Funding Options for Startups and Small Businesses
With the challenging economic conditions, more businesses are investigating alternative funding options. High-interest rates, inflation, and supply chain problems mean banks are less willing to part with their money, and securing loans is becoming a nightmare even for entrepreneurs with solid business proposals.
Data shows that big banks approved only 13.5% of small business loans in April 2023. This figure jumps to 28.7% for alternative lenders. Therefore, businesses have a significantly higher chance of securing funding by widening their scope beyond standard bank loans.
So, what types of financing are available, and what do you need to know before committing to a given funding option? Let's start by first covering the typical route.
Bank loans – The traditional funding route
Traditionally, a business looking for an injection of capital applies for a loan from the bank and goes through a lengthy assessment process in the hopes of being approved.
Once approved, you agree to a payment plan and repay the money (plus interest) over a fixed period. Bank loans come with strict penalties for missed repayments, including automatic late fees, a reduction in your credit score, and incurring higher interest if the repayment remains unpaid for an extended period.
Businesses must prioritize loan repayments when managing their cash flow or face potentially dire repercussions. You can simplify overseeing your accounts payable and reduce your chances of missing a repayment by utilizing a bill payment platform for SMBs. These platforms notify users of upcoming bills and offer quick payment options to prevent the late arrival of funds.
When considering your loan application, banks will take into account many factors, including:
- The amount you want to borrow.
- Credit score, which can include your personal financial history as well as your business credit score.
- How long you've been in business and your existing cash flow.
- The industry you are operating within.
- Whether collateral is being provided to compensate the bank in the case of non-payment.
- Your business plan and how you plan to invest the funds to show a return.
- Any existing debt the business has associated with it.
After reviewing these factors, banks decide whether your business qualifies for a loan and what your payment plan will look like (i.e., interest rate and time frame).
Debt financing vs. equity financing
Bank loans are a type of debt financing – you borrow money against your business, and you are responsible for repaying it. In contrast, equity financing is when you give up a share of the company in return for funding. The investors offering their capital receive a percentage of the company's profits (with the exact figure depending on the details of the deal) and often have a say in how the business is run.
For many businesses, especially startups, equity financing and securing investors is particularly attractive. It removes the burden of additional debt, freeing up your cash flow to focus on developing the company. However, this does come with the downside of relinquishing some control of the business and sharing any profits you make.
Private equity funding sources (investors that aren't traditional banks) can take many forms, including family members, private lending institutions, angel investors, and venture capitalists. These sources of funds can often help small businesses that may struggle to qualify for a bank loan.
For example, bank loan repayments will start putting pressure on the company to immediately generate revenue. Private equity investors, particularly venture capitalists, often take a longer-term view, looking to establish a product and grow market share before expecting a return on investment.
Angel investors and venture capital
Both angel investors and venture capital firms finance businesses and invest in startups in exchange for equity in the company. Venture capital firms are businesses designed around this model. They analyze markets, scout startups with potential for high growth, and examine their business plans to determine if they are worth investing in.
Angel investors do the same thing, except they are private individuals investing their own money. They also often have different ROI requirements. Venture capitalists generally want to exit within five years and get a return on their money so that they can invest in the next crop of startups. Angel investors may be more willing to invest in slower-growth companies.
During the early startup stage, companies can attract a group of angel investors to provide seed funding through a convertible note in exchange for a fixed percentage of the company (typically less than 20%). The convertible note is due in three to five years; at that point, the investors can reclaim their money (plus interest) or convert the note into the agreed-upon equity.
Venture capital firms and angel investors are often specialists in a particular industry and can also provide guidance and counsel to the new company. However, their focus on specific high-growth industries, like tech, medical, or online companies, limits the ability of startups in other industries to access this type of funding.
Other sources of funding
However, there are now plenty of other funding sources for new or expanding businesses. These include:
- Grants: Grants are government assistance for companies or entrepreneurs showing particular promise. They can be highly competitive as they are awarded, rather than borrowed, funds with no obligation to repay. They generally come with specific requirements depending on the type of grant and the reason behind its creation.
- Fintech: These lenders generally function only online, providing smaller loans with lower barriers of entry.
- Crowdfunding: With the internet, businesses can access a large number of people, asking for a small contribution from many individuals rather than a large contribution from a few. Crowdfunding is best suited to launching a new product. An entrepreneur will showcase their new idea or product and find an audience of interested consumers. They will then crowdfund financing to develop and launch the product.
- Peer-to-peer lending: Several online platforms are now available for peer-to-peer lending, where individuals lend money to one another, investing in new businesses with like-minded people. These platforms connect potential investors with entrepreneurs looking to get their idea off the ground.
Building your business plan before finding financing
With banks less willing to lend, many businesses are looking for other sources of funding. While plenty of options are available, it is important to drill down into the details and understand all of the financial obligations you might place on your business.
Ultimately, just because you can access funding doesn't mean you should, and it all comes back to the potential of your business plan. Ensure you have a rock-solid proposal and a meaningful way of converting funding into profit before approaching potential lenders or investors.