What is business financing?
By the most basic definition, business financing is the act of providing money for business activities. Of course that's just the beginning of an education in business finance. As a business owner, you'll need a lot of additional information in order to make smart financing choices for your business.
While some businesses succeed without outside funding, most reach a point where they need more capital that they can produce through cash flow. That's when they turn to outside capital. There are three primary purposes of financing:
- Funding business startup
- Providing cash for growth and expansion
- Dealing with unexpected financial challenges
Business financing is grouped into two categories: equity and debt. Equity financing involves selling an ownership stake in the business, while debt financing involves borrowing money.
Sources of capital vary widely, ranging from self-funding and traditional bank loans to venture capital and revenue-based financing. The availability of different types of funding depends on a variety of factors, including the type of business, size of the company, ownership structure, profitability, assets and other factors.
Why capital is critical for small business.
According to a recent Forbes.com report, small businesses are the major job creation engine for the U.S. economy, accounting for 74 percent of all new positions. Similarly, a report from the Small Business Administration states that small businesses account for almost half of all jobs in the U.S., and the Federal Reserve Bank of Cleveland reports that small businesses account for more than 40% of private sector GDP.
These employment statistics demonstrate the importance of small business to the U.S. economy. And that explains why capital is so important to small businesses: Access to capital is what allows many small businesses to develop products, expand into new markets and create new jobs.
But the reality is that small businesses' access to capital, in the form of equity or debt financing, is often severely limited. This can make it challenging for small-business owners to find the funding they need to help their businesses thrive.
Common Sources of Business Financing
The financing resources that are available to a business will vary quite a bit depending on the nature of the business, length of time in business, profitability and other factors. The most common sources of funding include:
- Self funding. More than half of all startups are funded largely by the founder's savings and credit. Many businesses rely solely on personal contributions. This reflects the reality that many financing options are simply out of reach for many businesses, leading owners to tap their savings or retirement accounts to meet business expenses.
- Bank loans. Many businesses approach banks for business loans, and large businesses find it relatively easy to borrow from banks. It's a different story for small businesses: According to recent reports, big banks approve fewer than one out of five small business loan applications. Smaller banks are somewhat friendlier to small business, but even community banks still reject nearly half of all small business loan applications.
- SBA-backed loans. The Small Business Administration does not loan money directly to businesses. Instead, the SBA guarantees a portion of the loans made by approved lenders.
- Alternative lending. As conventional bank lending to small business has declined, the void has been filled to a large degree by alternative funding options. These options typically base lending decision on the cash flow and overall strength of the business rather than the owners' personal credit score. Examples of alternative financing include revenue-based financing, merchant cash advance and invoice factoring.
- Business credit card. Many small businesses rely on credit cards to finance business expenses. In practical terms, a small business credit card is simply a personal credit card with the business name on it; approval and credit limits are based on the business owner' personal credit history.
- Venture capital. Venture capitalists are usually wealthy investors, investment banks or groups that pool funds specifically for the purpose of investing in businesses with the potential for high returns. In addition to an ownership stake, VC funding usually gives the new investors a say in major decisions that affect the business. Availability of venture capital is limited; with Forbes.com reporting that less than one-tenth of one percent of all startups receive VC funding.
- Angel investors. Angel investors are typically wealthy entrepreneurs who make early-stage investments in startup companies that have a special appeal to the investor. Angel investors may make equity investments in which they provide funding in return for ownership in the company, or they may structure their investment as debt. It is not easy for most businesses to access potential angel investors.
- Other funding sources. Additional funding sources for small businesses include friends and family, grants, crowd-funding and peer-to-peer lending.
Comparing debt and equity financing.
When a business reaches the point where outside funding is needed, there are two basic forms of financing to consider: equity and debt. With equity financing, a share of the company is sold in return for funding. The alternative is to take on debt by borrowing money.
It is important to understand the pluses and minuses of debt vs. equity financing, and it is equally important to understand that your business may not qualify for certain financing options. For instance, you can rule out equity financing if no one wants to buy a share in the ownership of your business.
