7 Ways to Finance a Small Business
The road to starting a successful business can be a long one, filled with many hurdles and obstacles along the way. Even if you have a great business idea, no business can succeed without a financing plan. While the process may sound daunting, there are many small business financing options, each with their own advantages and disadvantages. Here's a brief summary of startup business financing options for anyone thinking of starting their own business in 2012.
- Small Business Administration Loan
The Small Business Administration (SBA) was started in 1953 to encourage small businesses and entrepreneurs to start their own businesses. Under the SBA, there are two types of loans that can help borrowers to get the capital they need to start their business: a 7(a) guarantee small business loan and the 504 fixed asset small business finance program. The
7(a) guarantee loans for small business are more common for small businesses and can be applied for at banks participating in the SBA loan process.
"Both programs look for businesses not in the startup phase," said Chuck Evans, managing director at the South Eastern Economic Development Company of Pennsylvania. "They look for businesses two years into business cycle that are generating cash flow."
"The advantage to the borrower is they have more access to capital," said Evans of the 7(a) guarantee loan. "When borrowing with a loan, collateral or purpose often dictates the terms. If you look at real estate, you are looking at a 20- to 25-year term. If you are financing equipment, you look at the useful life and may finance it for five years. If you look at permanent working capital, you may only want to loan them for three years. With a guarantee from the SBA, banks can go up to 10 years for working capital, 10 years for equipment and 25 years for real estate. It gives the borrower longer terms and improved cash flow."
Additionally, banks may also be more willing to give these loans out as the SBA guarantees 75 percent of the loan.
"At a point, if that business goes under in the future and you have liquidated all of your collateral, acted like a prudent lender and done everything you are supposed to do, the loss is split," said Evans. "Let's say on a million-dollar loan, if you sell a building from the business for $600,000, that leaves a loss of $400,000. With a 75 percent guarantee from the SBA, they will give $300,000 and the bank will take a hit of $100,000."
"Because the loans are sold in the secondary market, they tend to structure a lot of those loans on a variable basis," said Evans. "If you are getting a 25-year fully amortizing loan at prime plus 2.75 percent today, interest is going to be at 6 percent because prime is currently 3.25 percent. Three years from now it might be nine percent. The interest rate risk is greater on the 7(a) program."
Additionally, borrowers must make a smart choice when choosing the bank to borrow from, Evans said.
"If you take 100 banks in the state of Pennsylvania, maybe only 20 banks made more than 10 SBA loans last year," said Evans. "If you deal with that few loans a year, you are not going to be able to understand the nuances of a program that is constantly changing, so it can turn into a slow and cumbersome process. If you go to a bank that does it well and does it on a regular basis, you stand a much better chance of a more simplified process because they understand it."
- Friends and Family
Know of a rich aunt or a wealthy friend who has some extra money to throw around? Then you have another way to finance your business . Friends and family present an interesting alternative to traditional forms of financing, but those who take them risk muddying personal relationships with a business decision.
"You can take advantage of those sources when your business lifecycle is early," said Evans. "If you are in an early stage of business, you are going to be forced to go to friends and family because the banks may not entertain your requests. Also, friends and family are not going to be charge you a high price for that investment. This funding is available when you need it and with less contractual hassles."
"The downside is that you risk lots of other things within the family dynamic," said Evans.
- Home Equity Loan
Home equity loans are based on the equity a potential borrower has in their home. For borrowers who have equity, the difference between what a home is worth and what you owe, in their home this form of financing makes for a great option to finance a small business due mainly to interest rates that are not only flexible, but also lower than traditional commercial rates. Interest rates for home equity loans can range from a half point under to one point over Wall Street prime, which is currently 3.25 percent. However, there can also be one potentially very large problem caused by this financing option.
"Home equity loans first of all are very cheap, rate-wise," said Al Engel, executive vice president of consumer lending at Valley National Bank. "It is a very low-cost form of borrowing that is very controllable by the entrepreneur as far as when he pays funds and redraws funds. The flexibility is tremendous."
"The risk is you are putting your home on the line," said Engel. "If the business fails or you fail to maintain the terms and conditions of the home equity loan or line, you risk foreclosure. This puts the home over your families head at risk, meaning there is personal liability for home equity loans."
- Credit cards
Other people looking for additional financing for their small business can look no further than their wallets. While business credit cards are among the most readily available ways to finance a business, experts warn that there are some significant things to consider before swiping that piece of plastic.
