21 Ways To Finance A Small Business

21 Ways To Finance A Small Business

One of the greatest challenges faced by entrepreneurs is how to finance a small business. In order to bring your dream to life, you need more than an idea and the work ethic to bring it to fruition. Without funding, you’re unlikely to get your enterprise off the ground. Following are 21 options that may help you find the financing you need.

21 Ways To Finance A Small Business

1. Personal Savings
2. Retirement Accounts
3. Friends and Family
4. Home Equity Loan
5. Life Insurance Policy
6. Credit Cards
7. Business Loans / Lines Of Credit
8. Invoice Factoring
9. Invoice Financing
10. Purchase Order Funding
11. Crowdfunding

12. Microloans
13. SBA 7(a) Program
14. Grants
15. Angel Investors
16. Venture Capital
17. Joint Ventures
18. Seller Financing
19. Stock Warrants
20. Pre-Sales
21. Royalty / Revenue-Based Financing

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Now, some of these options are better than others. Some may be a perfect fit for your situation, while others may be completely impractical. In order to find the right fit for your business, you’ll need to research each option and apply the required criteria for your personal situation.

Let’s discuss each of these options in a little more detail and review the pros and cons of each.

1) Personal Savings

Using your personal savings is by far the easiest method to finance a small business.

Pros:

The benefits include not incurring debt and maintaining control of your business by not having to take on a partner.

Cons:

Of course, the downside to using your personal savings is that you’re risking your own money. If everything goes pear-shaped, you can lose the savings that you worked hard to accumulate.

Recommendation:

If you have the money saved and can use it to finance your business, then, by all means, do it. Just make sure that you have a solid plan and are prepared to take the risk.

2) Retirement Accounts

Using your personal retirement account(s) to finance a small business is a similar option to using your savings. The benefits are the same, but the potential downside is a bit more complex.

Pros:

The money in your retirement account(s) is usually fairly easy to access, you avoid incurring debt, and there are no restrictions on what you can use the money for.

Cons:

The cons are the same in that you’re risking your own money. However, there’s an extra layer of complexity when using this option.

First, if you withdraw money from tax-advantaged retirement accounts, you can expect to pay taxes and/or penalties. Secondly, using money that you’ve worked hard to set aside for your future may hurt you later in life if your business venture doesn’t go well.

Recommendation:

I recommend an abundance of caution here. When considering this option, you should think long and hard before flipping that switch.

3) Friends and Family

Friends and family are other possible sources of funding for your business. You can take a number of approaches in this area. The first is to borrow money using a structured loan agreement. This would be similar to how you would borrow from a financial institution but without the bureaucracy and strict requirements. Chances are, your friends and family wouldn’t make you jump through the same hoops that a bank would.

Another option is to bring in friends and family as investors. You can make them partners in the business (silent or otherwise) in exchange for the funds you need.

Pros:

Getting your financing from friends and family has the benefit of being a much simpler process than many other options.

Cons:

On the other hand, going into business with friends and family also has the potential to ruin relationships.

Recommendation:

Proceed cautiously. Make sure your friends and/or family understand that this is a business arrangement and treat it as such.

4) Home Equity Loan

If you own a home and have some equity, you can use a Home Equity Loan to finance your small business. This can be simple and cost-effective. Mortgage rates are typically more competitive than business loans. In addition, home equity loans can usually be used for any purpose.

Pros:

Getting a home equity loan is usually fairly simple. Relatively low mortgage rates can make it a very attractive option.

Cons:

While they usually can be used for any purpose, your home equity loan may have some restrictions set by the lender. In addition, if your business doesn’t generate the income to pay it back, you’re still on the hook for it. Since the loan will also be collateralized by your home, you risk losing your house if you can’t make the payments.

Recommendation:

It can be an attractive option, but make sure you’re prepared to put your house up before you sign for a Home Equity Loan.

5) Life Insurance Policy

In some cases, you can borrow against the cash value of your life insurance policy. This varies by the underwriter and the type of policy you have. However, it’s common to be able to borrow up to as much as 90% of the cash value of your policy.

In some cases, you may also be able to receive what’s known as a “wash loan” or “preferred loan”. This type of loan is where the cost of borrowing the money is the same as the interest earned on the policy, bringing the net cost to zero.

Pros:

Access to funding is quick and easy since you’re borrowing against your own assets. You can also use the money for any purpose. In addition, there’s generally no monthly payment and no payback date.

Cons:

If you “expire” before paying it back, the loan comes out of any proceeds paid out by the policy. Of course, you won’t care at that point but your beneficiaries likely will. If the loan balance is higher than the cash value, your policy may be terminated and there may be tax consequences.

