.
In this guide, we’ll give you a step-by-step walkthrough to funding a small business today.
Equity Financing 101
One of the most popular ways to get a new business off the ground is to seek out equity financing from external investors or through self-funding (we’ll touch on that in a moment). Before we jump into an item-by-item discussion of the various forms of equity financing, it’s important first to discuss what equity is and why it’s useful as a funding concept.
Unlike debt, equity financing involves raising capital through a process of selling shares in a company. Each share represents the sale of a fraction of ownership interest in the company. Equity financing can take place in the form of a small seed funding found among family and friends, or a massive initial public offering (IPO).
Selling shares in a company in the form of stock is a popular way for small and medium-sized enterprises to raise capital for their business. However, every business owner interested in selling shares must read and comply with regulations set forth by the U.S. Securities and Exchange Commission (SEC)—businesses that fail to comply with SEC rules can face severe criminal penalties.
In short, equity is the opposite of debt financing. After an ownership stake is sold to an investor, there’s no need to repay debts. There are 7 common equity financing sources, and we’ll go into each below:
- Angel investors
- Venture capitalists (VCs)
- Family and friends
There’s no better business than a self-starting one. The process of “bootstrapping” refers, unsurprisingly, to the process of pulling one up from one’s bootstraps and getting the job done on self-reliance alone. Although most business ideas are impossible to bootstrap without external capital, it’s possible for some companies that don’t need to invest in inventory.
A bootstrapped business funds itself and continually reinvests profits into the company to spur long-term growth. Business-to-business (B2B) and service industry companies are often better-suited for bootstrapping than seeking out angel investors because, in most cases, sales alone can sustain the operations and growth of these businesses.
Whenever possible, it’s a good idea to bootstrap your company. For this to happen, the business model must be rock-solid and your books and sales funnel have to be positioned for sustainable growth.
The upside of bootstrapping is that it results in zero debt and won’t result in handing over any ownership stake in the company.
It’s not uncommon for entrepreneurs to self-fund their business ventures, especially in the early stages of its growth. Self-funding is different from bootstrapping because you are still raising funds, and not necessarily counting on the business to finance its founding. Instead, the entrepreneur draws on personal savings or debt (i.e., credit cards or a second mortgage), to fund the business venture without having to look for external capital.
If you don’t have access to private capital or debt to self-fund your business, you can sell off personal assets to bring in cash for your venture. For example, selling a boat or an extra property in the family can often generate enough capital to make a significant impact on a startup.
One of the most common ways to seek equity financing for a small business is to pitch your business model to an angel investor. Angel investors are high-net-worth individuals who have cash available to invest in a small business in exchange for an ownership stake. Investment groups are usually composed of professional angel investors that pool their resources together to hedge against risk and to perform superior market research.
If your business is interested in seeking out the assistance of an angel investor, we recommend speaking with your local chamber of commerce or searching online for an investment group.
In 2019, one of the fastest-growing methods of funding a business is to crowdfund it. Crowdfunding refers to a funding process by which an interested collective of parties contributes money (usually via an online platform like Kickstarter or IndieGoGo to fundraise for a cause.
In exchange for their contribution, crowdfunders usually receive a benefit such as a prototype of the product or another exclusive branded item.
Today, many artistic and entrepreneurial ventures are financed through crowdfunding. This is especially true of social entrepreneurship endeavors that are mission-based or aim to satisfy the public good. Although technically an alternative form of equity financing, crowdfunded business projects can also result in debt depending on the crowdfunding platform you choose.
Venture capitalists (VCs) are firms and organizations that provide funding for companies in the early stages of growth. Although VCs typically have deep cash reserves to invest with, unlike angel investors, they almost universally seek to own a large share of the company’s equity. Business owners who want to retain a majority share of their company should think carefully before consulting a VC for funding.
Most of the time, starting a profitable business cannot be done without spreading responsibility across various team members. Simply put, launching a successful business is hardly ever a one-person job. To ensure the sustainability of your venture (and to prevent burnout), finding a business partner or two is sometimes a good idea.
Forming strategic partnerships with other entrepreneurs is a great way to expand your professional network, grow your resource pool and combine talents, as well as expand your bootstrapping or self-funding capabilities. If your business partner has cash-on-hand, they can make a significant impact when it comes to fueling your company’s operations. Beware, however, of seedy business partnerships with individuals only looking out for their self-interest and not the good of the company.
Family and Friends
Believe it or not, many successful entrepreneurial ventures once started as family-funded businesses. In other words, they relied on cash infusions or donations from family members and close friends that wanted to see the business succeed. Sometimes this is considered a type of angel investing, but the relationships involved are entirely different.
