Funding for Small Businesses

Dominique W. Brooks
Small business owners shaking hands with loan officer

Financing a new business or obtaining additional funding for your existing company can seem overwhelming. However, there are several options for getting money for your ideas. With a well-thought-out business plan and balance sheet, you may be able to obtain the cash for a start-up or a business expansion.

Types of Financing

There are two main methods for financing your business. The best one for your business depends largely on how you want to run your business.

Debt Financing

In this form of financing, you get money from a lender with the promise to pay back the principal (the original lump sum) with a certain amount of interest.

Benefits:

  • You get to keep ownership of your company.
  • You may be able to deduct the principal and interest you pay on your business taxes.

Drawbacks:

  • You have to repay the debt and if you don't, there will be consequences.
  • Each new loan affects your credit rating.
  • You may have to offer up collateral to guarantee repayment.

Equity Financing

In equity financing, people or a business lends money in exchange for an ownership share in the company.

Benefits:

  • You don't have to pay interest payments and can use the money to grow the business.
  • You usually don't have to pay the investors back if the company fails.

Drawbacks:

  • This is not a short-term cash solution.
  • Other people have a say in how the company operates.
  • You have to share the profits.

Another less common form is mezzanine financing where the lender provides capital with the option to take ownership or get equity in the company if you do not pay the loan back on time and in full. These loans usually have high interest rates and are typically only granted to existing businesses.

Most companies end up with a combination of debt and equity financing.

A Closer Look at Financing Options

Lending Institutions

Most new small companies get their financing through banks. The bank will review your balance sheets including cash flow, revenues, business plans, credit history, and any assets to determine if you are a good credit risk. If you qualify, the bank can give you a loan or a line of credit with a repayment schedule. Establishing a good relationship with the bank before you need a loan may make it easier to get a loan later.

Other organizations that may grant loans include credit unions, savings and loans, commerce finance companies, or even friends and family. The Small Business Administration can help you by guaranteeing your loan if you qualify.

Small Business Administration

The Small Business Administration (SBA) has established guaranteed lending programs where the SBA will repay the bank if you default on paying back the loan. This makes the bank more likely to lend to small businesses because there is less risk.

Friends and Family

Friends and family are also possible sources for loans. You have to be careful; be clear about the terms and conditions of the loan, and make sure that you have everything in writing. You do not want to ruin family relationships over money.

While your family can be a source of loans, they may also choose to offer their assistance in other forms like an equity stake. A family member may give you the money you need in exchange for a share of your company. Again, you have to use caution. Communication is key in these situations and getting some legal advice may not be a bad idea to try to head off any problems in the future.

Grants

Grants are chunks of money that you don't have to pay back. You have to look for sources of grants; often the grants are offered for businesses in certain fields like technology or that are owned by specific groups like minorities or women.

Some places that may offer grants include the SBA with the Small Business Innovation Research (SBIR) Program for technology companies and local governments, corporations, and foundations for local start-up companies.

Business incubators may not offer money but you may be able to get things for your company like office space, hardware, software, Internet connections, administrative services, and business development help. For the most part, these services are free so in essence, these are similar to grants. The International Business Incubation Association has more information about incubators; another example is the Microsoft BizSpark program.

To find a grant, you should do some research by looking on the Internet, calling local economic organizations, local government, or checking with a local SCORE office. All grants require an application process.

Angel Investors

These are individuals who have a lot of money that they want to invest in various small companies. They look for companies that operate in arenas that interest them and offer cash and often business development assistance. You will have to give the angel investor some equity in your company - how much will depend on the investor - but you don't have to pay the money back and you often get a significant amount of time to get the investor a return on investment. If the investor comes into your project early, he/she usually will want a higher rate of return because of the higher amount of risk.

Occasionally, the angel investor will find you and your company; however, there are some places that you can look to find one for yourself like universities, angel groups, business incubators, or venture capital groups. You will need to get a meeting with the angel -- either through connections or by sending in a pitch that makes the investor want to hear more.

Venture Capital

Venture capital (VC) is similar to angel investing except it tends to come from a company whose purpose is to exchange money for equity in young companies with potential for high growth. These firms want to have an active role in the management as well.

Like angel investors, venture capitalists will give you some time to grow the company before looking for a return; however, the amount of time is not indefinite. Venture capitalists want to get their investment and profit out of the company as soon as it is feasible -- usually within a few years. Again the amount of rate of return a VC expects varies depending on when the venture capital firm invested; early investment is riskier and requires higher returns.

Finding a venture capital firm will take a bit of homework. For a list of venture capital firms, visit Venture Capital Resource Directory or Top 100 VC Firms. Once you pick one, you can use connections to get introductions or you can try to get an appointment to give a pitch for your business.

Private Investors

There are also equity investors that may invest in your business for strategic reasons. They are not angel investors but private lenders who may have some additional requirements. Legal advice may be helpful here.

Getting Funding for Your Business

Many options exist to fund your business. Your best strategy is to consider your business plan and projections, funding options, and your personal feelings when deciding which funding may be right for you. You may have to try more than one -or use a combination- but with hard work, you can often find funding for a strong business idea with a good business plan.

Funding for Small Businesses