Financing Options for a Small Business: Finding the Right Funding

A while back, we were approached by "Brian," an entrepreneur who started a company with a combination of funds from his personal savings account and credit cards. He was looking for a venture capital investment, but part way into his pitch, it was clear he was heading down the wrong path.

As in Brian's case, it's no mystery that funding is front and center in the minds of entrepreneurs. Financing options for starting a business abound, but what we've noticed is that people often go after the wrong type of funding for their kind of business. This can lead to undesirables like a shift of control that's out of your hands, feuds between you and your financiers, a waste of one of your most precious resources - time, and other nasty consequences.

With this in mind, we thought you might want to consider applying the "Goldilocks Principle" to your funding quest…choosing the type that's “just right.” To help you, we've highlighted various financing options that might fit your business.

Debt Financing

The vast majority of new small businesses are funded with debt financing via financial institutions. If you pass muster, banks can provide you with a loan or line of credit that comes with a repayment schedule and an interest rate. They will look carefully at your company's cash flow, collateral and the liquidity of your assets. You've got to have a sensible, written business plan, and you must know your financial situation inside and out. Note that one way to increase your odds of success is to establish a relationship with your banker prior to your loan request.

“In addition to showing a successful track record in managing their business, we also consider the customer’s existing account relationship with the bank as one of many factors in making lending decisions – and this can also include their personal banking experience with us,” said Brad Baumann, assistant vice president, regional business banking representative at Washington Mutual. “Of course, we are always interested in attracting new customers as well and would consider their previous history with another financial institution.”

Upside:

  • Don’t have to give up equity
  • Available to companies that can’t get equity funding

Downside:

  • Must pay interest
  • Limited networking or "business savvy" value
  • May require personal collateral such as home

Grants

Especially if you're in the technology game, consider securing a grant through the Small Business Administration's Small Business Innovation Research (SBIR) Program. There are also numerous state, regional and minority grant opportunities available. By working together with a government agency in a Cooperative Research and Development Agreement (CRADA), you can also optimize resources and cost-effectively perform research (thus requiring less funding). These programs are designed to help fuel the innovative fires at small businesses. Having been on the receiving end of these grants, here's our bottom line: Billions of dollars of "free money" should not be overlooked.

Upside:

  • Free money
  • Investors love the “leverage” that grants provide

Downside:

  • Highly competitive
  • How you use the funds is strictly defined

Equity Financing

While debt funding is most common, there are still tens of thousands of companies financed each year by private or "institutional" investors in exchange for an equity ownership stake. They range from the less sophisticated "friends and family" type, to high net-worth private investors known as "angel investors," all the way up to the sophisticated professional investors called venture capitalists.

Friends & Family

When you can't get debt financing, consider asking your rich Aunt Harriet for a little help. As a jolt of startup funding for many a family-run business, small business financing from friends and family typically comes in small amounts without a lot of hassle or legal expense, but be careful. Always stay professional and go heavy on communication. Depending upon your priorities, realize that business has risks, and preserving your relationships with friends and family is at least as important as your business opportunity.

Comfort zone: generally less than $50,000.

Upside:

  • Convenient, no nonsense
  • Fewest contractual strings attached
  • Available quickly

Downside:

  • Limited one-time source of funding
  • Be ready for an ugly Thanksgiving dinner at your in-laws if you lose their money

Angel Investors

Do you believe in angels? We do. With approximately 250,000 high net-worth private investors in the US who fund over 30,000 small companies each year, you might be seeing wings yourself. "Angels" have earned their name by typically being friendly and patient about their investments and by providing their business wisdom and valuable relationships along with their money. They often like to invest in groups, each taking a piece of the deal.

Comfort zone: $25,000 to $1 million.

Upside:

  • More than money, they invest business smarts and networking opportunities
  • Relatively patient about their investments

Downside:

  • Often difficult to find
  • Can be hard to manage the divergent interests of a large group of angels

Venture Capitalists

If you are beyond the startup phase, have initial revenues coming in, a quality team in place, and a clear path to eventually sell the business or go public in an IPO, you could be ready to approach the funding pros - venture capitalists (VCs). But because they funded the dot-com and biotech bubbles and were badly burned, VCs now have higher standards than ever. Still, they remain a serious player in the investing world. Keep in mind that their funding is very time-sensitive. VCs look to get their money and profits out as quickly as possible. They are a great source if you're planning for meteoric growth and will require further business financing in the future to achieve it.

Comfort zone: $250,000 to $10’s of millions. Must be a "fast growth" company

Upside:

  • Invest smarts and networking in addition to money
  • Typically have more money if you need more to grow

Downside:

  • Must be a “fast growth” startup business
  • Must be interested in selling the business or going public within three to five years
  • Must be prepared to share control

Strategic Investors

If you need to get to market quickly or perhaps short-circuit the "no name, no credibility" game, strategic investors can help. These equity financiers get their name because they come from within the industry you are targeting and find what you're selling to be "strategic" for their business objectives (such as somehow complementing or enabling the products or services they sell). But beware! They can swamp your business with opportunity, seduce you into reallocating your company's resources in a lopsided way, restrict you from dealing with their competitors as your customers, and even cancel their business relationship with you on a whim! Be sure you know what you're getting yourself into. Did someone say "lawyer"?

Upside:

  • Enhances your credibility in the industry
  • Money can come with access to benefits like manufacturing, distribution, and marketing

Downside:

  • Can force you to recalibrate your entire business to serve them
  • Dependency can be risky
  • Can prohibit you from selling to their competitors

Our bottom line: Choose Wisely

Just like Goldilocks, you'll have to make a choice. Some small business financing options will be too complicated and some too risky. Others will offer too little or too much. But if you do your homework and ask for the right amount from the right source at the right time, you will secure the financing for your startup that's "just right" and be well on your way to business success!


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