While this method of financing a company occasionally works, it can also cause unnecessary and unwanted tension between loved ones if the business fails.
Is Equity Financing Right for Your Business?
Ultimately, the equity funding available to you will be determined by your personal options, the industry your business is in and the people around you. Although for some it may be best to self-fund or bootstrap a small B2B or B2C business, it’s often better to seek out VCs or angel investors if you think you have the next Facebook or Amazon on your hands.
Debt Financing 101
On the other side of the coin is debt financing, which involves borrowing capital or other assets without sacrificing an ownership stake in the company. Instead, debt financing requires the borrower to repay the principal amount loaned to the creditor, with interest and fees, by a predetermined date.
When a business owner reaches a debt financing agreement with a creditor, strict terms and conditions are agreed upon that must be upheld by both parties. If the borrower violates the terms of the agreement or fails to repay the debt on time, severe financial penalties can follow.
For profitable businesses, the interest paid on a loan is a tax-deductible business expense. In other words, all interest paid on business loans can be written off your income tax return, often rendering the effective interest cost much lower than the written cost.
If you’re considering debt financing to get your business venture off the ground, we’ve compiled a short list of the most popular debt financing options for small businesses below.
SBA loans are affordable business loans backed by the U.S. Small Business Administration (SBA). The main benefit of choosing an SBA loan over another option is that SBA loans are secured by the federal government, which provides a level of security for the lender that enables them to lower interest rates.
SBA loans are among the cheapest forms of debt financing for small businesses. Although their price tag is attractive, perhaps their biggest selling point is their approval rates. Traditional commercial lenders, such as banks and credit unions, are often highly averse to issuing unsecured loans to startups and small businesses. However, since SBA loans are backed by the government, lenders are much more willing to grant them.
Applying for an SBA loan is a straightforward process that closely resembles the process of applying for a traditional term loan from a bank. Still not sold on an SBA loan? If not, consider the following competitive features of SBA loans:
- Annual percentage rates (APRs) between 6-8%
- Average amortization rates of 10 years or less
- Higher acceptance rates
Term loans from banks and credit unions are perhaps the most common form of debt financing for small and medium-sized enterprises in the United States. Be warned, however, that banks and traditional lenders will demand a proven track record of good credit and lending behavior before deeming you eligible for a loan.
In nearly all cases, bank loans require collateral. In other words, lenders will need you to put up some of your assets as security against the risk of defaulting on the loan. After all, if you fail to make repayments on the debt and declare bankruptcy, there’s little the lender can do to recoup their losses if the loan was not secured.
If you’re wondering what your business might be able to use as collateral, don’t sweat it. There are plenty of options business owners can consider when putting up collateral to secure a loan. Here are a handful of the most widely-accepted forms of business loan collateral:
- Real property (e.g., real estate, vehicles, home equity)
- Accounts receivable (i.e., unpaid invoices)
- Blanket liens
- Business equipment
Small Business Lenders
Although they can be hard to find in some areas of the country, there are plenty of commercial lenders that cater specifically to the needs of small businesses. Like bank loans, however, they will usually require a form of collateral, and some charge higher interest rates than a regular term loan.
The upside to applying for a business loan through a designated “small business lender” is that the chances of getting approved for a term loan are better than with a regular commercial lender. However, everything comes at a cost—especially business lending. In this case, the tradeoff is that the term lengths are generally short and the interest rates higher, which means more frequent payments and a potentially higher effective cost.
Business Credit Card
Getting approved for a business credit card is one of the best ways to build a positive credit history for a business owner. Although business credit cards may not have a high enough credit limit to finance major investments or capital projects, they tend to help most by tiding businesses through cash shortages and credit crunches.
When used responsibly, business credit cards can offer a host of benefits by building up your company’s FICO score and creating more convenient ways to pay for business expenses. Plus, many business credit cards offer cash-back rewards of up to 2% among other great perks and incentives.
Business Lines of Credit
A form of “revolving loan,” a business line of credit (LoC) is an invaluable tool for meeting the needs of a business as they arise. Business LoCs fuel the growth of a company by providing an as-needed pool of credit that can be drawn from gradually.
The main difference between a business LoC and a standard term loan is that a loan is received in a single lump-sum payout that is repaid in set installments in predetermined intervals. By contrast, borrowers can access their credit line whenever they need to for the cash needed, and interest is only accrued on the borrowed amount. Once it’s paid back, the capital can be reused.
Business loans made easy.
