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Start Your Business Startup Funding

Borrow or Fundraise? How to Fund Your Startup

Borrow or Fundraise? How to Fund Your Startup
Credit: www.BillionPhotos.com/Shutterstock

There are a lot of different ways to finance a startup. You could save up your own money and bootstrap the business. You could borrow money from family and friends. You could even invest some funds from your 401(k) account. But for many businesses, the choice comes down to taking out a loan or raising investor capital.

The financial path you choose will affect how you run your business in some way, so you should not make this decision lightly. Borrowing and fundraising both have their pros and cons, and the best option for you depends heavily on the type of business you run and what you need the money for.

Finance and business experts shared the advantages and disadvantages of loans versus fundraising, and weighed in how to make the right choice for your business. [Creative Financing Methods for Startups]

Options: traditional bank loan, SBA loan, alternative loan

Pros

A loan is one of the most cost-effective ways to fund your business, said Jay DesMarteau, head of small business banking at TD Bank. If you obtain your loan through a bank or SBA (Small Business Administration) lender, you'll usually have a lower interest rate than on a personal loan. You may even enjoy some tax benefits. Taking out a loan also gives you the opportunity to build up your business's credit score as you repay the loan.

DesMarteau noted that the biggest advantage of a loan is retaining full ownership of your company, which won't happen if you take on investors (more information on that below). 

Cons

If you're looking to get a traditional bank or SBA loan, the application process is very lengthy, said Jay Chang, co-founder of the personal growth and leadership resource, Achieve Iconic. You'll also need to satisfy a long list of prerequisites, which often includes being an established business, rather than a new venture. Chang noted that loans also mean you risk losing collateral if you can't pay off the loan.

Although alternative lenders often have much quicker approval and funding processes, they also typically charge high interest rates for that convenience. Evan Singer, general manager of SBA loan provider SmartBiz, warned business owners that while "fast financing" offers may help in a pinch, they may not be a good longer-term strategy due to the higher rates.

In some cases, both traditional and alternative lenders will put restrictions on what you can use your loan for.

Learn more about the different types of business loans and the application process here.

Editor's Note: Considering applying for a small business loan? If you're looking for information to help you choose the one that's right for you, use the questionnaire below to have our sister site, Buyer Zone, provide you with information from a variety of vendors for free: 

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Options: investor capital, crowdfunding (equity or consumer-based)

Pros

Finding an investor could be a better strategic move to help you grow your business, DesMarteau said. Investors often bring more to the table than just capital; they may have business connections, manufacturing capabilities, distribution expertise, etc. that you wouldn't have access to through other means. You'll also likely be able to receive much larger sums of money from a venture capitalist or angel investor than from a loan, if that's what your business needs.

If you're going the crowdfunding route, the barrier to entry is much lower than securing a loan, especially on sites with "backers" (i.e., Kickstarter and Indiegogo) as opposed to accredited equity investors. Rather than going through a lengthy credit check and application process, anyone can start a crowdfunding campaign with just a few clicks. This is also a smart choice if you need to raise a smaller amount of money; both business lenders and investors tend to deal in large amounts of capital.

Finally, fundraising works for businesses at any stage. Meanwhile, the "time in business" requirements for most lenders exclude brand-new startups that need to raise seed money to get off the ground. 

Cons

One of the biggest downsides to equity fundraising is having to give up part of your ownership of the company. Investors will likely take a larger share of your profits than a loan repayment would, Chang said, and they often ask for decision-making power within your business as part of their equity stake.

While consumer crowdfunding backers may not demand equity, these platforms typically have a low success rate, and campaigns take a great deal of time and energy to get funded.

Learn more about fundraising in Business News Daily's guides on attracting investors and equity crowdfunding.

Objectively speaking, neither loans nor fundraising is better or worse than the other. However, it's important that you consider all the factors involved and know your business's needs really well before making a final decision.

"Figuring out which one is right for you really comes down to your own business," Chang told Business News Daily. "Don't just spring for loans because they're the most obvious choice, or for crowdfunding just because every other entrepreneur you know is doing it. Business owners should research each option thoroughly and assess which one gives them the best chance of success."

Similarly, Singer recommended laying out one-, two- and five-year plans for your business and understanding your objectives, goals and vision. Once you decide those specifics, you can figure out which financial strategy will help you achieve your vision.

Regardless of which funding option you ultimately choose, here are a few smart tips to help you keep your business finances in order throughout the process.

Have an up-to-date business plan. Whether you're going to the bank or pitching an investor, the person giving you money is going to ask to see your business plan. This person needs to understand how your business works before he or she can decide if it's a worthwhile investment.

"A business plan is imperative to obtaining funding," DesMarteau said. "It should demonstrate knowledge of the business's market [and] ... customer base, and exhibit a viable track record."

Perfect your pitch. In addition to a business plan, you'll need to prepare a pitch for potential lenders or investors. Chang advised making it simple, brief and easy to understand.

"If your investors or lenders don't understand or aren't interested in what you're doing, you're not going to get very far," he said.

Understand the terms. Every business-financing deal comes with fine print, and before you agree to anything, you need to be sure you understand exactly what you're getting into. With investors, clarify the equity arrangements and the timing of how soon they'll want to see a return. With loans, ask about the repayment details, as well as any restrictions on how you can use your money.

"Not all [lenders] will refinance your debt, allow you to purchase new equipment or real estate, [let you] buy another business, etc.," Singer said. "Understand what your lender will actually lend for."

Don't give up. It's notoriously difficult to obtain business funding as a brand-new business, so if you're turned down at first, don't get too discouraged. There are other options out there, and even if your original plan doesn't work out, you can always try another avenue.

"Keep refining your pitch and business plan and keep hitting the streets," Chang said. "If you search long enough, you will eventually find the option that's right for you."  

Editor's Note: Considering applying for a small business loan? If you're looking for information to help you choose the one that's right for you, use the questionnaire below to have our sister site, Buyer Zone, provide you with information from a variety of vendors for free: 

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Nicole Fallon Taylor
Nicole Fallon Taylor

Nicole received her Bachelor's degree in Media, Culture and Communication from New York University. She began freelancing for Business News Daily in 2010 and joined the team as a staff writer three years later. She currently serves as the assistant managing editor. Reach her by email, or follow her on Twitter.