By Justin Biel, trends editor at Grow Wire
In short:
- Financing(opens in new tab) gives your business the capital needed to form, launch, grow or change direction. Before pursuing an option, understand how much capital you need and which financing source is best for you.
- Grow Wire’s “Financing Secrets” guide is designed for both emerging business owners and leaders who are looking to explore alternative financing options.
- In this first article of the series, we’ll both cover the basics of financing and give a primer on alternative methods.
You’ve likely heard the expression “you need money to make money.” But how do you go about obtaining said capital?
Grow Wire’s got your back. We’ll give you everything you need to solve this chicken-and-egg situation and get you to the next stage of business growth. This post kicks off our multi-part "Financing Secrets” series by providing a primer for those who are entirely new to financing, including a briefing on alternative methods.
First things first: How does financing benefit your business?
In general terms, financing is “the process of providing funds for business activities, making purchases, or investing,” according to Investopedia. “Financing” often comes from banks or other financial institutions that provide capital to businesses or investors, which helps them achieve their goals.
Financing enables companies to purchase products or equipment, add or expand locations, or hire more people than would otherwise be possible. It helps them grow their businesses and achieve their goals. Financing also benefits the financiers, as it allows folks with excess cash to “put their money to work” with the hope of enjoying returns on their investment.
How to tell if your business needs financing
Every business has different needs, so before going in search of money, it's best to determine how much your company actually needs. If you’re a new business owner, you’ll need to calculate your startup costs(opens in new tab). These are expenses to get your business going, such as office space, inventory, business insurance, communication equipment, initial salaries and more. Be aware that some capital may be needed to run the business at a deficit for a time before the company becomes profitable.
As you might’ve guessed, startup costs vary significantly based on the kind of business you’re running: online, brick-and-mortar or service. It’s difficult to be exact, but do your homework and try to get a realistic estimate of startup costs.
Financing isn’t only for startups, however. Established companies with track records of success often require additional funding to scale further. Sure, they have more financial history with which to make assumptions, but their funding goals are still based on estimated future capital needs.
So, what are my financing options?
There are six primary options to finance your business.
- Self-financing
- Investors (whether friends and family, angel investors or venture capitalists)
- Business loans
- Alternative financing (such as crowdsourcing and P2P)
- Private equity
- Public equity
Below, we'll give a quick rundown on each.
1. Self-financing
Self-financing, or bootstrapping, refers to funding the business through personal means without help from financial institutions or outside investors. You can self-finance your project through savings, by cashing in your retirement account or simply asking family and friends for support. It’s “the number-one form of financing used by most business startups(opens in new tab),” according to Entrepreneur.
If self-financing seems like a good option for you, then start by taking inventory of your assets: savings accounts, real estate, retirement accounts or investments in the form of stock or securities. Even vehicles or recreational equipment are considered assets: Essentially, assets are anything you can convert to cash. Generally, we all have more assets than we realize.
Self-financing is a considerable risk that needs to be considered carefully.
The pros: If you self-finance, you’ll have complete control over your business without taking on outstanding debt. You’ll also maintain your equity ownership.
The con: You may overextend your resources or underestimate capital needs, which can lead to business failure and financial hardship.
2. Investors
Investors are folks with capital who are looking to finance businesses. They typically come in the form of friends and family, angel investors or venture capitalists (VC’s).
I. Friends and family
This financing source is more common than you might think: 82 percent of startup funds come from either the entrepreneur themselves or friends and family, according to Small Business Trends.
While friends and family could provide the financial boost to get your big idea off the ground, they’re also a great audience to test and refine your pitch before meeting with outside investors. Securing their investment can be a crucial step up the financing ladder, as angel and VC investors may decline to be the first to invest in your company before seeing buy-in from those close to you.
If you’re thinking of going the friends and family route, see these tips(opens in new tab) from Martin Zwilling, CEO of Startup Professionals.
II. Angel investors
Typically, angel investors are affluent individuals who provide capital for a startup venture in exchange for convertible debt or ownership equity. (Think the “sharks” on “Shark Tank.”)
Angel investors can be within the friends and family circle, but they’re often found through organized angel groups. These networks share research tools and investment capital while serving as business advisors to companies in their portfolios. Often, angel investors "fill the financial gap" between friends-and-family investors and more significant, big-ticket VC funds.
The pros: Angel investors are less risky than debt financing in terms of equity. And most angel investors have some commitment to you and your project, making the investor-investee relationship more personal.
The cons: You’ll lose control of some business equity, and the angel investor may get a say in how you run the business. When profits are allocated or the company is sold, the angel investor will receive a portion.
Interested in connecting with angel networks? Check out these practical tips(opens in new tab) from the Business Collective.
III. Venture capital
The “third rung” up the investment ladder is venture capitalists, also known as VC's. VC's are the "big guns" of the investment world, comprising firms that typically invest large sums in early-stage, high-growth companies.
VC’s often make large loans to companies with aggressive return rates (think 30-50 percent), and they usually take equity in a company. Backing from a VC firm adds prestige to a business. VC's typically target companies they believe will go public or sell to larger firms in a relatively short amount of time. They’re the correct financing option if you're running a company with rapid revenue growth, proprietary technology and the potential to IPO or be acquired.
