Types of Sources of Finance

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Whether starting up a new business or expanding an existing one, finding sources of finance is always a concern for the small business owner. Small, privately held firms do not have the same access to funds that are available to large, publicly traded companies.

A business owner has two choices of funds: debt or equity. The primary sources of funds for small businesses are banks, trade credit and equity contributions from the owners.

With debt, the lender receives a promissory note that defines the terms of repayment with interest and a payment schedule, but the owner retains ownership of the business. The downside is that a failure to make payments on due dates could accelerate the loan and force the company into bankruptcy.

If the owner accepts an equity contribution from an outside investor, he has to give up a portion of the ownership. If too much equity is sold, the owner could lose control of his business. The good news is that the owner is not obligated to repay the investor.

Fortunately, a small business owner has numerous options to raise funds for the company.

What Are the Sources of Funding?

Personal Funds

Using personal funds to finance a startup or support a growing business is a choice that every small business owner faces. How much of her own personal assets is she willing to risk for the business? What would happen if the venture failed and the owner had no funds left on which to fall back?

On the other hand, is the owner willing to share ownership of the company with outside investors? This means giving up some control and having to report the status of the company to other people.

Most prudent and careful business owners will try to strike a balance between use of personal funds and taking on debt or outside investors. An owner could use a portion of personal savings, borrow against a life insurance policy, take out a home equity loan or solicit a personal business loan.

Business Credit Cards

These are unsecured, revolving lines of credit usually based on the credit score of the owner. While some credit card companies offer 0 percent introductory rates, the interest charges will soon increase to an expensive level. The maximum credit limits are usually not very high, so you will have to apply for several credit cards to get any significant amount of borrowing limits. One downside is that credit cards require a payment every month, and late charges can be staggeringly steep.

Loans From Friends and Relatives

For startups, loans from relatives and friends are often an easy source of funds. The repayment schedules can be flexible since they are a negotiated agreement between lender and borrower. The interest rate is negotiable. Unfortunately, sometimes businesses fail. This could create ill feelings, destroy relationships and make family get-togethers rather unpleasant.

Bootstrapping

If a business is growing and earning a profit, it may not actually need any outside financing at all. The company might be able to finance its growth with internally generated funds. Granted, this method will require some careful planning and tight cash-flow management, but it could be the best alternative.

With bootstrapping, the owner doesn't make commitments to fixed loan repayments to outside lenders and doesn't have to give away any equity interest in the company. A disadvantage is that bootstrapping could restrain a more rapid growth of the business.

What Are Sources for Short-Term Funds?

Bank Loans and Revolving Lines of Credit

Bank loans require good credit and a lot of documentation. A bank will ask for at least three years' worth of company and personal financial statements, tax returns and a business plan and will maybe even still request a personal guarantee. The approval process can take a few months.

Loans could be short term, such as 30 days, or up to several years, depending on the purpose of the funds. Interest rates will be a few points over the current prime rate. Bank loans usually have lower rates than other types of asset-based financing, but banks have much stricter credit requirements.

Bank loans can be used to finance growth in accounts receivable and inventory. They are usually secured by the underlying assets. Unsecured loans are only granted after several years of lending history and a strong balance sheet. Getting relieved of a personal guarantee is not easy. Banks prefer that the owners always have their own personal assets at risk and are not so willing to walk away if the business goes downhill.

Smaller banks are sometimes more attractive options since they work in the community and have more knowledge of local lending conditions. They offer better access to a lending officer who might place more emphasis on the borrower's character and not so much on the financial statements and credit score.

Supplier Credit Terms

Trade credit from suppliers is a major source of financing for business-to-business transactions. It is preferable to personal loans and expensive credit card revolving credit. Vendors are more likely to extend credit to a buyer because they are gaining a new customer who will hopefully be profitable.

Vendors are more willing to grant short-term credit to startups since they are making better profits on their sales of products to the buyers. The credit requirements from a supplier are much less stringent than banks and other types of lenders.

Commercial Finance Companies

Commercial finance companies make loans using a company's accounts receivable and inventory as collateral. These loans usually get approved quickly, but the interest rates are much higher than bank loans. These types of lenders will usually make loan advances of up to 50 percent of the inventory value and 80 percent against the accounts receivable balances.

