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Small Business Financing 101: Understanding the Different Funding Options Available

Written By: Eric Williams
Reviewed by: Mike Reyes
Last Updated September 20, 2023
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For a startup, funding is vital for getting the business off the ground, smooth operations, and growth and success. Insufficient understanding or unaware of the available funding options are two major reasons small business owners do not seek financing. Another significant reason would be the fear of being rejected. It is important to remember that a small business can reach its full potential with awareness, knowledge, and courage. 

Funding Options for Small Businesses

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Several funding options are available to small businesses, each with pros and cons. If you are a small business owner, we recommend having a robust plan before choosing a funding option and moving forward toward securing the funding.

Bootstrapping

Bootstrapping means financing your startup using your savings, assets, and operating revenues. It is by far the simplest way to finance a business. You won’t have to worry about impressing investors, pitching, or negotiating with them. With that kind of pressure out of the way, you just need to focus on your business and customers. 

Bootstrapping does away with outside influence and accords you more control of your project. It also makes pivoting easier. However, it does entail working with limited resources. According to empirical data, chances of survival while relying solely on bootstrapping are low. Bootstrapping limits the scale of operations. It can slow down growth and pressure a business to generate revenue. 

This financing option is more suitable for web-based and asset-light businesses. But with the right strategies, it can also work well for other businesses. GoPro is an example of successful bootstrapping. Nick Woodman started the business with just $10,000 from his earnings while living with his parents. GoPro eventually became a billion-dollar company. GoPro’s initial public offering (IPO) was valued at $2.96 billion. Some other examples of bootstrapped startups that became hugely successful companies are Apple, Coca-Cola, and Dell.

For successful bootstrapping, follow these tips:

  • Do thorough market research to ensure your limited resources will be utilized optimally. 
  • Make sure you select a business model that optimizes cash flow.
  • Try to be as frugal as you can. Budget carefully and keep your costs minimal. 
  • Focus on generating profits from the get-go.
  • Make use of organic marketing channels as they don’t cost money.
  • Serve your target market well and exceed expectations. 
  • Remember, bootstrapping is for the long term. Allow your business to evolve and grow.

Small Business Administration (SBA) Loans

The US Small Business Administration (SBA) has a funding program where small businesses can easily get small to large loans. Through SBA, you can find a lender suitable for your business. For businesses recovering from a declared disaster, SBA may provide direct loans. The rates and fees of SBA-backed loans are comparable to non-guaranteed loans. The down payments might be lower in the case of such loans. There may be flexible overhead requirements, and for some loans, collateral may not be required. You may even receive counseling and continued support. 

You can get between $500 to $5.5 million for your business from SBA-backed loans. This amount may be used for any business purpose, such as acquiring fixed assets or utilization as operating capital. There may be restrictions, so you should check with the lender first. General eligibility requirements include a sound business purpose, the ability to repay, and meeting SBA size standards. SBA prefers that these loans be used as a last resort after exhausting other non-governmental options (that is, if the business cannot procure the loan from elsewhere on reasonable terms). For successful loan acquisition, improve your creditworthiness, choose the right loan, and work on building relationships with lenders.

Traditional Bank Loans

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This remains the most popular and well-known finance option for all business owners. As the name suggests, this option involves taking a loan from banks for business purposes. The loan is supposed to be repaid over a fixed period. Taking a loan from a bank seems like a reliable and trustworthy option. Of course, this is in the case of banks that have built a good reputation over the years. 

With bank loans, you won’t have to dilute your ownership. For extra funds, you will neither have to wait for your business to generate profits nor will you have to run after investors. Bank loans allow you to grow your business by enabling you to take advantage of great opportunities on time. There won’t be any kind of interference from the bank regarding the usage of funds as long as you are particular about the repayments. 

The problem with getting a traditional bank loan is that banks are often apprehensive about lending to small businesses. They might have strict eligibility criteria for lending. Banks also might have a higher rate of interest for lending out to small businesses that don’t have much of a financial or trading history. Bank loans are more suitable for businesses with a good history and great growth potential. 

The application process for banks is typically long and time-consuming. It probably won’t be the ideal option if you are in urgent need of cash. You will not only be required to fill out the application, but you will also have to convince the bank that your business is a viable prospect (especially if you are applying for a large sum) by providing your business plan, history, and financial forecasts. In case you want to cover any ongoing business expenses, credit cards, overdrafts, or working capital loans might serve your purpose better.

Bank loans may be secured or unsecured. Secured loans are backed by collateral, while unsecured loans are not. The rate of interest will be higher for unsecured loans as compared to secured loans. But in case you default in repayment of a secured loan, you could potentially lose your asset. The credit limit with secured loans is often higher. 

Crowdfunding

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In crowdfunding, as the name suggests, you can finance your business by taking funds from a crowd. In this innovative option, you can use an online crowdfunding platform to source funds (small sums) from many individuals. This way, you can cultivate a community supporting your business and product. 

