Running a business is never an easy operation. Unless your company is on the same lane as Apple, Google or Amazon, you will probably need business financing. There is no easier way to grow your business without adequate business funding.
Small businesses have always found it challenging to get suitable financing options for their operations. This is because most of such companies don’t understand corporate financing in general. So let’s explore all you need to know about Financing your business by knowing the following;
- What is Business Financing?
- Types and sources of business financing
- Advantages and disadvantages of Business Financing
- Conclusion and Recommendation.
What is Business Financing?
Business Financing is the acquisition of funds and credit to run a business’ operations in a simple definition. Such operations are purchasing raw materials, increasing inventory, buying an asset, and growing product line, to name a few.
To meet specific goals and solve unexpected business operations problems, you need to have the right financing option for your business. If you get the wrong financing, you won’t be able to overcome the challenges you might be facing. So let’s understand the various types of business financing and choose the right one for your operations.
Types Of Business Financing
There are several business funding options you could find nowadays. But the Cavier is to know which one is the best option for your business. Knowing the right choice is an essential step before venturing into this commitment.
There are two major financing categories, namely Equity and Debt. We are going to look into both sources and the different options under each business financing category.
Equity financing is when you exchange a part of your business ownership for funding your business operations. Getting the funding from this type of business financing means giving the investor a share of your Business profits. With Equity financing, you are not liable to repay the initial investment should the business fail.
You should always make sure to define the investments from equity funding properly. This is because you wouldn’t want to encounter some misunderstandings down the line. You could give the investor membership units or stocks. These predefinitions will save you a lot of headaches in the future.
You can also establish different classes of stock that control voting rights among your shareholders. For example, suppose you have more than one investor. In that case, you might want to give preference to those with more significant investments. You might provide dividends to your most important shareholders.
There are 8 different equity financing options for your business. These equity business financing options are;
- Personal Savings
- Friends and Relatives
- Venture Capital
- Angel Investors
- Government Grants
- Equity Offerings
- Initial Public Offerings
1. Personal Saving:
The first place business owners always look for money is their savings. Private sources include your early retirement funds, personal savings account, life insurance policies, or home equity loans. Let’s cover the 2 main types of Personal savings when it comes to business financing.
A standard function of many life insurance policies lies with your borrowing against the present value of the policy. This policy does not include risk life insurance because it has no monetary value.
It takes about two years for a life insurance policy to accumulate a sufficient cash value to borrow. You can borrow the most money value of the policy. The credit will reduce the face value of your life insurance. In the event of death, the beneficiary must repay the loan before receiving the payment of this policy.
Home Equity Loans:
A home equity loan is any money you borrow against the value of your home. If you have already completed the payment of your home, you can use your home value as collateral. But if you still have an existing mortgage, you could only get funds for the amount you don’t owe.
For example, the total value of your house is worth $190,000. But you have an outstanding mortgage of $80,000. You could only get a home equity loan of $110,000 to use as collateral against the funding. The interest you will pay on a home equity loan is tax-deductible.
2. Friends and Family Members:
You can draw on private sources of funding, such as parents, family members, or friends. Acquiring such financing can be done in the form of equity funding. The friend or relative investing in your business usually receives a share in your company.
However, you should receive such financing with the same formality that you would apply to external investors. These formalities protect both of you in the future.
3. Venture Capital:
Venture capital refers to the financing of a business by companies or individuals. These investors usually invest in young or privately held companies. These investors provide funds to young companies in exchange for a stake in the company.
Venture capital firms don’t usually participate in the initial funding of a start-up company. They can only invest unless the start-up has management with a proven track record. As a rule, they prefer to invest in companies that have received significant investments from the founders and are already profitable.
Venture Capitalists also prefer companies or start-ups with a competitive advantage or a strong value proposition. This value proposition could be in the form of a patent, proven demand for the product, or an extraordinary idea.
Venture capital investors often take a practical approach to their investments. This approach requires a seat on the board of directors, and sometimes they also hire managers. These investors often provide valuable guidance and business advice to maximize the success rate.
However, venture capitalists strive for significant returns on their investments. Their main goals may be at odds with those of the founders. They often aim at short-term profits. As a rule, Venture capital firms focus on creating an investment portfolio of companies with high growth potential, which leads to high returns.
One vital thing to note:
Since venture capitalists take a high risk when investing in your company, they will want to have minimum annual returns of 25 to 30% of your total investment portfolio.
4. Angel Investors:
Angel investors are individuals and companies interested in helping small businesses survive and grow. So their goal could be more than just focusing on the returns your company could yield for them.
Although angel investors often have a specific mission focus, they are still interested in profitability and security for their investment. So you can still acquire business funding from angel investors without being worried.
Angel investors are often interested in the economic development of a particular geographical area in which they are located. So make sure you only approach the ones in the areas where your business operates.
5. Government Grants:
Federal and state governments often have financial support through grants or tax credits for business start-ups or expansions. But you need to have a solid business plan and a growth plan to get this type of investment. So make sure you have a clear business plan that showcases your ability to grow and succeed.
