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Grow Your Business Finances

3 Private Funding Sources for Small Businesses

image for OPOLJA/Shutterstock
OPOLJA/Shutterstock

You may be an entrepreneur still in planning mode in need of working capital to launch. Or maybe you've been operational for a decade but are ready to expand your business. Either way, the old maxim applies: "It takes money to make money." If you're struggling to get financing – or just starting to look for it – it's important to consider all your options. Private funding sources can differ from standard financiers because of what they bring to the table. 

"The type of financing a company does should be dictated by what the money is going to be used for," said Casey Berman, founder and managing director of Camber Creek. "What is the investor going to bring other than money?"

For small businesses exploring their financing options, the first order of business is to distinguish between debt and equity financing, said Brian Cairns, CEO of ProStrategix Consulting. Debt financing involves taking out a loan, whereas equity funding is a purchase of a share of the profits or control over the company. 

For many startups, securing investment is especially attractive, because it does not clock any liabilities on the balance sheet. 

"The main pro with any equity funding is its limited to nil effect on cash flow," said Cairns. However, "The main con is giving up partial control of the company." 

Private equity at the startup level is often seen in two forms: seed or angel investment, or venture capital.  

Venture capital (VC) firms invest money in startups, usually in exchange for equity in the company. Venture capitalists analyze business plans, financial statements and other business details to determine the overall expected return on investment before investing in a portfolio company.

Companies are most likely to attract venture capital if they have an immediate opportunity for growth, said Cairns, as VC firms will generally want to exit within five years.

"They are looking for rapid expansion, which will drive up the valuation," he said.

Such high-growth enterprises represent a lot of risk, which is why VCs require a much higher return on investment from their portfolio companies compared to other private equity firms.

Venture capitalists often also provide guidance to young companies, like mentorship, access to sales networks and other development opportunities.

"If a company is looking for private funding, looking for more than just money is key," Berman said. "In a lot of circumstances, the money might be more expensive than bank debt. However, the value that can be created through that partnership far outweighs a low interest rate."

The downside to working with VC, as with any lender looking for equity, is that you'll be giving up a certain percentage of your company. It also means that you'll have a third party to answer to as your business grows and changes.

"[Venture capital firms] will likely require more reporting and oversight," Cairns said.

Much like venture capitalists, angel investors finance startups usually in exchange for equity in the company. Unlike a VC, however, angel investors are private individuals investing their own money. Angel investors also have different ROI requirements depending on their risk appetite, which makes them a better fit for slow growth companies. On the other hand, some VCs expect 100% growth year over year, Berman said.

"Not all money is created equal," he said. "A venture capitalist is going to structure a deal one way, a private equity firm is going to structure a deal a different way, and an angel investor is going to do a different deal."

Similar to angel investing is seed investing, where a group of individuals or a government agency provides capital.

"They usually provide funding through a convertible note for a set fraction of the company, usually no more than 20%," Cairns said.

Most convertible notes, or IOUs, are due in three to five years, at which point, the investor can reclaim the money plus interest, or convert the note into shares, or equity. 

The first piece of advice for small businesses seeking investors is to be realistic about their options. Venture capital firms tend to operate in the $2 million-plus range, whereas seed investors usually offer up $100,000 to $500,000, Cairns said. 

When courting private equity firms, it's up to the startup to first make sure they fit the requirements. 

"The entrepreneur has to make sure that his or her deal fits within our 'box,'" said Lyneir Richardson, investor and director of Rutgers University Business School's Center for Urban Entrepreneurship and Economic Development. Next, Richardson reviews the startup's track record and current capacity. 

Only then does Richardson look into the deal itself and decide whether or not it's investable – "in other words, if the sources and uses of capital are reasonable, if the pro forma [is] believable, and if it's feasible that I will get the projected return on my investment," he said. 

For this reason, financial projections – such as future capital requirements, revenue and profit, and an ROI timeline – must be crystal clear. Many startups avoid guesswork by paying for a third-party valuation. 

Companies should avoid going overboard on the metrics, however – precision, not volume, is key. Richardson said one of the most common mistakes he sees during pitches is a PowerPoint overloaded with text. "I want the entrepreneur to clearly communicate a concise story that I can understand, believe and get excited about," he said.

Equity funding may be the favored option of debt-resistant small businesses, but it carries the major downside of the relinquishment of control. On the other hand, few small businesses possess the credit score or sufficient collateral to secure a bank loan. 

Luckily, cash-strapped small businesses can benefit from a growing number of new forms of lending. 

Alternative online and fintech lenders can be a great funding option for small business owners. They provide short-term, high-interest business loans for entrepreneurs looking to quickly grow and expand with capital. The biggest draw of these lenders, however, is their flexibility.

Alternative lenders rarely require equity like an angel investor or venture capital firm. Instead, they provide loan agreements that mirror conventional banks but usually have much more relaxed requirements to qualify and higher interest rates. Alternative lenders also have various loan packages and types, like invoice factoring, merchant cash advances, lines of credit and equipment financing. This flexibility makes alternative lenders the most viable option for some businesses.

The downsides to alternative lenders are the high interest rates and potentially demanding loan agreements. Therefore, though these loans can be easy to qualify for, they're best for businesses that have access to the capital to cover these short-term loans. Alternative lenders have the most demanding loan terms and agreements compared to VCs, angel investors, conventional banks and loans through the U.S. Small Business Administration program. While this can be a good avenue for financing, it's important to assess the overall risk to your business.  

The advice for convincing lenders is not too far off from the advice for convincing investors – both seek assurance of future repayment. "You often hear that venture capitalists tend to invest in people, more than in the ideas they bring. This holds in the world of small business lending as well," said Alex Kaschuta, lending manager at Fundsquire. Kaschuta judges what she calls "investability" based on the trustworthiness of the manager, how they run their operations and their industry knowledge.

As for the most common mistakes in pitching, Kaschuta, like Richardson, is also frequently confronted with TMI. "Sometimes borrowers will throw everything but the kitchen sink at the lender in the course of the due diligence process in the hopes that it will bolster the case for them," she said. On the contrary, "If we request seven documents and receive 20, we might see that as a sign of desperation be – most often justifiably – put off."

Finding the right type of financing for your business means knowing what you need the money for and what lender makes the most sense for you to partner with. If you're starting a new business, a VC firm can give you the guidance you need to get off the ground. Alternative lenders are best for short-term, high-interest loans for any type of business.

Regardless of the type of financing you need, the best way to find financing is through networking and connecting with investors of all types. Once you target a few, you can partner with the company that makes the most sense for your business.

Matt D'Angelo contributed to the reporting and writing in this article. Some source interviews were conducted for a previous version of this article.

Siri Hedreen

Siri Hedreen is a graduate of King’s College London, where she wrote for Roar News, London Student and Edinburgh Festivals Magazine. Find her on Twitter @sirihedreen.