Recommendation:

Make sure that you fully understand the loan provisions and potential consequences of this option. In addition, make sure that your family will be taken care of if everything goes south.

6) Credit Cards

Tapping your credit cards to finance a small business is another way to find the funding you need. Depending on how much you need and for how long you need it, it may or may not be a good option.

Credit card interest rates and minimum payments are usually not very competitive. If you only need a small amount or only need it for a short time, it may make sense.

Pros:

Getting a cash advance from your credit card(s) is a quick option, especially for short-term needs.

Cons:

Financing costs are expensive with credit cards and will cost you a lot of money in the long-term. In addition, carrying large balances (in dollars or percentage of your credit limit) can have a negative effect on your credit score.

Recommendation:

Credit cards can be a good option but only for short-term needs.

7) Business Loans and Lines Of Credit

Obtaining a business loan or line of credit from a financial institution is common option for small businesses. Financing rates for business loans are usually lower than other forms of financing. Unfortunately, getting financing from a bank can also be a challenging endeavor.

Banks usually have strict lending criteria and processes for issuing loans to businesses. You need to have a well-thought-out business plan, good credit, and assets to pledge as collateral.

In addition, the bank will have minimum requirements that they expect you meet. These include the length of time in business, personal and business credit scores, owner’s/shareholder equity, annual revenue, profitability, the purpose of the loan, and more.

You will receive a set of banking covenants that outline these expectations. In addition, the bank will likely monitor your financial ratios to make sure that you stay in compliance.

Pros:

Benefits include low financing rates and predictable monthly payments. Banks loans also help build your business’ credit and help you build a relationship with a financial institution.

Cons:

Obtaining a bank loan can be a long, difficult process that requires good credit and assets to pledge as collateral. Bank financing is often nearly impossible to get for startups or businesses without an established track record.

Recommendation:

If you have the ability to get a bank loan or line of credit, it’s definitely worth pursuing. Just be prepared for all the hoops that you’ll have to jump through.

8) Invoice Factoring

If you have a steady stream of customers, invoice factoring can be an easy way to improve your cash flow and fund the cash-hungry beast that is your business.

When you factor invoices, a finance company will give you cash now for the right to collect payments due by customers. They do this for a fee, of course, but in the end, you get your money sooner. This allows you to “self-finance” your cash needs for a small fee.

Pros:

Invoice factoring has a number of benefits. It doesn’t require collateral (other than the invoices). Approval is usually pretty easy and you can get up to around 90% of the invoice value as an advance. It also allows you to effectively outsource collecting money owed by customers.

Cons:

Invoice factoring also has some disadvantages. The paperwork can be extensive, the finance company may contact your customers directly, and they usually won’t deal with bad debt. If a customer doesn’t pay within a given time, you get the invoice back and have to refund the money back to the factoring company.

In addition, fees can be expensive. You may pay as much as 2-5% of the advance amount and the longer it takes the finance company to collect, the more you pay.

Recommendation:

Like any financing arrangement, make sure you fully understand the costs involved. Be sure you also understand how the bad debt process works and what that will cost you.

9) Invoice Financing

Invoice financing is basically the same as invoice factoring. The main difference between the two is that with invoice financing, you maintain control of the collections. Essentially, the financial institution is giving you a loan against the value of the invoices.

Pros:

You get immediate cash without putting up assets as collateral. You maintain control of your collection process and don’t have a third party contacting your customers. In addition, the fees for invoice financing are typically lower than for factoring.

Cons:

The initial advance amount for financing is usually less than for factoring (usually around 80%). In addition, since you maintain control of your collections, you won’t be able to effectively outsource that labor.

Recommendation:

Just as with factoring, make sure that you understand the costs and benefits.

10) Purchase Order Funding

Purchase order funding is similar in concept to invoice factoring or financing. When you use this method, you’re using customer orders to finance your business needs. In this case, the finance company will typically pay your supplier directly, based on your customer’s order. When the customer pays, they pay the finance company directly, which deducts their fees and sends you the balance.

Pros:

Purchase order funding can help businesses take orders that they otherwise may not have been able to. If your cash flow is limited or a customer wants to place an unusually large order with you, this can prevent you from having to turn them away.

Cons:

Like when you use factoring, you’ll have a third party involved in your transaction. This doesn’t always sit well with customers. They may think that you’re having financial difficulties which may spark concerns about your ability to service their needs.

Recommendation:

This is a good option if your business lacks the cash flow to pay for materials needed to fulfill a customer’s order(s).

