7 Ways Of Financing A Small Business
Whether you are starting your small business, or planning to invest to grow an already existing business, you will come to a time when you need to find extra cash.
Here are seven ways you could finance your small business.
But first, we should discuss the good and bad reasons why you are seeking the extra cash to invest in your business.
Good reasons to invest in your business include starting a business with a proven market or product and expanding a profitable business. Starting a business with a totally new idea is riskier, so if you are borrowing money or investing your own savings, you should be aware of the higher risk involved.
A bad reason to invest more in your business is if it is already showing signs of financial stress – a consistent history of making losses or showing negative cash flow trends. If this is the case, you should first look at how you can turn the business around to make a profit, or ways to improve cash flow. You must make sure that in investing more money you are not throwing good money after bad.
However, let’s assume that you have genuine, sound reasons to invest more in your business. What are the ways of financing a small business?
1 Borrowing On Your Home
The first source is borrowing on the value of your home. This method means that, technically, you are taking out a personal loan from your bank, and then introducing that “personal” cash into your business. The business does not owe the bank – you owe the bank.
The process of the repayment is actually in two stages – the business repays you, and then you re;pay the bank.
The “pros” of this method is that it is relatively easy and cheap. Generally, home mortgages are cheaper than business loans. Home mortgages are a bank’s bread and butter so their procedures should be relatively efficient and take you less time. The terms of home mortgages can be over a long period – perhaps up to 25 or 30 years, meaning repayments are less on a month by month basis.
The “cons” include the risk of losing your home if anything goes wrong with your business. The bank will not care if the business is having short-term difficulties because, remember that you owe are the borrower, not the business. All the bank sees is that you are not making the repayments. For some, this is a significant risk they would rather not take.
2 Business Borrowing
An alternative to a personal home mortgage is where the business takes the loan.
A bank will lend to your business directly, and in theory, if the business is unable to make repayments, the business has to face the consequences rather than you directly.
However, the bank may not only secure the loan over business assets, it may ask you to personally guarantee the business loan, or even put up your home as security. In either case, you will end up being liable for the loan if your business cannot make the repayments.
While this type of financing is “simple” and easily recognisable as a business loan, depending on the value and quality of the business assets, if you have to guarantee the loan or put up alternative security such as your home, it is no different from taking out a home mortgage from the point of view of risk. On top of that, a business loan will generally incur a higher rate of interest and will be for a shorter length of time like five to seven years. This will make monthly repayment higher.
3 Personal, Unsecured Loans
Depending on the amount that you want to borrow, banks may offer you a personal, unsecured loan.
Generally, these are for about a maximum of $20,000 and taken out in your name (not the business). The bank will not take security on the loan and they will only provide this if you can show a strong history of credit-worthiness. These will incur the highest rate of interest (because from the perspective of the bank, they have the highest risk of non-recovery).
If you have a short-term need for a smaller level of financing that you are certain that you can repay quickly, this is not a bad choice due to the speed by which it can be set up.
I would class using your credit card to fund this level of loan as a personal, unsecured loan – but be clear I do not recommend this because credit cards have the highest rate of interest and you could find yourself spiralling into debt more quickly.
4 Using Existing Savings
If you have personal savings that you can draw on, this would be the cheapest source of finance.
In effect, it costs you the opportunity cost of what you earn from those savings. For example, if those savings are in a low-interest paying savings account, in effect, the use of those savings will cost you the interest that you subsequently do not earn.
The question of risk will be dependant on what you are financing – a business decision rather than a financing decision.
One major advantage is that you finance your business while remaining beholden to nobody. A major disadvantage, of course, is that any loss means the loss of hard-earned savings.
When you consider this method of financing, do not – ever – use retirement savings such as a pension or superannuation plan. This is a specially designed type of saving for your retirement and should not ever be put at risk.