"There are minimal advantages to using credit cards to finance your small business," said Ken Nickel, senior vice president of community lending at Valley National Bank. "One of the few advantages is that the minimum payment on a credit card is very low. If you are a new business who is just starting out and you don’t have a lot of money coming in or you don’t have a ton of expenses, you can put it on a credit card and pay the minimum payment."
"The downside to credit card financing is that it doesn’t go away quickly and it also costs you a lot of money," said Nickel. "Particularly if a new business gets started and then has trouble making the payments, the interest rates and costs on the cards can build very quickly. The commercial loan market right now is in a range of probably 5.5 to 6 percent for commercial loans. When you get into the credit card market, you can be looking at interest rates of 24 percent and over. It can be really devastating to a business over a period of time to have to carry that kind of debt."
- Angel investors
Additionally, those looking to finance their business can always look to an angel … investor that is. Angel investors have been responsible for helping in the early stages several prominent companies, including Google, Yahoo and Costco. This alternative form of investing generally occurs in the early stages of growth for a company, with investors expecting a 20 to 25 percent return on their investment.
"The principal advantage of an angel investor is generally that you have a friendlier atmosphere and a quicker decision making circumstance for a smaller amount of dollars," said Mark DiSalvo, chief executive officer at Sema4 Inc, a leading global professional services provider of private equity funds. "You are not going to invest the levels of time, experience and diligence that an institutional investor would require."
Beyond this, angel investors can also help nascent businesses by acting as an advisor for them in their journey.
"More importantly, angel investors are an aggregate of smaller high net worth individuals that are going to afford fitting in a more appropriate amount of money," said DiSalvo. "Very few institutional investors today will invest less than $2 million, whereas angels will invest from $100,000 to $2 million easily. You are more likely to get an investor who has strategic experience so they can provide tactical benefit to the company they are investing in. That could mean that they have customers lined up for them. It can also mean they might have partnership opportunities for these businesses."
"In every stage, the investor and entrepreneur need to make sure they are the right partners for each other," said DiSalvo. "You have to fit the kind of investment with the need the entity has. That, however, is a difficult thing to discern."
- Venture capitalists
While venture capitalists are synonymous with the dot-com bubble of the late 1990s and early 2000s, the truth is that they may be a great source of capital if your business falls into a few categories. For small businesses who are beyond the startup phase with revenues already coming in, a venture capital investment may be for you.
Beware, though — venture capitalists have a short leash when it comes to staying with a company and they often look to recover their investment within a three- to five-year time window. However, for a fast-growth company with an exit strategy already in place, venture capitalists present a great way to quickly gain anywhere up to tens of millions of dollars that can be used to invest , network and grow their company quickly.
"The benefit of venture capital investors to a startup is that they can help them get the money and provide them with professional management expertise," said Brian Haughey, assistant professor of finance and director of the investment center at Marist College. "You may have a venture capitalist who concentrates on physics or nanotechnology. Because they focus on specific industries, they can generally offer advice to the entrepreneur on whether the product is going to fly or what they need to do to bring it to market."
"Sometimes the money comes in to easily," said Haughey. "During the dot-com bubble, the venture capitalists were throwing money at the startups and as a result, many startups forgot about what they should be focused on. A lot of businesses started thinking about fancy offices and they forget the commercial imperative that they needed to be making money. If money is too available, it lets some people get lazy."
Beyond that, Haughey warned of the imperative that venture capitalists always have in business decisions.
"They also have to make a return and usually have a five-year time horizon," said Haughey. "So they invest and you have to be able to show a profit in five years to return the capital. If you have a product that is taking longer than that to get to marke,t then venture capital investors may not be very interested in you."
- Strategic investors
In 2007, software developers began working on a then-unknown personal assistant application. That application Siri was bought by Apple three years later in 2010. One year later with the release of the IPhone 4s, Siri has become one of the most well-known and intriguing features of the new iPhone. Apple's investment goes to serve as an example of what a strategic investment can provide an upstart company.
"Strategic investing is more for a large company that identifies promising technologies," said Haughey. "For whatever reason, that company may not want to build up the research and development department in-house to produce that product, so they buy a percentage of the company. It is a cheap investment, but the company could turn out to be the next Google or Facebook for them."
"The first disadvantage would be loss of control," said Haughey. "You have this great idea and now you have to answer to someone else and you have to give up a percentage of your company. The question then becomes, 'would you rather have 100 percent of a tiny pizza or 50 percent of a huge pizza?'"
Beyond that, those using strategic investing must also think about the restrictions the investing company may place on them, as they can prevent dealing with any competitors and possibly even canceling the business relationship at any time.