6. Equity Offerings:
In this situation, you can sell company shares directly to the public. Depending on the circumstances, you can raise significant funds through share offers. The structure of the offer can take many forms and requires careful monitoring by the legal representative of the company.
7. Initial Public Offerings:
Suppose your company is already profitable and has strong management stability. In that case, you can use Initial public offerings or IPOs for financing your business. IPOs could only happen if your company is in business for several years.
To be straightforward with you, many business owners looking for business financing don’t go for this option. So you are better off with other funding options.
Warrants are a unique instrument for long-term financing. They are helpful for start-up companies to encourage investment by minimizing downside risk while offering upside potential. For example, a start-up company can issue warrants to management as part of the reimbursement package.
A warrant is a security that gives the holder the right to purchase shares of the issuing company. Holders of these warrants can buy these shares at a predetermined price during a specific duration.
The next major business financing category is Debt financing. This type of business funding is when you borrow debt capital from creditors. You should consider the obligation to repay the debt capital plus interest at a specific future date.
Debt financing may be collateralized or unsecured. With secured debts, you have to provide collateral (a valuable asset that the lender can pledge to satisfy the loan in the event of a default by the borrower). Conversely, unsecured debts do not have collateral. So you, as the borrower, have fewer worries with unsecured loans.
Debt financing (loans) can be in your repayment plans in the short or long term. In general, short-term debt is to finance ongoing activities such as operating activities. In contrast, long-term debt is to invest in assets such as buildings and heavy equipment.
As far as debt financing is concerned, you have 6 different options for your business. These options are;
- From Friends and Relatives
- Banks and Other commercial Lenders
- Commercial Finance Companies
- Government Programs
Now let’s cover each one to weigh in your options.
1. Friends and Relatives:
You can rely on private sources such as family and friends when starting a business. You can finance your business in the form of borrowed capital at a lower interest rate.
However, suppose you borrow from friends or relatives. In that case, you should do it with the same formality as you would with a commercial lender. A formal loan document is drawn up and executed. This document should include;
- The loan amount.
- Interest rates.
- Specific repayment terms (based on the forecast cash flow of the start-up company).
- And collateral in case of default.
2. Banks and Other Commercial Lenders:
Banks and other commercial lenders are prevalent when it comes to business financing. Most lenders require a solid business plan, a positive track record, and lots of collateral. As a start-up, you might not have such collaterals. Once your business is up and running and income statements, cash flow budgets, and asset statements are in place, you might be able to raise additional funds.
3. Commercial Finance Companies:
You could consider Commercial financing companies if you are unable to get funding from other commercial sources. Commercial funding companies may be more willing to rely on collateral quality when repaying the loan than on their company’s track record or profit forecasts.
Suppose you don’t have significant personal assets or collateral. In that case, a commercial Finance Company may not be the best place to secure financing. In addition, the cost of money from financial companies is usually higher than that of other commercial lenders.
4. Government Programs:
Federal, state, or local governments have programs to support new enterprises and small businesses. The government often provides assistance in a state guarantee to repay a loan from a conventional lender. The security gives the lender a repayment guarantee for a loan to a company with limited assets as collateral. The best-known sources are the Small Business Administration and the USDA Rural Development Programs.
You can use bonds to finance a particular activity. They represent a unique form of debt financing since the enterprise issues the debt instruments. Bonds differ from other debt financing instruments in that you could set the interest rate and the date of repayment of capital (maturity date).
In addition, you don’t have to make payments on the principal amount (and may not make interest payments) until the specified due date.
When a company issues a bond, it guarantees capital repayment (par value) plus interest. From a financing point of view, the bond issue allows the company to gain access to financing without repaying it until the funds are successfully used.
The risk for the investor is that the company will default or go bankrupt before the due date. However, since bonds are a debt instrument, they are ahead of the shareholders of the company’s assets.
A lease is a method of obtaining funding through assets rentals for the enterprise without debt or equity financing. A legal agreement between two parties establishes the conditions for renting a material resource. These material resources could be a building or pieces of equipment.
Advantages and Disadvantages of Business Financing
Now that we have covered the various types of business financing options let’s continue with the advantages and disadvantages. I think it would be unfair if I don’t cover the pros and cons of business funding. Without further due, let’s go.
- The most important benefit of business financing is that the business owner gets access to additional funds. The business owner can use these extra funds to solve some financial difficulties their business is facing.
- The interest paid on loan is tax-free.
- If you often face liquidity difficulties, you will have access to available funds to run your business operations smoothly.
- With ready-to-use finance, you can create appropriate business expansion plans.
Depending on the business funding option you go for, the disadvantages often vary. These disadvantages range are;
- Financing from sources like Venture Capitals requires you to have strong management with proven track records. If you are a start-up, you will be very much limited.
- Debt can put you under too much stress, making you take unnecessary risks when making financial decisions.
- You might also lose total control of your business because the investors might own a certain amount of shares.
Now you know what business financing is and the different options you have for funding your business. But how do you get funds to smoothen your business operations? You can check out these 10 places to get a business loan if you are a small business. These platforms and lenders have different funding types that we have come across in this article.