How to Finance a Business

bizfluent article image

It's the major hurdle every business owner faces: raising money. No matter how good your business idea is or how well you do in the early years, at some point you're going to need money to keep your growth from stalling. Today, there's a seemingly endless list of financing options from bank loans and overdrafts to personal savings and cash from sales. Broadly, these options fall into two categories: external finance, which comes from sources outside the company and internal finance, which is the cash you generate from inside the business.

Small Business Administration Loans

SBA-backed loans are traditionally the slowest way to get money for your business, but they come with low rates up to 10 percent and long repayment periods. To qualify, you'll need a credit score above 680, equity in real estate that can be used as collateral for the loan and a stellar business plan. If you meet these qualifications, then you're likely a good fit for the SBA's 7(a) loan program, which lets you borrow up to $5 million to meet your working capital needs or the microloan program that has a $50,000 funding limit.

Microloans are easier to qualify for and can give you some operating capital while you work on your credit score to qualify for a larger loan. The main risk is if you have no trading record and unpredictable revenues. Then, as with any type of financing, you probably won't qualify for the best rates.

Rollover for Business Startups

Another popular option for startups is rolling a 401(k) retirement plan into the new business or franchise. If structured properly, a rollover for business startups can be done without paying the early withdrawal penalties or income taxes that you'd usually have to pay for taking cash out of your retirement plan. A ROBS isn't a business loan, so there are no interest payments to make or debt to repay. Essentially, you're buying stock in your company using funds from your 401(k) and holding that stock in the company's retirement plan.

Obviously, you'll need cash in your retirement plan for this scheme to work and realistically, a ROBS is feasible only if you hold at least $50,000 in your retirement account. You'll also need to legitimately work in the business – absentee owners will not qualify for a rollover. As a specialized financing tool, you're going to need the help of an accountant to set the ROBS up properly. Don't try this one at home!

Business Line of Credit

With a business line of credit, you can borrow up to a maximum limit, say $50,000, and pay interest only on the portion of the money that you draw down. You can keep drawing and paying back funds as often as you wish, as long as you don't exceed the credit facility limit. So, it's a good option for those who need temporary access to cash. Terms vary, and the interest rate you get depends on your track record, business assets and projected revenues. Rates tend to be higher than with an SBA loan or franchise loans from a franchise company, but the approval is usually quicker – a day or two versus several weeks for a loan or a microloan.

Home Equity Loans and Lines of Credit

Most business owners will invest at least some of their own money to get a business idea off the ground, but what if you don't have any personal savings? Home equity loans, which are just a type of mortgage, let you leverage the equity in your home to borrow funds to grow your business. Because your home is on the line if you default, the loan is much less risky for the bank than, say, a regular small business loan which the bank may never recover. Lower risk translates to lower interest rates of around 6 percent, compared to the 7-to-30 percent you might get with a conventional business loan.

Classic Credit Cards for Businesses

One of the most overlooked sources of finance is the simple credit card. Credit cards are a flexible option if you need quick access to cash and a small amount of capital up to $50,000. Interest rates tend to be reasonable, ranging from 12-to-24 percent annually which is much lower than the 30 percent or higher rate you see with some small business lines of credit. You need to be disciplined, however, as interest can rack up quickly if you're not paying the balance down each month. Look out for cards that offer a zero percent introductory rate for purchases and balance transfers. Many providers offer cash backs and rewards when you charge purchases to the card, which is basically free money!

Business Retained Profits

If your business can hit the ground running with little or no startup capital requirements, and looks set to make more money than you need to cover your operating expenses, then congratulations! You're going to have some spare cash to reinvest in your business instead of paying it out as dividends to shareholders. The beauty of using retained profits as a source of finance is the money already exists in the business. You're not diluting the ownership of the company, and there are no debt obligations to repay. Retained profits are an extremely cheap source of finance, too, since all you're losing is the return you could have made on your dividend receipt if you invested the money elsewhere.

Cash and Expertise from Angel Investors

Angel investors are wealthy individuals who invest their personal funds in exchange for a stake in your business, so the most important thing to establish is how much control the investor will have over your company. You're essentially handing over a seat at the board and a whole bunch of stock in your company, so you must be comfortable with someone else bringing their opinions and expectations to the table. In return, you'll get a wealth of expertise and a network of contacts alongside the investment.

Unlike most other types of funding, you'll need a terrific pitch and the promise of 25 percent-plus annual returns to land an angel investment. The typical investment is somewhere between $150,000 and a cool $1 million, which you can take as a one-time cash injection or as a steady drip of funds. Check out the Angel Capital Association website for local groups that will accept requests for funding.

Hard Money Lenders

Hard money is finance-industry jargon for getting a loan from a private party. Peer-to-peer lending websites enable borrowers to get a 3-to-5-year loan from strangers by filling out a loan application online and finding investors who are willing to back their business. These platforms work by hooking you up with several lenders who each contribute a small amount to make up the total investment amount. Getting a loan depends entirely on the state of your finances, your business idea and credit score, and rates can be higher than a traditional loan. But if you have nowhere else to turn, it's another source of quick debt finance.

Family and Friends

Family and friends are last on the list for a reason: borrowing from people you love is fraught with difficulty. While friends and family may be persuaded to invest in your big idea, your relationships are on the line if the business does not perform as well as expected. Protect everyone by thoroughly documenting the loan terms and ownership stakes involved.