11) Crowdfunding

Crowdfunding has become a very popular option for raising money in recent years. Platforms like Kickstarter have made obtaining small amounts of money from a large number of people a viable option for many businesses.

Pros:

When you use crowdfunding, your risk is low. This is because you don’t pay any financing costs unless your funding is successful. Your only investment is your time. You also are able to gain much larger exposure by using their technology platform. You also don’t need to give up any equity and the process can help to validate your idea and/or business model.

Cons:

While you may not have to invest a lot of money, you will still have to invest some, in addition to your time. You also still need to deliver, so the risk of failure does not change. In order to be successful, you need to define your market positioning strategy well enough that the average person can understand it.

Recommendation:

If you plan to pursue crowdfunding, spend some time to research it thoroughly so you know what you’re getting into. You can start here.

12) Microloans

Microloans are typically small, short-term loans for businesses with low capital requirements. They also typically have fairly competitive rates. This can be a good option if you don’t need a lot of money to finance your small business.

Pros:

Microloans can provide credit to people that may otherwise not have access. In addition, they very often have better terms and conditions than traditional banking products.

Cons:

Microloans are exactly that; “micro”. As a result, the amount of money you can borrow is limited so you won’t be able to fund any large projects.

Recommendation:

Microloans are a great option if your cash needs are not that great. There are many organizations that offer microloans, including the Small Business Administration. Read more about the SBA’s program here.

13) SBA 7(a) Program

The U.S. Small Business Administration has a number of loan products, the most common of which is the 7(a) program. With this program, the SBA does not lend money directly. Rather, they guarantee the loan which is then provided by a local banking institution.

Pros:

SBA loans offer better rates than many business owners may qualify for when going through traditional funding sources.

Cons:

The SBA is a government agency and has its own strict requirements and purposes for which you can use the money.

Recommendation:

Like a bank loan, if you qualify for the SBA program, it’s definitely a good option. However, make sure that you’re prepared for the effort it will take to secure the financing. Make sure that you have your business plan and financial records all in good order.

SBA Loans Explained

14) Grants

Small Business Grants are a great way to finance a small business. There are countless organizations, but public and private, that offer grant programs. By nature, these grants do not have to be paid back. Organizations offer these to assist small businesses to succeed. There are also many grants available to specific groups such as women, minorities, and veterans.

It can take a lot of time and effort, however, to find one that works for you. Most grants are very limited in scope. In other words, and organization may only offer a grant to a specific type of business in a specific industry. Fundera has compiled a pretty thorough list here. Be aware, however, that there are literally thousands of grants available. As a result, you’ll need to devote a fair amount of time and effort to find one that fits.

Pros:

There are many sources of grant money out there. Grant money is given, not loaned, so you don’t have to pay it back.

Cons:

With free money comes strings. Grants have specific requirements and expectations. In addition, it can be very difficult to find one that suits your needs.

Recommendation:

If you have the time, do some research to see if you can find grants for your specific business. It can be well worth the effort if it results in financing your small business.

15) Angel Investors

Angel Investors are high net worth individuals that invest in businesses. Every angel investor is different and has different investing criteria. You may know someone that fits this description. However, there are numerous platforms online that provide a way to connect you with them.

Generally, angel investors will put anywhere from $25,000 to $100,00 into a venture, though this can vary widely. In addition, they typically want a substantial equity percentage and some level of control.

Pros:

Angel investors are willing to take a risk. They are also generally experienced in business and can offer valuable guidance to help you succeed. In addition, the money is an investment, not a loan that needs to be repaid.

Cons:

Angel investments may come with many strings attached. Terms can be ambiguous and the investors will not only dilute your equity but often your control as well. Angel investors generally have high expectations.

Recommendation:

If you’re considering working with an Angel Investor, do your homework. Make sure you know who you’re going into business with and that the expectations are clear. Consider hiring an experienced attorney to guide you.

16) Venture Capital

Venture Capital is similar to angel investments, however, the capital is provided by an investment company or group. Generally, VC firms pool money from individual or institutional investors which they then use to fund businesses.

Venture Capital investments come with the same pros and cons as Angel investments but on a larger scale. In addition, they often are focused on much larger investments in high-growth and/or “sexy” industries.

Pros:

VC funding is almost unlimited and can provide money for a business of any size. VC firms employ many experienced and talented people with many valuable business connections.

Cons:

Only the top business ideas have a chance of receiving an investment from a VC. Generally speaking, you will give up a lot of equity and control. It’s also very common for the company founders to be pushed out at some point in the future.

Recommendation:

Hire an experienced attorney. No exceptions.

