Finding the money to start their small businesses is usually one of the first problems entrepreneurs face. For most people, this process can be challenging and very frustrating. This experience is often due to a combination of wrong expectations and looking for money in the wrong places. This guide lists thirteen sources of small business financing. The first nine are tried-and-proven ways to finance small businesses. They may not be perfect, but they work. The last four are sources that you should avoid – at least initially.
Remember that finding the money to start your small business is a game of endurance. You must work hard to overcome potential rejection if you want to succeed.
Funding sources for small business
The following thirteen funding sources can help you start a small business. Some of these funding sources can be used by anyone. While others, like factoring, can be used only by certain businesses.
Source #1: Your savings
Most entrepreneurs start their companies by investing their savings. This source of financing can be ideal – if you have the funds. It puts you in complete control of your company. Furthermore, you never have to justify yourself to investors. This last point is an important benefit. You have the freedom to operate as you see best. There is a trade-off, though: this freedom usually comes at the expense of having little money.
Saving up to start a business takes determination and sacrifice. Save a portion of your income every month. Save as much as you can for as long as you can. You will need every dollar you can get your hands on. Consequently, you may have to give up luxuries – such as vacations and new cars – for a while. The reward is the ability to launch your startup.
Source #2: Your credit
Many entrepreneurs also use their credit – either through credit cards or a home equity loan – to start their small businesses. Be careful about using these sources, as you could ruin your credit, risk your home, or both. If possible, avoid using a home equity line of credit as the risk is too high.
Credit cards are best used to pay expenses directly related to a project. Once the project is completed, and the client pays, pay the credit card back. It’s best not to use credit cards to pay for startup company expenses that are not related to a specific revenue-generating project. This strategy limits the chances of something going wrong that could damage your credit.
Source #3: Family members and friends
One common way to finance a business is to ask friends and family members for an investment. This can be a good way to finance a company if your family or friends understand the risks. Unfortunately, they seldom do. The problem is that if things go wrong, your friend/family relationship is affected. And in any startup business, you are guaranteed that something will go wrong at one point or another. Consequently, we must recommend against this type of financing for most entrepreneurs.
If you start your small business using friends and family investors, you must decide whether to sell them equity or take a loan from them. Both have advantages and disadvantages. Investments from selling equity don’t have to be paid back. However, the person you sold the equity to becomes an owner and shares the profits. Loans, on the other hand, have to be paid back. However, once the loans are paid, the transaction concludes.
Have an attorney draft a formal agreement regardless of which structure you use. Lastly, separate the personal relationship from the business relationship – treat all investors professionally.
Source #4: Customers and suppliers
Two great funding sources for small businesses are your customers and your suppliers. Customers can finance your business by prepaying for orders or by giving you a partial advance. Obviously, you must use these funds to handle their transaction. This type of funding is not easy to get, but customers may be willing to prepay if your service is unique enough or if they really need your products.
Another great source of financing is supplier credit. Basically, suppliers can give your company 30 to 60 days to pay an invoice. Getting supplier credit is similar to getting interest-free financing for 30 to 60 days. It takes a little effort to get supplier credit, but it is definitely worthwhile. Learn more about getting credit terms from suppliers.
Source #5: Small Business Administration
One great source of small business funding is the Small Business Administration (SBA). The SBA has a special program that offers Microloans to small business owners. Microloans can reach $50,000 (varies by state) and are much easier to get than conventional financing.
They also come bundled with business training which can be very useful for first-time entrepreneurs. The SBA also works with banks to provide 7(a) loans. These loans are larger than Microloans and have stricter underwriting criteria.
Source #6: Peer-to-peer lenders
Peer-to-peer (P2P) lenders offer a platform that allows people to seek financing from other individuals. The P2P platform acts as a matching service and provides basic due diligence. Like Microloans, most P2P loans are small. They usually cap at $25,000 to $35,000.
Note that in a P2P loan, individuals are usually not lending money to your business. Instead, they lend money to the entrepreneur (personally), who then invests the funds into the business. Your personal credit matters since this loan is a personal loan.
Source #7: Invoice factoring
Most small businesses encounter cash flow problems because their commercial clients ask for payment terms. As a small business, you have to give them 30 to 60 days to pay an invoice. Otherwise, you could lose the client. The problem is that most small businesses don’t have an adequate emergency cash reserve and cannot afford to wait up to eight weeks to get paid.
You can improve your cash flow and get paid sooner by factoring invoices. Factoring allows you to finance slow-paying invoices, which provides your company with immediate working capital. You can use these funds to operate the business and get new clients. Transactions settle once your client pays their invoice in full.
The advantage of factoring is that it allows you to finance your business by leveraging the commercial credit of your clients. This method is a great option for small businesses with a strong roster of clients.
Source #8: Purchase order financing
Purchase order financing is a specialized product that can help product re-sellers with their supplier costs. It works only in transactions where the company buys and resells finished goods at a markup. The finance company handles the supplier payment, enabling you to fulfill the order and book the revenues.
This solution works well for small companies that have sold their products a few times and need funds to manage larger orders. To qualify for purchase order financing, you need to have an order from a large, creditworthy company and be able to show that you can manage the order.
Source #9: Leasing
Small businesses in certain industries need equipment to get started. One way to finance the equipment is to lease it through a finance company. Most equipment leases are structured so that the finance company buys the equipment and rents it to you for a monthly payment. Once the lease ends, you can buy the equipment from the finance company for a fairly modest cost. Learn more about leasing.
Sources that usually don’t work
Before finishing the article, we would like to discuss four common funding sources that usually don’t work for many small business entrepreneurs. There is nothing wrong with these sources, per-se; rather, they are just not the right source of money to start a new small business.
Source #10: The bank
Most business books recommend that you consider a bank loan to start a business. This approach may work well in theory but not in practice. Banks lend only against assets and cash flow. Unless you have a business with assets or substantial personal assets, you will not qualify for a commercial line of credit or bank loan. However, bank loans may be a good source of funding later on – once your business has grown.
Source #11: Venture capitalists and angel investors
Venture capitalists and angel investors can be a great source of financing if your company has the right opportunity for them. Consider venture financing only if you have an innovative concept with high margins that can scale quickly. Getting this type of funding is notoriously difficult. As a matter of fact, many entrepreneurs spend weeks or months creating presentations and pitching to venture capitalists and end up with nothing to show for their efforts.
Source #12: Government grants
Usually, the government does not provide grants to start or operate a business unless your business is in a specific industry or serves a very targeted cause. Remember that the government is investing your tax dollars and is very strict and careful when spending them. The government cannot help you if you need money to:
- Start a business
- Pay operational expenses
- Settle business debts
Unfortunately, trying to get this type of funding is a waste of time for most people. Your time is better spent looking elsewhere. Having said that, there are some exceptions. Here is a place to search for government grants.
Source #13: ACH Loans and merchant advances
ACH loans and merchant cash advances allow you to finance future sales. ACH loans are used to finance commercial sales, whereas merchant cash advances are used to finance credit card sales. You pay back the lender by giving them a portion of your monthly credit card sales or by allowing them to debit your bank account through the ACH system (direct debit).
The problem with these products, and with financing future sales in general, is that future sales are difficult to forecast – making these loans risky for the lender and expensive for you. We suggest you don’t get an ACH loan unless you have spoken to a qualified financial adviser.
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Disclaimer: This article is for informational purposes only and is not intended to provide financial advice. Please consult a professional adviser if you require advice.