Entrepreneurs have many options when raising funds for their startup including debt, equity and/or other types of financing. When it comes to deciding what type of funding to go after, there are no right answers. Every entrepreneur must determine what type of financing is right for them and their business. Some questions to help you make this decision include:
– Are your needs short or long term?
– How quickly will you be able to pay back the loan or provide return on the investment?
– Is the money for operating expenses or capital expenditures (items that will become assets)?
– Do you need the money upfront or in smaller pieces over time?
– Are you willing to assume all of the risk if the business does not success, or would you like to share this risk with investors?
Answering these questions can help you determine what type of financing is right for you. In this article, we introduce the various types of financing available to entrepreneurs and some of the advantages and disadvantages of each.
Debt Financing. For a startup business, debt usually comes from banks, microloan programs, private lending, personal credit cards or friends and family.
For bank loans, you borrow money with an agreement to pay it back at a pre-determined time frame and interest rate. While you maintain full ownership of your company with a bank loan, you are liable to pay back the loan regardless of whether your venture succeeds or not. These loans are often backed by assets or third-party guarantors.
Microloans are very similar to bank loans, however, they tend to loan lower amounts and usually provide a more competitive interest rate.
Private lending is a good alternative when banks are unwilling to provide a loan. Private lenders terms are similar to banks, however, they usually specialize in a specific industry and are more willing to take on higher-risk loans.
Though we do not recommend using credit cards for long term financing, they are a great tool for cash flow management. It is important to pay off your balance at the end of every month to avoid high interest rates and digging your company into a pile of debt. If managed correctly, credit cards can be some of the cheapest money around. However, if managed poorly, they can be some of the most expensive forms of funding.
Lastly, friends and family can be a great source of funding for your small business. They are typically less rigid regarding your credit history and loan terms. Nonetheless, we still recommend structuring the deal with the same legal thoroughness that you would with any other lender to avoid problems down the road.
Equity Financing. If you decide to pursue equity financing, there are angel investors, venture capital firms and friends and family. With equity financing, you sell partial ownership of your company in exchange for cash. In this scenario, the investor assumes most of the risk for if the company fails, they lose their money and you do not owe them their losses. However, if the company succeeds, equity investors generally receive a much better return on their investment than the interest rates a bank would receive on the same amount of cash. Furthermore, as equity investors take on a much higher risk than lenders, they typically want to be involved with the company on an advisory level. This can be a blessing and a curse. Many entrepreneurs relish the opportunity to gain guidance and support from seasoned professionals. However, investors interests may not be aligned with yours so it is important to not give up too much control of your company when passing out equity.
The type of equity investor you approach depends heavily on the amount of money you need, the stage of the business you are at, the industry you are in and the growth potential of your company.
Similar to debt equity, friends and family can be a great source of equity funding for your business. Rather than agreeing to a payment plan and interest rate, you agree to a percentage of equity.
Angel investors work in the same way, however, they are usually considered to be a step up from friends and family in terms of sophistication and investment amount. They usually invest in sectors that they have a personal interest in and rarely look at investment below $1 million.
Venture capital firms are professional investment organizations that invest in growing businesses knowing that some of their investments may not be successful but are able to take that risk because their return is so large. Venture capitalists will generally want a large percent of equity in exchange for their cash and as a result, the option to exert a significant amount of control.
Other Financing Methods. There are other methods of raising money including crowdfunding and grants.
Thanks to social media and other internet based technology, entrepreneurs are able to leverage their networks of friends, colleagues and like-minded individuals to gain funding through crowdfunding websites. Typically, entrepreneurs post a request for funding on a crowdfunding site, such as kickstarter.com , with a description of their project or company and what they tend to spend the money on. Depending on the site, funding may come as a donation or a loan. Crowdfunding is not for everyone. It is generally successful for entrepreneurs with a compelling story or project that has universal appeal.
Another source of funding comes from grants. However, grants are extremely rare for for-profit businesses and we usually recommend against pursuing this strategy.
Despite the tough economic environment there are still ways to raise money in this day and age if you have a good business that is also a good investment. No matter what method of financing you chose, we recommend that you put together a professional business plan and speak with a trusted financial adviser.