Every business requires money to fund operations and grow. Generally, the more complex a company’s product or service, the more expensive it likely is to produce. Funding a company’s operations can take on many forms, the most common of which are briefly described below.
Owner financing is not an option for most people, but even if it is, it is not necessarily the wisest way to finance your business growth and operations. The primary benefit of owner financing is that as the owner you avoid having to comply with rules, regulations and reporting requirements that go along with outside financing, and you maintain complete control over all decision making. A major drawback to owner financing is that as the owner you are both the debtor and creditor and assume all the risk, not to mention that you must have funds available to invest in the business and can afford to incur any loss.
Borrowing From Friends and Family
Friends, family and associates may be the best source funds for a startup or early stage company. We’ve all heard the old adage: don’t borrow money from friends or family. That said, there have been many successful companies that were started with the help of friends and family members. Regardless of the source of funds, it is highly recommended that a written agreement be drawn up clearly stating the terms of a loan and repayment. Repayment could be structured to begin immediately or possibly upon the occurrence of an event, such as the company having a designated level of revenue or achieving break-even.
For many small businesses and startups, a loan guaranteed by the Small Business Administration (“SBA”) is an option, assuming no prior debt default issues exist. The SBA will guarantee nominal loans to start-ups and small companies for all types of business purposes. SBA loans are made available through many national and state commercial SBA participating banks. The benefit of an SBA backed loan is that it is available to new companies with no operating performance history. For companies that have been operating for a year or more and can show the potential to generate income, a loan through a commercial financial institution may provide a higher level of funding and more favorable terms than an SBA loan. In addition, after an initial SBA loan has been paid off, the borrower may be able to secure a subsequent SBA loan with a higher level of funding. A commercial loan will likely require the borrower to meet certain ongoing requirements, such as regular production of financial statements and tax returns.
Line of Credit
A line of credit(“LOC”) is a pre-approved loan for a specified maximum amount of money, in which the funds are disbursed by the lender when requested by the borrower. A LOC is typically secured through a commercial financial institution and usually requires that the borrower have a strong balance sheet, and a good credit rating. The terms of a LOC may be structured such that the borrower is only required to make monthly payments sufficient to satisfy the accrued interest on the outstanding balance for a limited period of time before having to make principle payments. A LOC may be used to cover expenditures in the short-term, when cashflow is limited, then repaid at a later date when cash flow improves. A LOC is also beneficial for companies that experience fluctuating cash flow. As with a commercial loan, a LOC will likely require the borrower to meet certain ongoing requirements, such as regular production of financial statements and tax returns.
Equity financing is simply the issue of a portion of the company’s equity in exchange for assets, which could be either tangible or intangible. A small business owner may be able to exchange a portion of her company’s equity for tangible property such as cash or other assets, such as equipment, materials, or even real estate. Equity may also be exchanged for intangible assets, such as the rights to patents and trademarks, an individual’s expertise or a commitment to perform specialized services for the benefit of the company.
Equity financing may also be obtained from individuals or organizations which specialize in the capital investments. These are typically referred to as Angel Investors and Venture Capitalist. These individuals and organizations each has different criteria for how they make investments. Some will provide startup or seed money, as it is often referred to, in exchange for a percentage of the companies equity. Others will only invest in certain industries, or only after an entity achieves a specified level of revenue. Equity financing is the way most companies raise funds for operations and growth during their startup and early stages.