5 Borrowing From Friends Or Family
It doesn’t matter how close you are, nor how solid you think the investment is, nor even how much you put these borrowings on a commercial footing.
As soon as you mix business and personal relationships, something gives. Either you feel the added responsibility and the extra stress, or they are seen to be more interested in their investment than you would like. In either case, relationships will change.
Unless you are prepared for that, just don’t.
I will, however, make an exception for business colleagues. Depending on your relationship with them, it may be an option to borrow from business colleagues, but only of the terms are commercialised and clear. Do to put yourself in a situation where you have differences about the performance of the loan.
6 Finding Partners/Investors
This is a totally valid way to finance the business, especially if you see that the extra hands would be useful as you expand the business.
This method of financing can work in two ways.
First, your new partner may buy a part of the business from you, and you then lend the money into the business. This means that the business has to make the repayments back to you before sharing any profits.
The second method is where the partner directly introduces his share into the business as capital. This is not a loan – it is his investment.
The end result is the same – the partner benefits from sharing in profits rather than from earning interest.
You can have two kinds of partners – silent partners or active partners. In my opinion, silent partners are more difficult because at some stage, you may start to feel that you are doing all the work while they “meddle” from the outside. This is a perception – but I have seen it wrecking the partnership in real life.
Active partners are extremely beneficial if you both get on and think the same way about the business. As the business expands, you may need the extra pair of hands – so long as you are clear about each other’s roles and responsibilities in the business.
What makes an investor different from a partner is that investors may take on a less hands-on approach to the business. There are independent investors who make investments in what they see as growing businesses so that they eventually sell their investment – back to you or to third parties – for a capital gain. The advantage of an investor to you is that they usually bring with them a depth of experience in running and building businesses, and their advice at the strategic level could be invaluable.
In the case of investors, you should make sure that you are clear about roles and responsibilities – and very clear on their exit strategy. You do not want to be surprised in a few years’ time that they ask you to buy them out at a great profit for them, or that they ask you to find other investors or even to take the business public.
7 From Profits And Cash Flow
Depending on what you are financing and the amount you need, you can always expand the business through profits and cash flow, particularly if both are strong.
To do this, you will need to have excellent, accurate profit and cash flow forecasting so that you can match the requirement for financing with the profit and cash flow.
While it sounds like you may have to take time to “save” the finance you need, depending on what you need it for and when you need it, it may be possible to fund directly from ongoing cash flow.
For example, if it’s for the purchase of an asset like equipment, you may be able to obtain short-term equipment finance like a lease or a hire purchase contract, for a relatively short period of 1 to 3 years, and make the repayments from cash flow. While this sounds like a short-term loan (which technically it is), the fact that a relatively small sum is borrowed over a relatively short period that you are sure can be met from regular profits and cash flow makes this much less risky.
There may be other ways you can raise a lump sum from cash flow funding.
You can consider Debtor Finance, where a finance company basically “purchases” your accounts receivable and gives you a discounted lump sum. They collect the debtors and if there is a shortfall, you will have to make it up. Usually, the collection is done in a way where your customers are unaware that there is any change.
You may also be able to raise a respectable lump sum if you really push some old debtors to pay quickly – a lump sum that you would normally not expect to collect except over an extended period in small drips. Potentially, you can achieve this by offering “Pay-Now” discounts or other methods.
With longer-term planning, you can also save the old-fashioned way from profits and cash flow, just by putting a percentage of income aside every month.
In summary, there are at least seven different ways you can finance your small business.
They differ by risk, and by what you need the finance for, and for how long.
With proper planning, you should be able to find the finance you need for growing your small business.
But, and you will find more detail in several other blogs posts I have written, you need to ensure that you are investing for sound reasons. We all want to grow our businesses, and sometimes, you need extra finance to do so. But please, do not rush into borrowing or using savings if you haven’t fixed core problems like making losses, or having negative cash flow.
On that note, go to my blog at teikoh.com for more information about financing and growing your small business.
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