Financing a small business can be complex, but with a few tricks of the trade, you can get a plan of action going in no time.
Debt, equity, and other creative financing give you the money you need to help start or grow your company. In theory, you could pay the upfront costs and cover the gaps in cash flow. But if you’re not willing or not able to dole out your own cash to cover these costs, you have a menu of options available.
In fact, most successful small business owners will look to outside sources to fund their business. Here, we review the must-have info on the menu of financing options you may consider.
First, Know What You Can Afford
Whether they realize it or not, most businesses have a specific budget or budget range they need to start up—or to operate their business smoothly. But more importantly, you need to know the amount of financing you can afford.
A handy tool called the debt service coverage ratio (DSCR) can help you figure out what range of financing you can afford. Your DSCR is calculated by taking your periodic cash flow and dividing it by your loan payment for the same period. For a loan with monthly payments, take your monthly cash flow and divide that by the loan payment. Now you’ve got your DSCR.
All lenders require a minimum DSCR of 1, and most will want to see a DSCR of at least 1.35, to give you a little breathing room in your cash flow. You should also consider what figure you are comfortable with. A 2 is considered conservative, while a 1.15 connotes a bit more risk.
1. Debt Financing
Debt financing is, simply put, borrowing money from a lender and paying it back with interest. Financing a business through debt can help your company get started, transition through growth, and operate smoothly.
Let’s take a look at the most popular types of debt financing worth your consideration:
Term & SBA Loans
With a term loan or an SBA loan, you get a lump sum of cash, on which you’ll make regular payments in monthly increments. A short-term loan ranges from three to 18 months at rates of 14% and higher and can be a great option if you need cash in a pinch. That said, be aware that in lending, fast equals expensive. SBA loans offer better rates but have more qualification criteria and longer approval times, as well as stipulations on what you can spend the money on.
If your business is more established and you have a good credit score, a traditional or medium-term loan may be a better and more cost-effective fit for your needs. They take more lead time to fund, but you can secure them at a lower rate.
Business Credit Cards & Lines of Credit
Business credit cards tend to be easier to qualify for than more traditional loan products. They offer special deals on starting APRs, have higher credit limits, and can be paid through easy portals. In addition, using a business credit card will simplify your bookkeeping and provide you with revolving credit. Using one could give you speed and flexibility that you might not find with a term loan or SBA loan.
A line of credit is very similar in that you have access to funds and you can draw on those funds whenever you need to. With a line of credit, you only pay interest on the money that you actually take out and use. Once you’ve repaid your lender, your pool of funds gets refilled to the original amount. Read the fine print on your agreement—high fees for late-payments are par for the course with this option.
An equipment loan enables you to use the equipment you need to purchase as the collateral. It’s a fast and easy way to get the funds you need to buy equipment to help you operate and grow, even if you have less than stellar credit.
If you operate a service-based business and have slow-paying customers, invoice financing can be a great way to get your keep your cash flowing and your receivables on track.
With this method of funding, an invoice financing company buys your accounts receivables for about 85% of the value of your invoices. When your customer settles up, you’ll receive the remaining 15%, minus fees. While this financing can be fairly expensive, it will keep your cash flow predictable so that you can continue normal business operations without stress.
2. Equity Financing
Equity financing is another way to fund your small business. In essence, you sell a portion of your business in exchange for some cash and business guidance from your investor.
While this process takes longer than debt financing, you may be able to receive more capital—and you only have to repay the investment if your business succeeds.
Angel investors are individuals who have the interest, time, and potentially large sums of money to invest in your small business. The upside for them to fund your business is their access the financial proceeds if your business takes off.
Similar to angel investors, venture capital firms trade capital for equity. But here, the whole company invests in your business—not just one individual. However, only a small portion of small businesses qualify for venture capital, as those firms tend to favor tech-focused companies with high growth plans.
3. Get Creative
While debt and equity are two of the most common options for small businesses, financing has become increasingly popular through other, more creative methods.
Friends or family who are in the position to help finance your growing business can help you avoid the costs of traditional funding options. Take steps to outline your plan and create a contract as explicitly as you would with a traditional lender to avoid conflict in the long run. This will help ensure both parties approach the financing agreement realistically and appropriately.
For new undertakings and projects, crowdfunding platforms like Kickstarter or IndieGoGo may be a good avenue. In this scenario, you forgo the traditional obligations of debt and equity financing and let others decide whether or not your business is worth financing. The challenge to crowdfunding is that your business funding comes from a large number of very small contributions, so it might be tough to reach your goal.
Ultimately, you can fund your business’s growth with some or all of these options. Just remember that whichever financing option you explore, the best practice is always to do your research first, and don’t be afraid of the details—that’s where the gems are.
Article contributed by Kristina Paider of Fundera. They make lenders compete for your business. It’s the easiest way to shop and save on a small business loan.