How to Choose the Right Type of Funding or Financing for Your Small Business
Navigating the myriad options for small business funding can be daunting. The right choice can propel your business forward, while the wrong one might set you back. Whether you’re just starting out or looking to expand, understanding which type of funding or financing best suits your business needs is crucial. This post will guide you through the key considerations to help you make an informed decision.
Assess Your Business Needs
Start by clearly defining what your funding needs are. Are you looking for capital to cover startup costs, to expand operations, or perhaps to smooth out cash flow fluctuations? The purpose of the funding will often dictate the type of financing that is most suitable. For example, a short-term loan might be perfect for a quick cash flow fix, while equity financing could be better for a significant expansion.
Understand the Different Types of Funding Available
There are several types of funding available, each with its own pros and cons:
Debt Financing:
Includes traditional loans, credit lines, and merchant cash advances. While debt must be repaid with interest, you retain full control of your business.
Pros & Cons of Debt Financing for Small Businesses:
Advantages
- You keep all of the ownership – no dilution of equity
- Easy administration
- Predictable/ easy to plan for
Disadvantages
- Repayment
- Impacts credit rating; Collateral needed
- High cost; Restricted cash flow
- Strict requirements
Types of Debt Financing for Small Business:
Small Business Loans & Traditional Bank Loans
A small business loan gives you access to capital so you can invest it into your business. The funds can be used for many different purposes including working capital or improvements including renovations, technology and staffing, business acquisitions, real estate purchases and more. When a bank is assessing if you are eligible for a loan and how much debt your business can afford, they look at many different factors such as the condition of your business, the available collateral, your cash flow and your character. Depending on what type of loan product you are applying for, the requirements and terms can vary so be sure your lender explains what they will need from you in order to qualify.
SBA Loans
SBA loans are business loans partially guaranteed by the U.S. Small Business Administration and issued by participating lenders, usually banks. These loans have tight lending standards, but if you can qualify for an SBA loan, their flexible terms and low interest rates can make them one of the best small business loans. Types of SBA Loans include: SBA 7(a) Loans, SBA 504 Loans, and SBA Microloans. Read more about these loans on the Finance Learning Center
Business Credit Cards
Business credit cards are designed for use by businesses, as opposed to personal credit cards, which are used by individuals. For small business owners in particular, having a business credit card can be a good way to keep their business and personal expenses separate for bookkeeping and tax purposes.
Lines of Credit
A business line of credit is a flexible business loan that works similarly to a business credit card. Borrowers are approved up to a certain amount and can draw on their line of credit as needed, paying interest only on the amount actively borrowed.
Where To Go For Small Business Debt Financing:
- Traditional banks
- Online lenders
- Credit unions
Equity Financing:
Involves selling a stake in your business to investors, typically venture capitalists or angel investors. This doesn’t require repayment like a loan, but you will have to share profits and potentially some decision-making power.
Pros & Cons of Equity Financing for Small Businesses:
Advantages
- There is often no obligation to pay back the funding you receive
- Intellectual capital
- Sharing ownership
Disadvantages
- Sharing profits and power
- Can be time consuming
- Often comes with a lifelong obligation
- Must consult with investors when making decisions
Types of Equity Financing for Small Business:
- Small Business Investment Companies (SBIC’s)
- Venture Capital (VC)
- Private Equity
- Angel Investors
Grants:
Grants offer a way for business owners to get money that can help them grow their business, without having to worry about paying back funds or splitting profits.
Small business grants can be a great funding option for startups, as well as for businesses that can’t qualify for traditional debt financing.
Grants can be provided by government entities or private organizations, and can be tied to specific industries, purposes, or groups.
Crowdfunding:
Crowdfunding is a way to access funding that is done by raising small amounts of money from a large number of people or organizations. This can be a great way to raise funds without giving up equity or taking on debt.
Pros & Cons of Crowdfunding for Small Businesses:
Advantages
- Could build awareness for your brand, especially if the campaign goes viral.
- Could help test your business’ viability before making a big investment.
Disadvantages
- Can be difficult to stand out and attract donors or investors.
- Fees can be involved, even with donation based crowdfunding.
There are four types of crowdfunding for small business:
- Donation based
- Reward based
- Debt based
- Equity based
Consider the Cost of Capital
Each type of funding comes with different costs. Loans have interest rates, equity financing involves giving up a share of future profits, and grants may require a significant time investment to apply. Evaluate the cost-effectiveness of each option based on your business’s financial projections and how comfortable you are with these costs.
Evaluate Eligibility Requirements
Not every funding option is available to every business. Some loans require a strong credit score or collateral, while certain investors might only fund businesses in specific industries. Research the eligibility requirements for each type of funding to determine which ones are realistic options for your business.
Reflect Long-Term Impacts
Consider how each funding option will affect your business in the long run. Debt might strain your cash flow due to regular repayments, whereas giving up equity could influence your control and decision-making. Choose a funding route that aligns with your long-term business goals and growth strategy.
Choosing the right type of funding for your small business involves a careful balance of understanding your immediate needs, the cost of capital, eligibility criteria, and long-term impacts. Take the time to evaluate each option thoroughly and consider seeking advice from financial advisors or mentors.
Still unsure about the best funding option for your business? Visit our Finance Learning Center for detailed guides and resources that can help you make the best financial decisions for your small business’s future.
