According to a report published by the Harvard Business School, financial institutions are less willing to participate in loans below $100,000 due to their high transaction costs and low profitability. Although loans to small businesses took a mighty blow after the ‘08 financial crisis, this is still the most popular funding option for starting businesses.
For decades, the self-employed and small entrepreneurs depended on traditional loans through banks, private credit entities, family and friends, or grants sponsored by the government. But things are changing and now you can also use angel investors, seed accelerators, and crowdfunding to finance your early-stage business. Let’s look at some of the different financing options to give you a better understanding of the options that exist.
1. The Three Fs
FFF refers to “funding through family and friends”, or sometimes, also known as “family, friends, and fools”. These people who lend you their money as debt usually don’t have the best business acumen. So they don’t add much value to your business apart from the cash. According to a survey, 5% of American adults have given funds to someone to start a business at some point in their lives. If you decide to ask for funding from your friends or relatives, it is important to have a strategy, avoid pushing them and have a solid plan in place to pay them back.
The most intrepid entrepreneurs can bootstrap their business, which basically refers to starting a business with the capital you have available right now. Bootstrapping may place financial risk on you and build a pressure to break even quickly. Having limited resources may even come in the path of scaling exponentially. But if done right, the benefits are immense. You retain full control over your business while still retaining 100 percent of your profits. For this you get to be more autonomous but also need to be creative and thrifty.
3. Traditional bank loans
As we mentioned before, getting a loan for a small business has become more difficult after ‘08’s financial crisis. But banks still grant loans to entrepreneurs with good ideas. Of course, you need a good business plan to convince them. According to Lael Brainard, community banks in the United States account for approximately 50 percent of all outstanding loans from small businesses and are a major source of microloans.
4. Online loans
Online platforms represent only a small percentage of the market for small business loans, although they are growing exponentially. Online loan companies such as Lendio, Kabbage, and Accion use non-traditional data sources in their underwriting process. These companies offer an advantage over larger banks by valuing the business on multiple factors rather than credit scores. The disadvantage is that regulatory practices have not yet been clearly established.
While seeking online loans, you should always make sure that you read and understand the terms of any loan completely. Research and compare multiple options and avoid companies that are not well established.
Crowdfunding is based on the idea that general public would invest money for the creation of your product or service, usually with the promise of some kind of reward, once completed. It may not have seemed like a practical option a decade ago, but now crowdfunding is an immensely popular form of financing.
Websites like Kickstarter and Indiegogo allow you to start a campaign, set a financial goal and offer rewards to the people who contribute. The best part? You get the much-needed cash-flow and market validation even before you invest your time, money, and effort into production. And you keep your equity. There is a whole science behind raising money through these sites – we will leave that topic for another day.
6. Investors angels or venture capitalists
Angel investors and venture capitalists are individuals or institutions that provide equity capital to companies at an early stage. They not only provide capital but also valuable know-how and actively advise the founders. The investors are often former successful founders who have successfully set up and subsequently sold a company in the past.
Unlike angel investors, venture capitalists (VCs) are pools of several investors that carry out their investments according to a highly institutionalized process. Angel investors enter during the early phases of the startups for a higher equity. VCs, on the other hand, wait for the business to build some traction.
While angel investors and VCs bring immense value to scale up budding businesses, they have high expectations and only work with businesses that can prove they have an established cash flow or a very high potential for growth.
7. Credit cards for small businesses
Credit cards are recurring credit lines that can be used again and again, once you have paid off your debt. There are several great credit cards for startups that offer lucrative benefits such as 0% APR, no annual fee, cashback and rewards on every purchase, and low credit requirements. You can also keep your business credit score separate from your personal score and build a credible credit history to increase your chances for better financing in the future.
8. Incubators and accelerators
Incubators and accelerators are institutions responsible for promoting startups through a system of mentoring, training, educating, and providing a growth-focused atmosphere. These are a kind of “school” for founders. At the end of the program you usually present your idea to a round of investors. Many of these institutions also introduce you to the investors. The incubators and accelerators require a fee, or a small portion of equity, or both to provide this facility.
The problem with many entrepreneurs and business owners is that they don’t consider all their options. They lock themselves into a single financing option and spend all their time and energy trying to make that method work. Opening your eyes to all the options that we mentioned above can increase your financing opportunities.
Regardless of which form of financing you choose, before you talk to an investor, you should be well informed about your market, be able to present a concept, and present a well-thought business plan.
Which of these types of financing would you use for your idea?