Equity Financing vs. Debt Financing
Both debt and equity financing come with benefits and tradeoffs. In the former, the cost to the borrower comes in the form of debt that must be repaid with interest. In the latter, ownership in the company is exchanged for cash.
Business owners who expect their businesses to be immediately profitable are better served by debt financing, since the borrowed sum can be repaid quickly. Although equity financing can generate larger cash infusions than debt financing, it can come at a high cost if the company expands and the shares become worth more than the borrowed amount.
Is Your Company Ready for an Initial Public Offering (IPO)?
If your business has already gained a foothold in the market and is enjoying large year-over-year profits, then you may be considering selling stock on public markets and mulling over when you should launch an initial public offering (IPO).
Many business owners dream of one day “going public” and doing an IPO, but very few make it. Roughly 90 percent of startups fail in the United States, so it’s no surprise that the vast majority never see the day where their company name pops up on the ticker of a major stock exchange.
If you’re unsure as to whether your company is “IPO-ready,” chances are you aren’t. Although an IPO can be an effective way to acquire equity financing for your successful business, it comes with many responsibilities to the SEC, financial unpredictability due to volatile capital markets and a massive concession of control over your company’s fate.
Most experts agree that unless an IPO makes perfect sense for your business, you should pass on it.
The Equity Advantage
There’s more to equity financing than merely securing a deal and walking away with cash in your hand. Selling an ownership stake in your business comes with benefits and advantages that many first-time entrepreneurs don’t immediately realize.
For one, equity financing goes beyond simply selling stock. Once you’ve secured a deal, you effectively bring a new advisor and mentor on board who can help provide strategic direction for the company and offer professional expertise. Often, equity partners or investors will elect to sit on the Board of Directors of a business.
In this sense, equity financing should be understood as more than a purely financial transaction. It’s a partnership between two or more parties with a common interest—that is, increasing the profitability of the business.
Sometimes, however, the so-called “equity advantage” can backfire and mean financial ruin for an otherwise thriving company. If you bring misdirected talent into your company through equity financing, that can expose you to poor strategic guidance that steers your company toward the rocks if their influence isn’t checked. Who’s involved in the company can be even more critical to your success or failure than the resources that come with them.
How to Attract Investors
One of the best things you can do to rope in potential investors and instill faith in your company is to draft a rock-solid business plan. After all, when you’re seeking out an angel investor or a venture capitalist, you’re effectively selling them the promise that your company has a reliable roadmap to profitability ahead of it.
Without a plan in place, your chances of winning their trust are just about nil.
Drafting a Business Plan
Don’t be intimidated by the task of developing the “perfect” business plan. Instead, focus on keeping the document short and precise and including all the common elements that are expected of a complete business plan, including:
- Executive summary
- Long-term strategy
- Marketing strategy
- Human capital plan
- Operations plan
- Strengths, weaknesses, opportunities and threat analyses (SWOT)
- Business exit strategy
It’s important to remember that a business plan should be a short and accessible roadmap detailing how your business intends to expand and how it’ll be refined over time. If the document is too long or obscure, you can guarantee that investors will let it collect dust in their desk drawer—they will not have the time or interest in entertaining a business plan that’s not actionable.
One essential key to writing an effective business plan is to keep your audience in mind. Remember, you’re writing for wealthy investors who are rich in resources but short on time. Keep your prose neat and tidy, without any filler, jargon or buzzwords. Stick to the facts in plain English that anyone can quickly skim through.
Although the executive summary is the most important ingredient in a startup business plan, it’s crucial to include a financial plan in your roadmap, too. Without a well-sourced financial plan that’s been vetted over by a professional accountant, it’s unlikely an investor will take your pitch seriously.
Make sure you include plenty of information about your company’s projected financial forecast and future earnings.
Funding a Small Business Through Grants
Non-repayable grants are sometimes issued to small business owners and entrepreneurs who come from a marginalized background, or to those with a mission-based business model. Although grants can be hard to come by, if you know where to look you can find plenty of philanthropic efforts to help disadvantaged people start a successful enterprise.
Despite what you may think the word “minority” means, the majority of American residents currently qualify for minority status. In other words, it can’t hurt to apply for a minority grant if you fall under any of the minority categories the federal government recognizes.
If you aren’t approved for a minority grant, you might qualify for an interest-free loan. In many cases, “grants” do not necessarily mean “free money.” Rather, many of them are only interest-free loans that are designed for minorities, women and military veterans looking to kickstart their civilian life.
How Much Funding Does Your Business Need?