Another option to finance receivables is factoring. In this type of financing, accounts receivable are sold to a commercial factoring company. Ownership of the accounts passes to the factor. These advances can be either with recourse or without recourse. Recourse means that the finance company buys the receivables, but if the obligor claims a merchandise dispute, the receivables go back to the company. Without recourse means that the finance company buys the receivables without any conditions.

Factoring is a way to finance slow-paying invoices. An advantage of factoring is that it relies on the creditworthiness of the customers rather than the credit of the owner. Commercial finance companies are more likely than banks to accept owners with less than stellar credit scores.

Receivables financing can be a quick solution to short-term cash needs. Not as much documentation is required and borrowers do not need three years of financial statements and tax returns. Being in business for six months is usually good enough.

What Are the Long-Term Sources of Finance?

Equipment Leases

Leasing is an important source of financing when a borrower has limited access to debt markets. A lease conserves cash that could otherwise be used for normal business expenses and for financing growth. Payments are fixed, which makes budgeting easier.

Leasing equipment enables a business to stay up to date with changing technologies. When the lease is up, the equipment is turned in and replaced with the newest models. This eliminates the hassle of buying machinery and then trying to resell it later.

Because of accounting rules, a lease does not show up on a company's balance sheet. Monthly lease payments are considered a business expense, not a long-term debt obligation. This gives the appearance that a business has less debt in proportion to its equity base.

Small Business Administration Guaranteed Loans

Loans from the SBA have long repayment terms and attractive interest rates. The disadvantages are that they require a large amount of documentation and take a long time for approval. Banks like to make these loans because they are guaranteed by the SBA, so the banks have basically no risks. SBA loans can be used for working capital, buying equipment and refinancing other debts, such as high-interest credit cards.

An important advantage of SBA loans is favorable repayment terms that don't strain the cash flow of the business. SBA offers 25 years of repayment for real estate, 10 years for purchases of equipment and up to seven years for loans used as general working capital.

What Are the Sources for Raising Equity?

Venture Capital

Venture capital could be a great source of financing for a business that is introducing an innovative new product with a potential for high-profit margins. Venture capitalists like to make investments that grow quickly so they can either take the company public or sell their equity interest to another investor for a profit.

Getting an approval from a venture capital firm is notoriously difficult. Many entrepreneurs spend months putting presentations together and making pitches, only to receive declinations. The odds of attracting a venture capital investment are very low.

Another downside of dealing with venture capitalists is the loss of control. The original owners will have to sacrifice a significant portion of their ownership to the venture capital firm. The partners of the venture capital firm may have more input about how to run the business and more ability to make important decisions than the owners.

Angel Investors

Angel investors can be a source of funds for startups. They are more motivated to see the business succeed than getting a return on their investment, unlike venture capitalists, who are only interested in a financial return. Angel investors place their hopes on the entrepreneur instead of the viability of the business.

The terms from angel investors are more favorable compared to other lenders. They are affluent individuals who can afford to take the risk and assume the loss if the investment fails. Angel investors have more patience than venture capitalists while the business grows and develops its market.

Crowdfunding

If your question is "How do I finance a startup business?" then crowdfunding might be the answer. In the last several years, crowdfunding has become a popular source of funding. It is a good resource for startups for entrepreneurs who do not have an established track record but who have innovative products or ideas that can attract potential investors. Investors found through crowdfunding do not look at the owner's personal financial information as a bank would.

Attracting funds from crowdfund investors is a campaign to rally support for your new and creative product and is a continuous process. Crowdfund investors often do not get ownership in the business but instead receive a gift from the company. This gift could be an early edition of the new product or getting their name mentioned in credits for the business.

Other types of crowdfunding involve debt or investors taking a portion of the ownership of the business. Crowdfund campaigns usually consist of numerous individuals making small contributions rather than a few investors taking large shareholder positions.

The primary sources of funds for small businesses are bank loans and credit lines, trade credit from suppliers and loans from owners and shareholders. Most credit for small businesses is short term. Small business owners have to reconcile their own views of debt and how much equity in the business they are willing to give up.

References

About the Author

James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.