Owner’s Equity or Outside Financing?
There are only two potential sources of growth capital: owner’s equity (e.g., retained earnings, personal funds) or outside financing. Owners often don’t have enough equity to fully fund growth themselves, so they typically need to pursue outside financing.
Growth financing can come from a variety of different sources, including the following:
1. Commercial bank — This is the first type of growth financing that many owners think of. Before approaching a bank to talk about a loan, however, you should order a credit report to check on the status of your personal credit.
So what does your personal credit have to do with getting a business loan? A lot, especially for small businesses. Most banks today are carefully reviewing “global” cash flow, which is a combination of the business’ finances and the owner’s personal finances. There’s often a fine line between the two so banks want to see how well small business owners are managing their personal financial affairs before making a business loan to support growth.
There are several different types of bank loans that can be used to help fund growth, such as:
- Line of credit: This lets you borrow up to your credit limit for any purpose, including investing in receivables and inventory to fund business growth. Once you’re approved for a line of credit, you don’t have to apply again when you need funds. It’s usually a good idea to apply for a line of credit ahead of time so you have easy access to the money when funds are needed.
- Term loan: This is a longer-term loan that’s amortized over a number of years, such as a three- or five-year loan. Term loans are usually used to finance the purchase of assets like equipment or property that will help grow your business. The amortization schedule should match the useful life of the asset that’s being financed.
- Equipment lease: This may be a better financing option than buying certain types of equipment outright — especially for assets with built-in obsolescence like computers and high-tech equipment. There are also tax benefits associated with equipment leasing, and leasing can offer cash flow advantages as well such as 100%financing with no down payment and flexible monthly payment options.
2. Online loans and crowdfunding — These have become increasingly popular in recent years as a way for small businesses to obtain financing for many different purposes, including funding growth. Online lenders such as OnDeck, Kabbage and BlueVine offer an attractive value proposition: Easy loan applications and fast response in exchange for what is usually a higher interest rate than rates charged by commercial banks.
Most online lenders have created proprietary credit scoring models that let them make loan decisions in a matter of minutes. Both lines of credit and term loans are available from online lenders, with loan amounts ranging from $5,000 to $500,000 or more in some situations. Interest rates generally range from 10% to 25% or higher in some situations.
Some of the most popular crowdfunding sites, meanwhile, are Kickstarter, Kiva and IndieGoGo. With crowdfunding, individuals can choose to contribute their own money to help businesses grow. Keep in mind that crowdfunding sites generally don’t allow businesses to offer equity, revenue sharing or any other financial incentives to those who contribute money toward their growth.
Most banks today are carefully reviewing “global” cash flow, which is a combination of the business’ finances and the owner’s personal finances
3. Venture capital (VC) and angels — Obtaining growth funds from a venture capitalist or so-called “angel” investor is inherently different from borrowing money to fund growth. Unlike business loans, VC funds do not have to be repaid to investors with interest. Instead, VCs and angels will receive ownership shares in your business in exchange for their investment in your company’s growth.
There are pros and cons to obtaining growth capital from a venture capitalist or angel investor. The biggest benefit, as noted above, is that the funds don’t have to be repaid. But there’s a tradeoff not only in the potential cost of giving up equity in your business, but also in the loss of control over many aspects of running your company and the future direction of your business.
For example, VCs and angels may exert pressure to achieve short-term results that could prove detrimental to your long-term success. And there’s no way of knowing right now what the potential opportunity cost might be of diluting ownership in your business. But just think of how expensive it ultimately would have been for Bill Gates or Steve Jobs to have exchanged ownership shares in Microsoft or Apple for financing during their early growth stages?
4. Family and friends —You might have to look no further than the people who are closest to you for the capital needed to support business growth. If you decide to borrow growth capital from family members and friends, be sure to structure the loan as an arm’s-length transaction to make it official. This includes documenting the loan in writing, along with the interest rate and repayment terms.
Before borrowing growth funds from family members and friends, you should carefully consider the impact this could have on your interpersonal relationships. While obtaining growth financing for your business may be important, it might not be worth possibly jeopardizing friendships and family relationships.
Start Preparing Now
Now is a good time to start thinking about how you will finance future growth in your business. This way, you’ll be better prepared when faced with new growth opportunities.
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