You will have to start a fundraising campaign on the platform. On most crowdfunding platforms, such campaigns take place on an all-or-nothing basis. If your fundraiser meets the target, you get the funds and will be charged a fee by the platform. If the campaign is unsuccessful, the contributors will get their money back. 

In the case of small businesses, the most common and popular types of crowdfunding are peer-to-peer (similar to borrowing from banks), equity (similar to selling stock), and rewards (sum contributed with the expectation of getting a non-financial reward in return) crowdfunding. 

Crowdfunding can provide many non-financial benefits as well. As mentioned above, since the people will have a vested interest in the business, they can help you craft winning strategies. They can bring invaluable knowledge and experience to the table. Additionally, they can help expand your network, which could create fantastic marketing opportunities. They can also help you refine your offering and gauge the demand for your products. 

To avail yourself of the benefits of crowdfunding, you should be ready for the challenge. You must remember that there is no guarantee of success and that you may or may not reach your funding goals. You will have to spend time and effort on the fundraising campaign, and your focus will be divided between your business and the campaign. Depending on your chosen type, you may either lose control of your business or have to offer rewards. There is also the risk of fraud. If someone makes a pledge and does not pay, you could lose your money. Someone could also steal your concept after learning about it on the crowdfunding platform. 

To successfully manage a crowdfunding campaign, follow these tips:

  • Carefully consider your investment goal, and keep it as low as possible.
  • Create a buzz around your crowdfunding campaign.
  • Check out other successful crowdfunding campaigns on the platform and note down points that may have contributed to their success.
  • Prepare a clear and engaging video that can capture your audience’s attention and promote your business.
  • Be sincere in your communication and answer all queries (whether publicly or privately).
  • If you are offering rewards, be creative about it. Rewards can help you get more investment.

Venture Capital and Angel Investors

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Venture Capital is a form of investment in small businesses with strong potential for long-term growth. Although venture capitalists and angel investors make investments in return for a stake in the business, there is quite a bit of difference between the two options. A firm typically manages venture capitalists, while angel investors (usually high-net-worth individuals) operate independently. 

Equity considerations and investor involvement are two important factors that we suggest you consider before opting for either of these two funding options. While both options involve dilution of ownership, the involvement (and interference) is likely more in venture capitalists’ case. Additionally, angel investors are more likely to have a high threshold for risk, and they will also be open to investing in early-stage startups (pre-revenue stage). On the other hand, venture capitalists only invest in low-risk and late-stage (pre-profit) startups. However, venture capital may fetch you non-financial benefits like industry connections, additional knowledge, and guidance for business direction.

For pitching to investors (both angel investors and venture capitalists) and securing funding, you must go through multiple steps. You will need to craft an impressive pitch deck. Investors would want to know about your product or service (and the problem it will tackle), your team, the competitive landscape, business traction, your revenue model, and financial information (current financial position and how you intend to use the funds). For an excellent investment pitch, you must understand your audience and adjust your content accordingly. 

Peer-to-peer (P2P) Lending

Peer-to-peer lending works through a website or platform that connects the lenders directly with the borrowers (no intermediaries required). Although the platforms will evaluate borrowers, the decision to extend the loan lies with the lenders. P2P lending platforms charge fees for their services, but their charges are typically lower than traditional financial institutions. P2P platforms are regulated at federal and state levels to prevent them from usurping the money extended by lenders.

As a small business owner, you might find it easier to access funding quickly through this option. No collateral is required. The terms are also typically flexible, and various types of loans may be available. However, you need to consider that you will be paying fees for the platform and the interest to the lender. It will add to your costs. Finding reputable P2P lending platforms will require some research. You will need to create an account on the platform. The platform might have some specific eligibility criteria. Fill out an application for a P2P loan. When a lender chooses to provide funds to you, we recommend checking the interest rate before approving. 

Other Financing Options: 

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  • Microloans: You can get loans up to $50,000 through SBA funding intermediaries. You can use these loans to expand your small business. The only restrictions over these loans are that they may not be used to purchase real estate or pay existing debts.
  • Grants: If your small business can help meet federal research and development objectives, it might qualify for a federal grant. Apart from this, grants are available from state agencies as well as private agencies. With grants, you can grow your business without incurring debts. Although the application process might take time, the payoff will be worth it. Research and find a match for your business offering and needs. Study the responses of previous grant winners, to understand the expectations better. Your application should demonstrate that you have a concrete plan for using the grant money. Show the value of your business. Stick to all the directions related, including word limits and deadlines.
  • Competitions: Participating in business competitions can help you secure the funding you need for your business. You can take advantage of the multitude of business plan competitions. Find a competition relevant to your business type and industry.
  • Credit Cards and Lines of Credit: For business expenses, you have the option of using a business credit card. It works similar to a personal credit card. A business credit card can help you boost the purchasing power of your business since it will help you access a higher credit limit. You can use it to build a stellar credit history for your business and improve your credit scores. Just a caveat from our side here: It can be challenging at times to separate private and business expenses, but it is a must. Try to manage credit as responsibly as you can. With business credit cards, you may, at times, receive rewards.

