Choosing how to fund your small business is an important aspect of your overall business plan. Depending on your decision, it can also affect your business and its ability to generate revenue and remain viable for years to come.
Here we’ll explore three different options for small business funding: seeking investors, incurring debt and bootstrapping. We’ll also examine the pros and cons of each, and what scenarios work best in each instance.
When to Get an Investor
Before choosing an investment over a loan, consider the amount of money you need, how long you need it and what you plan to do with it. If you choose the investment route, you may be required to convert your company into a corporation. Doing so shields the investor from liability and you from having to pay back potential lost money; it also means you’ll have a new partner with opinions on how to run your business.
Choose an investor when:
- You need money for a long or uncertain amount of time. The type of investment you want is sometimes referred to as open-ended or permanent capital. Instead of sticking to a set timeframe, in these situations, investors allow businesses to focus on long-term goals without having to worry about meeting short-term benchmarks.
- You need money to grow. In this case, your company should already be profitable and the money you need to reach your full potential should be quantifiable.
- You need a network. You need an investment that offers capital and connections. Often called “smart money,” these investors offer help in the form of finding better suppliers, new clients or additional avenues for revenue.
- You don’t qualify for a loan. Unless your business is already in the black, or you’re willing to put your personal assets on the line, many lenders won’t loan to an early-stage startup they consider to be “high risk.”
- You don’t want the liability of a loan. If you can’t or don’t want to take the risk, you’ll need an investor who is willing to take it for you.
When you seek investment capital from venture capitalists, angel investors or investment firms, you benefit from receiving all of your required capital upfront. This gives you freedom to ramp up your business the way you want with the security of having the necessary funding in place.This can have great advantages in allowing you to purchase the supplies or inventory you need, fully staff your organisation and even purchase or lease equipment and real estate for your business.
There are drawbacks to getting investors, as there are with any source of funding. By looking for investment capital from outside sources, you will have to share ownership of your company with these backers. This is typically done by offering shares in exchange for certain investment amounts. This can have far-reaching consequences, as technically these shares give your investors a say in how you run your business.
For this reason, you should be careful when selecting investors, as you want to be sure they understand and share your vision. Find like-minded people or investment firms who will support your efforts, not undermine them. For first-time business owners, it can be difficult to convince an investor to take a chance on you and your idea since there is no proof you’ll be successful.
If your small business needs a lot of money upfront to get off the ground — say you need to manufacture products, rent or purchase real estate or lease a lot of expensive equipment — seeking investors might be your best option.
Funding the initial costs to get a business up and running creates a high barrier to entry for entrepreneurs. Seeking investors can remove this barrier very quickly.
When to Get a Loan
Whether starting or scaling your business, your source of income will influence the direction your company is headed. Consider the amount of money you need, how long you need it and what you plan to do with it as you decide between a cash loan or investment. While a loan includes an obligation to repay its lender, it doesn’t include a secondary source with rights to running your business. Because you’ll still have sole ownership, the lender won’t be entitled to your business’s profits or responsible for its losses.
Choose a loan when:
- The money is needed for a short or defined amount of time. Typically the time frame is less than two years, and you know it can be paid back in time because you already have a sufficient cash flow.
- The money will be used to buy equipment, seasonal inventory or any other items that have resale value.
- The money is available from family or friends who have agreed to not have input in your company. In this situation, make sure to agree on an interest rate (if any) and payback timeline.
- The amount needed is less than $250,000, and is less than 10 percent of the company’s overall annual capital needs.
Some entrepreneurs choose to take out a loan to fund their startup. If you have a good credit score and a steady stream of revenue, debt might be a viable option. For many entrepreneurs, loans might be the fastest way to get the capital they need. Additionally, loans allow you to acquire cash without having to sell shares — meaning you’ll still own 100 percent of your business.
Entrepreneurs can also get a business credit card and use that credit limit as their startup fund. In some cases, getting a business credit card might be easier than going through the formal loan process. In most cases, loan payments follow a predictable schedule, allowing you to easily account for them in your budget.
The flip side to this is that taking out a loan to start your business means you’re always going to be “behind.” Depending on your industry, interest rates can be very high. In the beginning, your first few months or even years will be focused on paying back the loan, which can cause a major drain on your revenue.
Additionally, if you run out of loan money prematurely, you’ve run out of money period. Chances are, you won’t be able to get an additional loan and if you haven’t developed any relationships with investors or found your own funding sources this could simply mean the end of your business venture.
Lastly, it can be very difficult for new entrepreneurs to secure a business loan because, similar to investors, lending organisations don’t have any guarantee they’ll get their money back. If you are able to secure a loan, your lenders won’t have any stake in your company’s success because they’ll get paid regardless of the business’s outcome.
If you have a good personal credit score, low initial startup costs and a short-term plan to make revenue quickly, taking out a business loan or incurring debt might be a viable option for your business.
Bootstrapping, which comes from the old phrase, “pulling oneself up by the bootstraps,” suggests that sometimes you just have to take charge and make things happen yourself.
Many entrepreneurs consider this the preferred way to fund your business because you, the small business owner, are responsible for finding your own funding to start your business.
You might decide to reach out to your friends and family for money, start a crowdfunding campaign or even dip into your personal savings account. The biggest benefit to bootstrapping your startup capital is that you don’t answer to anyone but yourself. There are no investors to keep happy or loan payments to make; your business will sink or swim solely on your abilities.
The downside to bootstrapping is that it can take a lot of time and energy. It also forces you to go it alone, unless you have a partner who is also contributing startup funds. Others find it daunting because of the isolation.
Some entrepreneurs feel they have a great idea to start with, but might be looking for guidance six months later. Someone who has investors would be able to use this network of funders as a readily available advisory board. Bootstrappers have to build all of their relationships themselves.
If your business idea is relatively small, meaning it doesn’t need a huge office, tons of employees or a lot of inventory to begin, bootstrapping might be your best funding option. It’s also a viable choice if you have supportive friends and family who are willing to pitch in to help or if you’ve spent the past few years building a nest egg.
Choosing the right funding option for your business will take time and careful consideration. Make your own list of pros and cons for each choice. If one of these options just doesn’t work for you, disregard it.
If possible, interview other small business owners in your area or in your industry and ask how they got their initial funding. In the end, take a moment to really consider the position from which you want to start your business, and then do it.