Small Business Financing - How to Fund a Small Business
18/03/2021
Whether you’re just starting a business, have recently purchased one, or have been running it for years, business finance is always something a business owner will be interested in. Finance can not only help you to get your business off the ground but later on, it can help expand it. The traditional route of going through the banks is always an option, but are there any other ways you can look? The answer is yes, there are.
Credit and Bank Loans
If you’re looking to secure a loan from a bank or other commercial lender you’ll need to have a substantial deposit at your disposal, and the loan itself will often be secured on assets. Banks usually offer loan-to-value ratios of around 60%-70% and the more money you need to borrow, the more expensive the loan.
The assets could be in the form of your house or company’s inventory for example. If you then fail to repay the loan, the bank is entitled to take this collateral – meaning you could lose income or, in a worst-case scenario, end up having to sell your house.
With the potential for such big losses, it’s always best to be entirely sure you can pay back a bank loan when taking one on.
Bank funding takes many different forms, with the main services including:
- Loans
Banks can provide a set amount of credit to businesses, which is repaid by either an agreed schedule or through monthly payments. The interest rates are typically fixed for the life of the loan, though some may change in line with inflation.
- Equipment Funding
If you need expensive equipment for a long duration of time, equipment funding could be a sensible option. There may also be other financial benefits to this option, such as tax deductions and depreciation (when the value of the equipment falls over time).
- Property Lending
Property lending loans are provided to buy property or land.
- Business Overdraft and Lines of Credit
These allow you to borrow up to your credit limit whenever you need to, however, these are normally for the use of periodic financing. Your credit limit will usually have been agreed upon when you opened your account.
- Vehicle Funding
This is for the use of leasing or purchasing commercial vehicles such as company cars.
Personal Savings or Retirement Funds
If you have saved enough money, using your personal savings or retirement fund is an option. The advantage of using your personal savings to finance your business is that no interest would be paid and there would be no obligations to anybody else. However, if you’re looking for funding, it’s unlikely that you’ll have the figure you want saved.
Another option is to use retirement funds. It might be a possibility to draw down funds from your own pension pot to put into your company, however, be aware that you may have to pay tax on any money you do take out, so it’s advisable to seek advice from a financial advisor before doing so.
Government Grants and Small Business Loans
If your business is viable but lacks the security required to meet normal lending requirements, a government-backed initiative – the Enterprise Guarantee Scheme – might be able to bridge the credibility gap on your behalf.
The scheme is delivered by British Business Financial Services and backed by the Department for Business, Innovation & Skills. Under the terms of the scheme, the borrower is still responsible for paying 100% of the loan, but the government guarantees 75% of its value in return for an annual premium that helps to cover the cost of the plan. Sums between £1000 and £1.2m can be borrowed over a period of up to ten years and more than 40 lenders have signed up to the scheme – including many high street banks as well as specialist lenders.
Though not exhaustive, some initiatives a business owner can take advantage of include:
The EFG is a loan guarantee scheme provided to enable additional bank lending to UK-based SMEs that are viable, however, lack sufficient security to secure a normal commercial loan.
The RGF supports projects and programmes currently dependant on public sector investment that is creating economic growth and sustainable employment.
This initiative provides loans, mentoring and support for small start-ups with potentially viable propositions but is unable to attract investment from banks.
For businesses unable to secure private investment, the government is making £3bn of support available to back export loans and cut the interest charged on export loans by a third. It also provides guarantees, insurance and support for export businesses.
- Business Finance Partnerships
Businesses can directly apply for finance with several non-traditional fund managers and lenders.
For more information about government grants, visit GOV.UK
Angel Investors and Venture Capitalists
An angel investor is someone who invests their own money into a small business in exchange for shares in the business. Mentoring and advice are usually involved in this type of financial agreement as the individual wants to see their investment become a success. For startups and businesses focused on expansion, this is a popular source of finance. They normally work with businesses that are at an early stage of development and a growing trend has been for angel investors to participate in groups to collaborate on research and investment advice.
Venture capitalists have become much more popular since the dot com boom in the late 1990s. The technology industry remains one of their favoured sectors to work with, and venture capitalists are well-known for favouring high risk, high reward businesses that have significant potential for development and growth.
With a higher level of risk, there is the possibility of a considerable payoff, however, they normally require significant equity in the business in return for investment. The venture capitalist route can therefore result in a large percentage of ownership being handed over by the business owner(s).
Both venture capitalists and angel investors will want to know business details like:
- How you intend to grow your business?
- How many customers do you currently have?
- How will you make your business profitable and when will this be achieved?
- Who are the business leaders and what is their previous business experience?
Be aware that funding agreements for these options could involve the removal of you as a director if the venture capitalist or angel investor isn’t convinced you have the necessary skills to grow the business and, more importantly, pay back their investment. They will want to replace you with someone they feel is more suited to this task.
Crowdfunding
As one of the latest funding trends, it is probably the least well known. Crowdfunding involves obtaining finance from a large pool of investors and allows businesses to attract funding through pitching on public websites.
As a result, you can end up pitching to thousands of potential backers on sites like Kickstarter instead of just asking one or two individuals for funding. People pledge money online in return for rewards when the project is funded. Most importantly, crowdfunding sites use an all or nothing funding approach. The funding goal is either reached and the money given to you, or if it isn’t reached the project receives nothing.
There are less stringent credit checks, no collateral requirements and usually better-informed investors. It is also a quicker process and you are likely to receive your funding much faster than you would from a bank.
Crowdfunding has become a favourite among business that have poor credit ratings, are new and have no credit ratings, and those who don’t have the capital to start their business, but do have an idea.
Well-known crowdfunding sites include the UK based Crowd Funder, the larger US-focused site Kickstarter, and smaller but more internationally supported site Indiegogo.
Peer-to-peer Lenders
Peer-to-peer (P2P) lenders are similar to crowdfunding, in that investors match borrowers and lenders directly. P2P works by posting how much funding your business requires and the maximum amount of interest you are willing to pay on a P2P site. Lenders can therefore decide how much they are willing to lend and the rate at which they will do it, much like Dragon’s Den.
As they’re more personal, they can be more favourable on both sides, as borrowers normally pay less than the standard banking rates, whilst lenders receive a higher return rate on their savings. It’s not all plain sailing though, as the risk is higher.
One of the most popular P2P sites in the UK is Zopa, whilst Prosper is a well-USED P2P site in the US.
Friends and Family
Relying on friends or family for finance is a popular option for short-term funding solutions. This is an option, however, it should always be approached with caution. When money and friends or family are mixed, it’s important to make sure you have a clear written legal document that explains your agreements and ensures both parties know where they stand.
The advantage of using friends and family to help with funding is that it’s likely to be a lower-cost source of funding than going to banks, and they’re more likely to be flexible if you’re unable to pay.
Weighing Up Your Options
It’s important to note that no single option is the best option. Every business will have its own strengths and struggles, and different methods will suit different businesses. Likewise, each method will suit businesses in different stages – a long-established café looking to expand probably won’t benefit from a Kickstarter, whereas a board game company looking to have its first release made would be far more suited to it.
Doing your research and testing out different financial scenarios to be clear about what funding your business requires is also essential. Weigh up the advantages and disadvantages of your options and ensure you are aware of the implications each one will have on your business. Taking the time to fully evaluate all your options will allow you to select a funding option suited to your business needs.