17) Joint Ventures

Do you have a customer or supplier with whom a formal business alliance could benefit you both? If your interests align, it may make sense to pursue joining forces. You provide the product, expertise and/or intellectual property and they provide the necessary capital.

Pros:

Benefits include funding your enterprise, a flexible arrangement, and sharing of costs, expenses, and risk. You may also find synergies between your two (or more) organizations that benefit you both.

Cons:

Joint Ventures can be structured in myriad ways and can be very simple or very complex. In addition, each party has their own values and priorities which can potentially create friction.

Recommendation:

Hire an attorney. Make sure that you and your potential partner are abundantly clear on the nature of the relationship.

18) Seller Financing

If you are looking to finance a small business that you intend to purchase, seller financing is a very common option. In fact, the majority of small businesses are unable to secure tradition financing, which leaves seller financing as the only viable option.

When the seller agrees to finance the sale, it is most often only for a portion of the business. The seller almost always wants some cash, though the amount will vary based on the circumstances. Terms can be very flexible with a multitude of payment arrangements. However, seller financing will carry higher interest rates than bank loans. This is due to the risk that the seller is assuming of you taking over their business.

Pros:

Seller financing can be structured in any way that the buyer and seller agree upon. As a result, it can be very beneficial for both parties.

Cons:

Financing costs are generally higher than traditional sources of funding. In addition, the seller may require non-traditional terms and conditions. This can result in very complex agreements.

Recommendation:

Hire a specialist that is familiar with seller financed transactions. And an attorney.

19) Stock Warrants

A less common method of financing is the stock warrant. Stock warrants give the holder the right to purchase shares of the company and a predetermined price for a defined period of time. While not a viable option for many business owners, it can be a good way to finance a small business under the right circumstances.

If you have a great business strategy and a product with unlimited potential, this may present an attractive investment for the person. You could sell them stock warrants, which would provide you with the cash you need and the investor with the opportunity to participate in your success.

Pros:

Stock warrants generate cash without borrowing money. In addition, if the investor exercises the warrants, they will be paying you more money for the stock they purchase.

Cons:

You may have to give up a substantial amount of equity to make this option work. In addition, the warrant price would likely be much lower than the market to make it attractive to the investor. As a result, it may give you heartburn to have to sell a large portion of your business at a price that’s well below the current market value.

Recommendation:

Attorney, attorney, attorney.

20) Pre-Sales

Pre-selling your product or service is a great way to generate cash to finance a small business. Selling your product in advance gives you the cash you need to produce it. As a result, your customers are essentially financing your business.

Many companies use this method to introduce new products. In addition to getting your money upfront, it can create a lot of buzz in the market. When combined with a thoroughly planned marketing campaign, this can be a very successful option.

I once purchased a luxury condominium as a rental that was sold using this type of model. The builder pre-sold 40% of the units at a substantial discount, then used the sales and deposit money as proof of concept to secure the construction financing.

#RealLifeExample

Pros:

Make sure that you plan an entire marketing campaign to roll out your offering. You need high visibility to ensure that you get the financial results you’re looking for.

Cons:

You still have to deliver. In addition, you need to make sure you manage your finances well so that the money you collect in advance covers the costs of all of the promises that you made.

Recommendation:

Plan a thorough marketing campaign. Take your time to get it right. If your time is limited, this probably isn’t the best option for you.

21) Royalty / Revenue-Based Financing

Royalty Based Financing or Revenue Based Financing is a method that involves giving investors a share of future revenues. Investors provide capital in exchange for participation in the success of the business. Generally, an RBF agreement differs from a traditional investment in that the investors don’t have any equity in the business.

Pros:

RBF investors are willing to take more risk. Their investments don’t need to be paid back if things go poorly.

Cons:

Agreements can be complex and will require transparency on your part.

Recommendation:

I know, I sound like a broken record but hire an attorney. Legal agreements of any kind require specific expertise, so make sure you spend the money to get it. It will pay for itself down the road.

In Summary

Finding a way to finance a small business can be extremely challenging. The fact is, it’s one of the most difficult things that most small business owners will ever do.

There are many options available for every type of business. It takes time, effort and expertise in order to find the most suitable method for you. Do your homework and don’t be afraid to hire an expert to help you. It will pay for itself in the long run.

Is Your Business Running You? A Fractional COO can help.

Kevin A. Nye

A veteran of multiple industries, Kevin A. Nye has parlayed more than 20 years of management and leadership experience into a consultancy designed specifically for the benefit of small businesses. Having served in roles in Supply Chain, Operations and Regional management, Mr. Nye was most recently the Chief Operating Officer of a regional steel company and is currently focusing his expertise to help small business owners create the organizational foundation required to grow their enterprise.

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