Now that you've decided to start running your own small business, your next decision is critical: how are you going to get (or keep) the business up and running. In other words, how are you going to pay for things like employees, raw materials, a place to work from and marketing?
Other than money you invest personally or get from friends and family members, you can get financing from outside sources in two basic forms (or a combination of them):
- Debt financing, or
- Equity financing
Understanding how these finance options work, as well as careful planning, will be big factors in whether your business succeeds or fails. Because, while mismanagement is cited most frequently as the reason businesses fail, inadequate or ill-timed financing is a close second.
Your business plan is critical not only for determining what source of financing is best for you, but also for determining whether a lender will gamble on the business. A business plan is essentially a road map of the business's goals for the next year or more. Most prudent lenders will require such a plan before lending money.
To optimize your chances of getting the right amount of financing, it should be clear from your plan that:
- The business has enough cash flow to repay the loan
- You understand the business's industry and the underlying economics of its supply and demand
- There's a strategy for maximizing the worth of the business and minimizing risk to the investors and lenders
In addition, it might be a good idea to make an "information package" for new lenders, and keep it up-to-date. It should include things like the business plan, year-end financial statements, a description of the business, and the resumes of top managers.
Debt financing is when you borrow money on a promise to repay it. While friends and family are often sources for loans, bank financing is the most common type of financing for businesses, especially small businesses.
In most instances, a lender will require the borrower to give what's called "collateral" to make the loan. Collateral may consist of a pledge of accounts receivable (money owed to the business), inventory, or real estate. If you don't pay the loan, the bank takes the collateral, sells it, and uses the money to pay your loan. It's also quite common for lenders to require business owners to personally guarantee repayment of the loan and to sign one or more promissory notes.
A term loan is the simplest form of commercial bank financing. With a term loan, you borrow a specific amount of money that is paid back over a specific period of time (usually more than a year). A term loan is usually repaid in equal installments of principal and interest.
A line of credit is a lender's promise to lend you up to a specific amount of money from time to time. The promise isn't binding, that is, the bank can cancel or close the line of credit at anytime. Lines of credit usually don't exceed one year but may, at the bank's option, be renewed yearly.
A revolving credit loan is similar to a line of credit. The lender commits to loan up to a specific amount from time to time as needed by you, and the terms of the loan are almost always set forth in a formal loan agreement. Unlike a line of credit agreement, the bank must lend the amount requested by you, so long as you're following the loan's terms and conditions.
Government loans are also available, most notably through the U.S. Small Business Administration (SBA). The SBA does not make direct loans, rather banks and other lenders make loans, with the SBA guaranteeing repayment.
Equity financing is when you sell ownership interests in your business. The idea here is that an investor pays you for a share in the ownership of the business, and thus a share in the profits, and you use the money invested to finance the business. These ownership interests can take various forms, but the most commonly known is securities, or shares of stock. The shares are often offered to the public ("going public") for purchase through a "stock exchange," such as the New York Stock Exchange (NYSE).
Creating and selling securities is often regulated by federal securities laws, which are complex and could cause you big legal problems if they're not followed. So, if you're considering equity financing, consider these laws carefully, or get some help from a business or securities law attorney.
Venture capital firms or "venture capitalists" invest in startup or mature businesses not ordinarily in a position to publicly issue securities in exchange for capital. Venture capital financing may be an excellent means of getting the financing quickly, with far fewer up-front costs than those associated with a typical securities offering.
Venture capital firms may purchase equity, make loans, or both, but they usually take stock or equity ownership in the business. Because they ordinarily invest in higher risk companies and a significant percentage of their investments will not be successful, they usually demand a greater return on their investment. As a result, they often require the financed companies to give up a significant percentage of their ownership interests.
Questions for Your Attorney
- As far as financing is concerned, does it make any difference if my business is a partnership, limited liability company, or sole proprietorship?
- What kinds of fees and charges are customary with commercial loans?
- I want to lend my brother some money to start his business. He promises to repay it, and I trust him, so I don't need anything in writing, do I?
- How much will it cost to create a system for selling shares of stock in my company, and how long will it take?