This article covers the ten most effective ways to finance a small or growing company. We cover several options that can be used to finance a wide range of situations.
What do you need the funds for?
There are several options you can use to finance a business. Some products are flexible and can be used to solve a variety of challenges. Other products have a specific use. The best strategy is to match your financing need with the most effective product to meet your objective.
Keep in mind one general rule of thumb during your selection process. Revolving lines of financing, such as lines of credit or accounts receivable financing, usually work best to handle short-term cash flow needs. Loans work best for buying company assets. There are exceptions to every situation, though. Ultimately, you must choose the solution that works best for your situation.
1. Personal savings
Most small businesses in Canada are financed using the owner’s savings and investments. Owners can use their savings to cover any business expense, such as buying equipment, paying employees, adding inventory, etc.
Using your savings has some limitations. Building enough savings to contribute to a business takes years of patience and discipline. Even then, your personal funds may be sufficient to cover only initial business expenses. Ultimately, every growing business eventually outgrows its owner’s ability to fund it through personal savings.
2. Local investors/associates
Business owners can also get financing from local investors and associates. Local investors usually include business associates, colleagues, friends, and family. These investors have the flexibility to make equity investments or provide loans based on the company’s needs.
Getting funds from these sources can be easier than getting other types of funding. The business owner usually has a personal relationship with the investor. Unfortunately, for this reason, this type of financing can be fraught with problems.
If you choose to use this source of funds, we suggest you treat all your investors professionally. This professional approach includes giving regular updates, using financing documents, and consulting legal advice.
3. Angel financing / venture capital
Angel investors and venture capitalists (VCs) offer similar services but work with companies at different stages of their development. Angel investors focus on new businesses, startups, and small companies. They usually are successful entrepreneurs who invest their personal funds in small ventures. Angel investors can be very flexible and offer a “hands-on” approach when helping your company.
Venture capitalists work with early-stage companies that usually have some traction. The company may have a proof-of-concept and needs funds to scale nationally or globally. Venture capital companies usually attract funds from institutional investors, family offices, and wealthy individuals. Given their size, venture capital companies tend to focus on companies that can scale quickly and reach very high valuations.
Angel investors and VCs provide the ultimate flexibility. They can structure equity investments, loans, lines of credit, or even mezzanine funding. However, finding the right angel or VC can be a difficult and competitive process.
4. Equipment financing
There are two ways your company can finance the acquisition of equipment. The first option is to get a loan to buy the equipment. Equipment loans are amortized over a few years and are secured by the equipment. However, some lenders may ask for additional security, such as a personal guaranty. These loans have similar qualification requirements to conventional business loans.
The second option is to lease the equipment. Leasing the equipment is similar to renting it. The finance company buys the equipment and retains ownership while you pay a monthly fee to use it. Leases can be structured so that you own the equipment after the final payment. Other leases require that you return the equipment at the end of the lease.
5. Business loan
Bank loans are the best option if you need funds to buy an asset (e.g., inventory, machinery, factory space, etc.) or grow your business. Due to their structure, loans are not the best solution for ongoing cash flow problems. A revolving line of credit (option #6) is the better option.
Loans are structured to provide the funds up front, and payments are amortized over several years. Each monthly payment covers interest and part of the principal. The last payment settles the loan.
Qualifying for conventional business loans is not easy. Banks usually require that the company show that it can pay for the loan out of the business’s cash flow. Loans are typically secured against the business but may also require personal assets.
6. Revolving line of credit
A revolving line of credit is one of the most flexible financing solutions. It is somewhat similar to a credit card. You can draw funds from the line to cover business expenses. The line is paid back regularly, which reduces its balance and increases availability.
Lines of credit are best used to cover short-term expenses. These expenses include buying inventory, paying suppliers, making payroll, etc. A line of credit is not the best option for purchasing assets, such as equipment. These are best acquired using equipment financing.
Qualifying for a line of credit is similar to qualifying for a conventional bank loan. Companies must show a track record of operations, have financial statements, reasonable credit, etc.
7. Invoice financing / invoice factoring
This option provides a revolving line of financing that is secured by your accounts receivable. Invoice factoring is used by companies that have cash flow shortfalls because they must offer net-30 payment terms to their customers.
Factoring lines provide similar benefits to a revolving line of credit. However, the products use a different structure. While this solution has easy qualification requirements, it’s also more expensive than conventional financing.
8. Purchase order financing
Purchase order (PO) financing allows resellers to finance existing orders for finished goods. The solution has a narrow scope and works only in transactions where the reseller buys goods from a third party and resells them to a customer. It cannot be used by manufacturing companies. Manufacturing companies with large purchase orders should consider supply chain financing instead.
The main advantage of PO financing is that it can finance very large transactions. This enables small companies to book orders that exceed their financial resources.
9. Supply chain financing
Supply chain financing can be used by companies that need funds to buy materials to fulfil a large client purchase order. In most cases, the finance company buys the goods and resells them to your company at a small markup. To qualify, companies need to have a few years of operational history, be credit-insurable, have a good management team, and be profitable.
10. Inventory financing
Inventory financing allows you to capitalize on your existing excess inventory. It enables you to get working capital from the asset, which can be used for other business purposes. Inventory financing is expensive, and it’s best to consider other available options first.
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