Understanding your business’ financial needs can help determine the funding sources that best meet those needs. Most options fall into one of three categories: debt financing, equity financing or alternative financing.
Understanding Your Options
At some point, most businesses, regardless of size, will need more capital than they have readily available. The reasons vary – from covering a short-term gap, like paying salaries before having the income to cover them, to longer term interruptions, like building a new facility or starting a new product line.
According to the 2020 Small Business Credit Survey1, the most common way businesses cope with this shortage is by funding it themselves. If faced with a two-month revenue loss, roughly 47% of business owners surveyed would use personal funds to bridge the gap: however, that isn’t always the best solution. Also, of those surveyed, 29% said they’d defer payments, and 30% said they would downsize.
For some businesses, self-financing may be the right option, but for others, there could be a better choice. Understanding the different types of business financing available can help you find the best financing for your specific situation.
Financing Options to Help You Reach Your Business Goals
There are three primary methods for acquiring capital.
- Debt Financing involves securing a loan from a bank or other financial lender
- Equity Financing involves selling ownership in your business in exchange for the capital
- Alternative Financing involves working with non-traditional financing sources – not banks or stock or bond markets
Debt financing, or traditional bank financing, is the process whereby your business receives a loan from a financial institution. In return, you promise the lender you’ll repay the money within a certain period and with interest. Here are five examples of the traditional bank financing available to business owners:
- Term Loans. Term loans are useful for financing working capital, equipment and real estate. They allow you to borrow varying amounts of money with flexible term lengths. Term loans can have low payment flexibility, and they require collateral in some cases
- Commercial Mortgages. Commercial mortgages can help you fund construction, acquire property, or repay construction loans. They often have lower interest rates than term loans or lines of credit, and the loan terms are usually longer, which can keep payments manageable. Commercial mortgages may require a substantial initial down payment
- Equipment Financing. Equipment financing can improve cash flow and help better budget your business expenses. Because you’re leasing and not purchasing the equipment, it can also help you lower your overall costs. Equipment financing is useful for equipment that you plan to replace often, such as those that are affected by changes in technology. However, you have no equity in the equipment, which means your costs may be higher than with other types of financing. And, depending on the type of equipment, the financing terms could be longer than the useful life of the equipment
- Lines of Credit. Lines of credit can help resolve short-term cash flow needs. Normally open-ended, they can be kept open longer than regular small business loans. Lines of credit should be repaid in full at least once a year, but you can re-borrow against them when you need to. Lines of credit allow you to access funds on a constant basis while you build credit. They can be secured or unsecured, and they normally have flexible repayment options. Lines of credit can be difficult to acquire for a business that is just getting started. They can have some risk if you find you cannot make the interest, fee or principal payments
- Business Credit Cards. Business credit cards can help you manage your short-term expenses, providing access to easy and convenient financing while you build credit. They’re also useful for separating your personal and business expenses and, like personal credit cards, some offer rewards. However, the rates on business credit cards can be higher than other financing sources and can change. Also, if you make a late payment on a business credit card, your personal credit could be impacted.
Instead of adding more debt to your business portfolio, equity financing allows you to exchange a percentage of ownership in your company for financing. This financing comes from investors and not a financial institution. These investors, also called angel investors or venture capitalists, tend to look for companies with high growth potential.
In the past several years, additional funding channels have emerged outside of the debt and equity sources. These can be useful for individuals who may have difficulty acquiring funding from more traditional sources.
- Crowdfunding. Pools small amounts of money from different investors. There are three common types of crowdfunding:
- Donation- and rewards-based crowdfunding. Provides investors money without the expectation of any financial compensation. Rewards-based crowdfunding provides some benefit in lieu of a financial return, such as early access to a new product
- Peer-to-peer and peer-to-business lending. Anonymously connects borrowers with multiple lenders. The lenders receive interest in return for their investments
- Equity crowdfunding. Provides investors with a stake in the company in return for their investment
- Personal Savings/Friend or Family Loan. Sometimes this is the fastest way to secure funding. It is important to spell out the loan terms completely, so all involved have the same understanding of the repayment plan.
- Online Marketplace Lending. Allows one or more investors to make loans directly or indirectly to small businesses while evaluating a borrower’s creditworthiness. Online marketplace lending typically involves installment loans with terms like traditional bank loans.
Identifying the Best Financing Option for Your Business Situation
Understanding your needs and the considerations behind them can help you identify the best option for your business. It’s important to have a clear vision of why you need the money, a realistic idea of the amount you need, and the knowledge of approximately how quickly you’ll be able to repay the debt. While the right amount of financing can help grow your business, too much financing with large repayment requirements can set you back.
To access additional financial education resources for entrepreneurs, visit our Financial Education Center.