The First Rung: Financing Your Small Business
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One of the most appealing features of the capitalist dream is the notion of a ladder to success: no matter where you start from, there's nothing at all to prevent you from climbing steadily to the top. It's this notion that motivates people to begin their own upward climb by starting a small business. Finding appropriate finances is where many prospective entrepreneurs slip on the ladder's first rung. But if you're aware of the options available to you, willing to take appropriate risks, and knowledgeable about exactly how much financing you need, you should have no trouble with taking that first step, and then the next, and then the next--all the way to the top.
Debt Versus Equity Financing
By and large, financing comes in two flavors: equity and debt. There are clear advantages and disadvantages to each, and either represents a valid choice for the right company business plan.
At first glance, equity financing seems like the safer option for both lenders and business owners. Equity financing involves a trade: investors will give you money, and in return you give them a voice in your business (voting rights, a share of profits, etc). The advantage of equity financing is no direct obligation to repay the investment according to any schedule or interest rate. So equity looks like the way to go, right?
The problem with equity, however, is that it significantly dilutes control over your business. If you're planning to start a small business in the first place, you likely have an extremely specific idea about what you want to do and how you want to do it. Equity investors, however, may want to have a stronger hand in designing your business plan, possibly even to the point of changing it altogether. In less severe cases, this
can be a minor nuisance; at worst, it can invalidate your reason for starting a small business altogether. And if you've put up any of your personal assets toward financing your business (which almost all small business owners do), you stand a very real chance of losing your assets to the interests of your investors.
Debt financing, however, has its own disadvantages. It involves borrowing a certain amount of money from a willing lender, guaranteed by an agreement to repay the loan (almost always with interest) according to a fixed schedule. The lender has no role in directing your business, and is tied to you only by the obligation for repayment. This leaves you with much more control over your business, but also with more risk in the event of a rough start or even an early business failure. Additionally, the higher the interest rate--small business interest rates average around 12-15%--the more effective your business has to be at the start, and the fewer profits you'll see during the repayment period.
Even if one of these financing options is more in tune with your business plan than the other, it's still important to find a good blend between equity and debt financing. The debt-to-equity ratio is one of the indicators banks and certain other lending institutions use to gauge the overall soundness of your business plan. Thus it is one of the major determinants of whether or not you'll get the financing you want. Generally speaking, if your equity financing comprises anywhere from one-half to two-thirds of your finances--and if you have a good credit rating in general--lending institutions will be willing to put up the rest of the money.
Debt and Equity Financing Options
To find the equity financing you need, it's important to look at the human element. Figure out who you can find to invest in your business--friends? family? other local business owners?--make sure you have a clear business plan to present to them, and be wary of anyone who seems too interested in exerting control over your business ideas. You need equity financing to qualify for the most attractive loans, but don't let easy equity financing today lead to an unsatisfying business or damaged personal finances tomorrow.
Since there's no question of direct business involvement, it's much easier to find lenders for financing on a debt basis. The trick, however, is to find lenders willing to give you the interest rate you want. Home mortgages can give you a good rate and an extremely long-term repayment schedule, but you put your home at risk in the event of business failure, so be careful. It's also possible to use your home mortgage as equity financing, but you'll end up paying a higher interest rate, and you may find yourself and your business beholden to a bank or mortgage company.
Small business credit cards can be a good source of cash flow for employee payments and incidental supplies, as well as a good way to cover unexpected expenses, but high interest rates (averaging around 20%) and low amounts of capital (averaging around $6,000) make credit cards impractical as a primary source of funds. Lending institutions make a living out of financing small businesses and are often more than willing to lend you large amounts of capital, but the interest rates (as high as 30% in some cases) make these an unattractive option for many small business owners.
The US government offers Small Business Administration (SBA) loans which feature low interest rates (average 8%) and high amounts of capital, but you're required to deal with the government directly, which is often less than appealing due to the paperwork alone. And finally, if you can show a sound business plan and have excellent credit, banks offer some of the lowest interest rates and highest loan amounts around. It can be difficult to qualify for a bank loan, however, so make sure all of your ducks are in a row before you sit down at the table with the financial officer to start talking.
How Much Do I Need?
A crucial part of having your ducks in a row, of course, is knowing exactly how much money you'll need and what you plan to use it for. At root, this is the same issue you face when deciding on a business plan:
determining exactly what your costs are, how you'll meet them, and how you'll turn a profit on the whole activity (the name of the game, after all).
You'll need a well-defined business plan in order to figure out exactly what your costs are. If you have vague ideas about exactly what purchases you'll need to make, what you'll pay your employees, and what the regular costs of operating your business will be, you run severe risks of being unable to repay your loans or give your investors a return, which means business failure.
So look at your business plan carefully, and figure out anything that you have already that might work toward it. This might include:
- personal finances
- operating equipment (cars, computers, office supplies, software)
- operating space (office space, a few extra rooms in your house)
Then, figure out absolutely everything you might need for your business. Here are just a few examples:
- operating equipment (anything you aren't already bringing to the table)
- regular costs (rent, electricity, phone bills, Internet access)
- employee salaries & benefits
- travel expenses
- distribution expenses
- anything else called for in your business plan (raw materials, licensing fees)
Once you have all of that figured out, consult your business plan again for some idea about where your receivables (payments from customers) will come from, and how much you'll receive for the first months or years of your business. If you expect your assets-liabilities ratio to be running fairly close to the wire at the start of your business, don't be afraid to ask for a little bit more money in either debt or equity financing (preferably equity). You want to be able to make your repayments in full and on time (or ahead of time), in order to maintain a good credit rating and a good relationship with your lenders. That way, when it comes time to expand your business, you'll have no trouble getting the extra financing you need--and you'll have a slight cushion in terms of assets for those crucial few months.
Financing a small business is, no question, one of the most difficult tasks facing a prospective entrepreneur. But if you have a good idea of how much control you want to retain over your company, how much you'll be able to repay every month, and how much--down to the last detail--it'll cost to run your business, you can take that first step onto the ladder of success. And you can make sure--no matter how difficult the rest of the climb may be--that your foot won't slip.
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