Business Line of Credit

Although it is more challenging to qualify for a business line of credit (LOC), once you do qualify, you can use it for larger business expenses. The line of credit can be as much as $100,000. With business credit cards, you can draw money anytime, but with a business LOC, there is a fixed draw period. They also have a specific credit limit, depending on which you can tap into the funds within the years of the draw period. With LOCs, you may have to pay origination fees, interest, annual maintenance fees, draw fees, and late fees. LOCs may be secured or unsecured. This option is most suitable for your short-to-mid-term financing needs.

Factors to Consider when Choosing a Funding Option

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Before you shortlist or finalize funding options, consider these factors:

  • Business Stage and Growth Plans: The stage of your business and growth plans will help you determine your capital requirements and the specific purpose for which you need the funds. 
  • Interest Rates and Cost: While considering the various funding options, compare the interest rates, fees, and all associated costs. This will help you narrow down your options, as these costs will also affect repayment.
  • Repayment Ability and Risk Tolerance: Make sure that you have the ability to repay the loan. For this, you will need to take into account the repayment schedules, terms, and your cash flow. Do not forget about interest rates. Be very honest with yourself about your threshold for risk tolerance. You need to ask all the important and difficult questions to yourself (and your co-founders, if any), such as whether you are ready to share control of the business or if you are ready to take on debts. 
  • Legal and Regulatory Considerations:  Carefully consider the ramifications of your decision. Awareness of legal or regulatory requirements associated with the funding option is a must. If you are unsure about anything, seek professional advice. Take opinions from financial advisors or business mentors. They will be able to provide you with insights for your specific situation and business needs. 

We also recommend that you assess your creditworthiness. Check if you have collateral that can affect eligibility or interest rates. Additionally, ensure investor compatibility with your business objectives. Some funding options take longer than others for application and processing, so you need to check if the timeframe is suitable for your business needs. You should also explore industry-specific funding options. In the case of equity financing, consider your exit strategy in advance. 

 Financial Management and Accountability

It is not sufficient to just procure the funds. What you do with those funds will make all the difference. Here is what we recommend for proper financial management and accountability:

  • Proper Fund Allocation and Tracking: For efficient allocation of funds, we highly recommend that you create a detailed budget. Since you may already have planned the allocation to present to your funding source, it won’t be very time-consuming after you get the funds. Carefully monitor your expenses and your cash flow. Cut costs wherever possible. Take the services of a professional accountant for accurate record-keeping and regular reporting. Share reports with the stakeholders regularly and maintain transparency throughout.
  • Repayment Strategies and Financial Discipline: Maintain a separate bank account for business. It can tempting to mix personal and business expenses, but keep them separate for the sake of clarity and accountability.  Ensure that your business is fulfilling all tax obligations accurately and on time. Maintain strict financial discipline and accountability. You might need some internal controls and audits to prevent fraud and errors.
  • Investment in Growth and Planning Ahead: Plan and invest wisely in areas that will help accelerate the growth of your business and secure its future. It is a good idea to invest in your financial literacy and that of your team. For better visualization and insights of your business data, you can consider using Power BI. It is okay if you are not an expert; opt for a Power BI for beginners course online. It is fairly easy to master. You must review your financial performance and adjust your strategy accordingly periodically. 

We also recommend diversifying funding sources so you do not become over-reliant on a single option. Diversification of funding sources will also help you reduce risk.

FAQs

How can a small business be financed?

There are mainly two ways of financing a small business, namely debt financing and equity financing. Debt financing refers to borrowing funds from suitable sources, while equity financing refers to offering a share/stake in the business in return for the funds. In debt financing, there is usually interest involved, while in equity financing, profits (as well as losses) are shared.

What is the best financing option for a small business?

It is not correct to decide that a certain financing option is best for all small businesses. The suitability of financing options varies according to the needs of the business and the terms associated with the financing option. The needs of the business are defined based on several factors, such as the stage of the business and the competitive landscape. The suitability also depends on how the pros and cons of the financing options align or go against the plans for the business.

What types of financing are available to small businesses?

Several types of financing options, both in equity and debt financing, are available for small businesses. Financing options include bootstrapping, Small Business Administration (SBA) loans, crowdfunding, angel investors, microloans, Peer-to-peer (P2P) lending, grants, business credit cards, and lines of credit.

What is the most common form of financing for a small business?

Usually, small businesses start with bootstrapping and funds from family/friends. Credit cards and bank loans are the next most common forms of financing. Businesses with a great product or plan try for grants, angel investors, or venture capital. The choice of financing option for each business varies depending on the stage, needs, and financial situation of the business. 

Conclusion

As a small business owner, you need to weigh the pros and cons of all the available funding options. Research about the specific options available to your type of business will empower you to make informed decisions. Explore funding avenues tailored to your business needs and make the right choice. An appropriate funding option will accelerate your journey toward entrepreneurial success.

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