An important part of starting or expanding a business is financing. One of the most common reasons that small businesses fail is due to insufficient capital. Finding the right type and source of financing is critical for a company’s success.
Types of Financing
There are two types of financing, equity financing and debt financing.
Equity Financing is money raised by a company in exchange for a share of ownership in the business. Equity financing allows a business to obtain funds without incurring debt or without having to repay a specific amount of money at a particular time.
Start-up companies typically rely upon equity financing to start their business. This can be in the form of personal savings, funding from family, friends or private investors. For established businesses, equity financing can come from partners, Angel Fund Investors and Venture Capital Firms.
Debt Financing is money borrowed that must be repaid over a period of time, usually with interest. Debt financing can be short-term with repayment due in less than one year or long-term with repayment due over a period of time greater than one year. Loans are often secured by some or all of the assets of the company or owner and lenders usually require the borrower’s personal guarantee in case of default.
Sources of Financing
- Commercial Banks and Credit Unions- Commercial banks and some Credit Unions are typically the major sources of debt financing. They can provide funding for both short-term purposes, such as lines of credit and short-term loans, and long-term financing for real estate, equipment and working capital. Small Business Administration (SBA) guaranteed lending programs encourage banks to make long-term loans to small businesses in exchange for an SBA loan guarantee.
- Angel Fund Investors- Angels are groups of investors or private investors who contribute money in exchange for an equity position in the business and perhaps a seat on the board of directors. Angel investors can provide valuable expertise, management skills and strategy advice. Angel Fund Investors are particularly interested in early-stage, high growth potential companies that have had significant financial investment from owners.
- Venture Capital Firms-Venture capitalists seek high-risk investments in young, unproven companies with potential for very high rates of return in a short time period. They start where Angel Fund Investors leave off, typically investing more money than Angel Investors.
- Community Development Loan Funds- Local economic development associations (EDA’s) have loan fund pools that are designed to stimulate economic activity by financing small businesses who may not qualify for traditional commercial bank financing. Contact your regional economic development associations to see if these are available in your area.
- Crowd Funding- Is an alternative source of funding by which a small amount of money is gathered from many individual contributors to fund a specific project. This funding may be treated as a loan, a trade or it may be treated like a donation with no expectation of repayment. Kickstarter and KIVA are examples of crowd funding organizations.
Can I Qualify for a Business Loan?
When applying for a traditional bank loan or an SBA loan, there are certain criteria that most lenders look at. These credit criteria factors are commonly referred to as the 6 “C’s” of Credit.
- Confidence- Lenders will look upon the Management experience and knowledge of the industry as a means of determining if the company has a reasonable chance of success. Lenders need to be sure that the person/people making the business decisions have the skill set and experience to lead the company. Detailing examples of management and business success will help instill a level of confidence from your lenders. A well-thought out business plan(link) can help promote a level of confidence.
- Character- The soundness of a small business loan is often dependent upon the trustworthiness of the owner. Character can be viewed as the owner’s positive reputation in the industry and past experience in handling credit. Your personal and business credit history should be clean and positive. A bad credit report can be a basis for denial of a small business loan. Meeting tax obligations is also an indication of positive character.
- Capacity- The biggest question that a lender will ask is if the company has the cash flow(link) capacity to repay the loan. Historical cash flow will be reviewed, as well as projections, to determine if the company can repay its operating expenses and all debt payment requirements. Providing realistic projections based upon sound assumptions and historical cash flow will be critical in demonstrating your company’s ability to pay its debts. You should be prepared to provide 2 -3 years of cash flow projections.
- Capital- Lenders are willing to partner with you in funding your business but will not fund the needs 100%. You will be expected to fund 20 -30% of a new project as well as having positive equity position in the company. Prospective lenders expect you have contributed from your own assets and to have taken personal financial risk to establish the company before asking them to commit funding. If you have significant investment in the business, you are more likely to do everything in your power to make the business successful.
- Collateral- While lenders are primarily looking at the management experience and cash flow in evaluating a loan request; they do want some assurance that if the business cannot repay the loan, they have a secondary source of repayment. Assets such as equipment, vehicles, real estate, accounts receivable and inventory are considered possible sources of repayment if they can be converted to cash by the bank. Both business and personal assets can be sources of collateral. Lenders want enough collateral value, on a discounted basis, to cover the amount of the loan.
- Conditions-The nature of the loan request is another important factor in determining loan eligibility. Lenders want to know how much money you are requesting, what the funds will be used for, and for how long the money will be needed. How will the current economic climate and future trends affect your company? How are similar businesses faring and how much competition do you have? Your business plan(link) should address these issues.
Documents Needed to Apply for Financing
Business Plan- A well-thought out and comprehensive business plan outlining the history of the company, management experience, marketing plan and financial review should be provided to the prospective lender. The cover letter should address the purpose of the financing request, the amount and terms requested, the source of repayment and the collateral offered. The business plan should be treated as any marketing effort- you are selling the promise of your business.
Personal Financial Statement- A current personal financial statement on all owners should be provided to the prospective lender. This will indicate the personal net worth of the owners and their ability to provide personal sources of collateral. Personal tax returns will also be required.
Balance Sheet-A current company Balance Sheet will reflect the company’s assets owned and liabilities or debts owed. The net worth of the business should be positive. Lenders will pay close attention to the level of debt owed in relationship to the amount of equity in the company. A highly leveraged company will have difficulty in acquiring additional financing.
Income Statement- Profit and Loss statements for the past 2 years as well as within the last 90 days will be reviewed in determining the company’s profitability, sales growth and ability to fund internal operations. Three years of projected cash flow statements should also be submitted. Company tax returns for the past 2 years should be submitted with the loan package.
Your local SBDC office and business counselor can assist you in reviewing your funding request and preparing a packet to provide to your prospective funder. Contact your local SBDC office to set up an appointment. (locations link)
Many people are under the false impression that there are grants to start for-profit businesses. Outside of research and development grants for technologies of interest to the federal government under the Small Business Innovative Reserrch (SBIR) grants, there really are no grants for this purpose. See our FAQ on this subject.