The type of loan or grant you apply for will be determined by the capital needs of your business. For those who need small amounts of capital (i.e., $50 thousand or less), a short-term loan or a business line of credit might be in your best interest.
On the other hand, if you have capital demands north of $100k, long-term SBA loans or term loans may be a better fit.
Determining the financial needs of a new business is no easy feat. But neither is getting a startup off the ground. Indeed, one of the greatest challenges for new business owners and entrepreneurs is calculating how much money you need to see yourself through the first months of operation. If you estimate too conservatively, you’ll run out of capital. If you borrow more than you need, you can throw your business into financial jeopardy.
Adding Up Expenses
The key, then, is to take a pragmatic approach to determine your business expenses. Start by adding up your expected business costs, including the various one-time costs associated with launching a startup (i.e., legal and professional fees, incorporation fees, licensing, etc.). Then, factor in the recurring expenses such as salaries, rent and other forms of overhead.
After you’ve added up the recurring and one-time expenses for the first three to six months, you have to calculate the amount of starting capital you’ll need to get the ball rolling. To do this, get your hands a little dirty by conducting independent market research in your industry or niche.
Through your research, you should find out how long it takes for companies in your industry to become profitable and self-sustaining. If the average time to self-sufficiency is 5 months, you should plan for at least 6 months of funding to give yourself a bit of wiggle room.
Mind the Gap
Most entrepreneurs don’t start their business cold. Once they’ve formulated an idea to work with, they start saving up for the launch of the company. If you’re in the early stages of drafting your business plan and thinking about getting the company in operation in the coming months, start saving now.
As the saying goes, the best time to start saving is a year ago. The second-best time to save is now. Once you’ve added up your expenses and the amount of time you’ll need to become self-sufficient, you need to measure the gap between the money you need and your current level of savings. The difference needs to be bridged through either debt or equity financing.
Alternative Forms of Business Financing
It feels like the business financing landscape changes drastically every few years. In 2019, there are options available for funding a business that didn’t exist less than a decade ago. Here are a couple alternatives to conventional debt and equity funding:
Online Small Business Lenders
Traditional bank lending is notoriously hard for small businesses to qualify for—especially those just getting their start. By turning to alternative online lending, small business owners are more likely to qualify for funding.
These lenders also offer a wide assortment of creative business financing solutions, like lines of credit, short-term loans, invoice financing and merchant cash advances. Plus, if you’re looking for capital right away, instead of in weeks or months, alternative lenders can deliver. Depending on your situation, you can get approved within hours and funded as fast as same day.
Business loans made easy.
As fast as same day | Rates as low as 9.99%
Before you get the wrong idea, it’s important to point out that business incubators don’t always provide business financing. However, some do, and at affordable rates. Business incubators and accelerators are membership-only service centers that offer mentoring, networking, training, office space and other great perks for business owners and entrepreneurs.
Businesses that are still in the nascent “seed stage” of their growth plan are well-suited for a business incubator. These groups, although operating on a membership-fee basis, provide technology and skills transfers that can make up for lack of expertise on your end.
For instance, if you have a background in finance but need graphic design talent to get your company started, chances are an incubator will have someone on hand to help you.
Even if the incubator or accelerator group doesn’t offer explicit grants or debt financing, you can still acquire funding by other means. Many incubators host competitions and other events funded by major sponsors. If you decide to throw your hat in the ring, your business can win serious startup cash simply by showing up and pitching your idea.
Also known as “microcredit,” microfinance is a lending arrangement in which a creditor, usually a not-for-profit organization, lends a small sum of low-interest cash to a borrower. In most cases, microfinance is reserved for low-income individuals and groups that do not qualify for conventional business loans or credit lines.
Microfinance is typically defined as loans of $25,000 or less, although we’ve seen microfinance loans as small as $100. One of the main advantages of choosing microfinance over conventional lenders is that microlenders often provide free mentoring and strategic advice for those who use their services.
Rather than maximize profits, microlenders are often focused on community service and helping underprivileged entrepreneurs succeed. Consequently, they are more likely to accept unsecured loans and take on clients with minimal credit history than major banks and commercial lenders.
Finding What Works for You
Funding a business today isn’t as straightforward as it once was. Although entrepreneurs have more options than ever to acquire funding and startup capital, they can also get bogged down by decision fatigue.
From choosing between debt and equity financing to narrowing down precisely how much cash you need to get off the ground, there are many choices that need to be made before a business applies for funding.
There’s no one-size-fits-all formula for acquiring business financing. To fund a business successfully, you need to play the long game and be willing to do plenty of research, soul-searching and consulting to find the best solution for you.