3. Business loans
If maintaining control of your business is essential but you can't self-finance, a small business loan could be a smart option. Business loans are acquired through banks or credit unions, and each offers slightly different terms.
Before approaching a financial institution for a loan, give yourself the best chance of success by putting yourself in the lender's shoes. Treat the application process like a job interview: Come prepared with a business plan, an expense sheet and financial projections. Look for the best terms. SBA-backed loans are a smart option, as they offer favorable interest rates and repayment terms.
The pros: Business loans have low interest rates and offer autonomy over the operations of your business. They come with tax-deductible interest payments and the potential to access a significant sum of money.
The cons: Business loans involve long and detailed application processes. Lender rates fluctuate. The loan may require collateral, and it’ll impact your balance sheet, as it appears as a liability.
Learn more about financing with a business loan(opens in new tab) at Business News Daily.
4. Alternative financing
While there’s no technical definition for alternative finance, the Small Business Administration says it’s “financing from external sources other than banks or stock and bond markets.”
Alternative methods such as crowdfunding and peer-to-peer (P2P) lending networks offer new financing options, such as microloans, that may be right for your businesses.
I. Crowdfunding
Crowdfunding involves raising funds through small donations from a large number of people. Major crowdfunding platforms are Kickstarter and Indiegogo. In crowdfunding, lenders typically receive a “gift” for their contribution instead of equity in your company. This “gift” can take many forms, but most often, it’ll be the product itself. Most crowdfunding is reward-based, but equity and loan structures also exist.
The pros: Crowdfunding allows you to maintain ownership -- and sell the product -- while raising funds. Platforms like Kickstarter can reach broad audiences, give your product validation and help refine your concept before launch.
The cons: It takes time and money to create and market your crowdfunding campaign. And if it fails, the public will see it in full view. Crowdfunding hugely favors consumer-facing products: It can be restrictive in that once you offer a "gift" to lenders, it's difficult to alter business plans.
Here’s an extensive list of pros and cons to evaluate(opens in new tab) before moving forward with crowdfunding, from strategy site FundBeam.
II. Peer-to-peer lending
A viable substitute to traditional financing, the peer-to-peer (P2P) lending market is expected to reach over $150 billion by 2025.
P2P lending doesn't involve traditional banks. It's a mostly online system that matches interested lenders with borrowers looking for loans. By cutting out banks, both parties benefit: lenders get higher returns, and borrowers get lower rates.
To acquire a business loan through P2P lending, you need to complete a loan application with an online vendor. This usually involves info such as your credit score and business financials. Then, you’ll receive details about the loan, like an APR and a borrower’s grade. Once approved, your loan payments will go directly to your lenders. The P2P platform facilitates the entire transaction.
The pros: P2P business loans have a faster application and approval process than others: Companies usually get funds within two weeks of approval. Credit rating is also less of a deterrent to funding in P2P loans, and you may find lower rates.
The cons: Overall, P2P is a new and relatively unregulated industry, without the controls of established banks. P2P funding may hurt your credit score, because P2P networks accept individual borrowers, not legal entities.
Similar to crowdfunding, many established P2P lending platforms(opens in new tab) are available. Do your research, then choose the one that best fits your needs.
5. Private equity
Private equity (PE) is a type of financing related to large-scale business transactions, occurring from capital sources not listed on a public exchange. Investopedia defines private equity as “funds and investors that directly invest in private companies, or that engage in buyouts of public companies, resulting in the delisting of public equity.”
PE funds come from accredited investors or institutional investors, who make massive investments over long periods of time. It’s mainly tailored to large businesses that are preparing for further expansion.
The pros: PE investment adds a massive influx of capital, a growth-focused mindset and management expertise from investors. It’s a “fast track” to getting your large company to the next stage of growth.
The cons: PE investment leads to a re-distribution of equity, reducing control of founders. It can lead to pressures on management to make aggressive changes in pursuit of increasing company value.
6. Public equity
Public equity is what it sounds like: making portions of your company available to the public so they can “have a piece” in the form of stock. Public equity involves undergoing an initial public offering, aka “going public,” to make your stock available for purchase. To go public, you’ll often need an underwriter (usually an investment bank) to set the price of the stock and manage its sale. However, this is not always necessary: Take Spotify’s recent underwriter-less IPO(opens in new tab), for example.
Your company will need to be fairly substantial in size -- conventional wisdom says at least $100 million in revenue -- before going public.
The pros: Going public gets you lots of cash, fast. Plus, it makes laypeople more aware of your brand – you’ll get serious street cred from being listed on the stock exchange.
The cons: Going public comes with many regulations, as Investopedia notes. Extra capital is often required just to ensure you’re compliant. And, as noted, your company will need to reach a certain size before even considering this financing option.
The good news: there’s no lack of financing options. You’ve just got to choose the right one for YOU.
Choosing the best financing option is a big decision, and the “correct answer” can change over time as your company scales. Both traditional and alternative financing methods are beneficial. As an owner or business leader, your goal is to evaluate these options carefully with regard to your individual business.
We’ll explore exactly how these financing methods play out and highlight stories of founders and companies that have experienced them first-hand as Grow Wire’s “Financing Secrets” series continues. Stay tuned.
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