Speaking about ways of financing small business we must clearly define what this term means since the ways to attract additional money by small and big businesses differ and have its own peculiarities. So, small business financing is understood as a set of means allowing a businessman to attract necessary funds either to launch a new undertaking, or to buy already existing small enterprise, or to invest assets into current small business to support present or future commercial performance.
Oftentimes small business financing is called franchise financing or startup financing.
Generally, there are several options to fund small businesses. The decision about the most suitable one must be taken carefully in each particular case since every option has both advantages and shortcomings.
The last world financial crisis (the consequences of which we experience until now) resulted in a sharp shrinking of conventional ways of small business financing. Apart from that, a new financial reality gave birth to alternative forms of small business financing. That’s why the rule of thumb says it does make sense to separate all existing ways of small business financing into two groups, namely traditional and alternative ways of financing small businesses.
Let’s review each group and its components in turn.
Traditional Ways of Financing Small Business
Historically, an entrepreneur may opt between debt financing and equity financing to receive some extra money to make the ends meet in case the situation demands monetary injections to support the business. Debt financing means you simply arrange a deal aimed at borrowing necessary funds while equity financing presumes selling ownership rights to obtain capital instead.
This way of small business financing is attractive because the lender has no power to influence the decision making process within the organization that borrowed money. Besides, the lender doesn’t participate in profits that are generated by business due to the received loan. The main disadvantage concerns payments according to the loan reimbursement schedule that is usually troublesome for an overwhelming majority of small businesses, especially the growing ones.
Unability to guarantee a timely loan reimbursement may cause a forfeiture of assets that secured the loan. Personal assets of business owners are also under the risk if they were pledged.
A process of credit approval is also connected with some unpleasant moments. First and foremost, the borrower may be recognized as not eligible for the loan or in better case receive the loan with higher interest rates. It’s not a rare situation when the borrower is demanded to pledge personal assets as security. Moreover, it takes much time to settle all the questions connected with credit approval.
It’s always useful to remember that an extraordinary indebtedness may put the undertaking on the verge of a possible bankruptcy. There is no need to explain a direct relationship between debt burden and bankruptcy risk.
There are numerous sources of debt financing including credit unions, banks, loans provided by organizations supporting small businesses, individual credit cards, friends and family members.
A businessman has an opportunity to obtain additional funding by selling equity rights to the interested parties. In this case the entrepreneur doesn’t deal with all aforementioned problems of debt financing. Apart from that, usually the owner has no need to repay the investors if the business becomes a failure. Nevertheless, equity funding does have its own shortcomings that include but not are limited to the following.
Selling ownership rights, the businessman loses a certain part of control over his business while investor acquires an opportunity to exert a pressure on decisions taken and participate in the distribution of profits generated by business. Additionally, the top management is obliged to inform the investors about important business events and run the enterprise in a way that is most beneficial for investors. Sometimes equity financing is demanded to be made in a strict correspondence with state securities legislation.
You may find potential equity investors among venture capitalists, angel investors, family members and friends.
Alternative Ways of Small Business Financing
Since financial instability hit heavily on traditional ways of small business financing causing its dramatic decline, the free space was occupied by the alternative forms of financing. To be true, a lot of new options represent new sources of debt and equity financing but that is not to be said about retirement funds.
Financing of small business with the aid of retirement funds has not become a wide-spread practice yet. However, in developed Western economies it is considered to be a good alternative. It is also known as robs (retirement owned business), “401k small business financing”, “rollover as business startup” or “ROBS financing”. Pay attention that retirement financing does not mean that the businessman takes money from his retirement account to support his business.
Retirement funds financing combines the benefits of both debt and equity financing. The business owner still preserves the management control over his enterprise while troublesome debt payments are eliminated. It’s no surprise that the number of entrepreneurs using this way of financing their small business is constantly growing.
Although the US Internal Revenue Service (IRS) informed that financing of small businesses with the aid of retirement funds is legal the technique still requires adherence of some technical prescriptions. That’s why it is important to have experienced employees to do everything in a proper way to avoid possible complications.
New Options of Debt and Equity Financing
Modern sources of debt and equity financing emerged as a response to the inability of traditional ways of small business financing to provide additional funds in terms of financial crisis.
Peer-to-peer lending and crowdfunding are now gaining more and more popularity in various countries all over the world. It’s interesting to note that such conventional form of financing as borrowing money from family members or friends has evolved too. Now with the aid of specialized websites, for instance, TrustLeaf, you can ask your relatives to lend you extra money if you feel uneasy to do it face to face.