How large is the business finance marketplace?
In 2013, The Wall Street Journal reported that U.S. banks had more than $1.45 trillion in business loans outstanding. Most of those loans have been made to large businesses, with just 5 percent of all the loans made by large banks going to small businesses according to AmericaBanker.com.
Since the end of the Great Recession, growth in the business lending market has been driven by loans to large businesses, while lending to small businesses has declined significantly. In fact, according to FDIC data, the share of nonfarm nonresidential business loans going to small businesses has declined from 51 percent in 1998 to just 26 percent today.
While famous venture capitalists make news with big investments in sexy startups, most business capital comes from other sources. In fact, personal loans and investments from friends and family account for most startup funding.
According to data reported by Entrepreneur.com, of the $533 billion in annual startup funding in the U.S., $42 billion provided by venture capitalists and angel investors goes to less than one percent of new companies. By comparison, 57 percent of startups use personal loans and credit, and 38 percent report funding from family and friends.
The role of finance in the small business life cycle
When many people think of business financing, they focus on startup funding and early-stage investments. After all, the business pages often feature headlines about the latest venture capital deal or big investments made by famous angel investors. But business financing can be necessary during virtually all stages of a business' existence.
Startup funding. This is often where the headlines are generated, but even if your launch doesn't make the financial blogs, you still need to figure out how to fund your startup. According to Entrepreneur.com, the majority of startups are funded at least in part by the founder's personal savings, with an average of $48,000 invested.
Early stages. The first year or two are a critical time for most small businesses, with Forbes.com reporting that 80 percent of new businesses fail within the first 18 months. Access to working capital is critical at this stage, and the SBA reports that nearly 15 percent of small businesses use a business credit card to finance operations or expansion.
Growth and expansion. Some businesses can fuel their growth plans through cash flow alone, but most businesses will require outside financing to maximize their potential. This is a stage where virtually all funding options come into play. Companies that don't have access to venture capital or angel investors will usually consider traditional bank loans and alternative financing options.
7 uses for business financing
Businesses can require financing at virtually all stages of their existence, from startup through maturity. The 7 most common uses of debt and equity financing are:
- Cover startup expenses
- Fund growth and expansion
- Increase payroll and staffing
- Purchase inventory
- Acquire equipment, machinery or vehicles
- Fund advertising and marketing
- Pay for emergency repairs and unexpected expenses
6 factors to consider when financing your small business
To save time, minimize headaches and improve your likelihood of receiving financing, it's important to match the specific needs of your business with the financing options that may be available. These questions will help guide your choice:
- Why do you need financing? Consider short-term financing such as a line of credit or merchant cash advance if you need money for seasonal payroll, inventory or other operational expenses, Capital expenses such as equipment purchases, real estate or other fixed assets may be eligible for long-term financing.
- How urgent is your need? Consider the lead times involved in various financing options. It can take many months to finalize venture capital or angel funding (if it's even available). Traditional bank loans can take a month or more for approval. If you need funds immediately, consider revenue-based financing or merchant cash advance, which can provide cash in a week or less.
- Do you need short- or long-term financing? A bank line of credit, merchant cash advance or revenue-based financing can provide short-term funding for things such as seasonal payroll or emergency expenses. Traditional bank loans and equity investments can provide long-term financing for capital expenditures and business expansion.
- How is strong your credit history? Traditional bank loans require a high personal credit score. Consider alternative funding options such as revenue-based financing or merchant cash advance if your credit report is less than stellar.
- Do you want to use your personal assets as collateral? For traditional bank loans, you'll usually need to provide collateral in the form of personal property to help the bank minimize its risk. Consider other financing options if you don't want to use your home or other property as collateral.
- Are you ready to give up equity? Venture capital and some angel investments are off the table unless you are willing to sell a portion of your ownership in the company. When you sell a share of the company to a VC or angel, you'll often give up a certain degree of control, too.
Qualifying for business financing
Theoretically, quite a few types of financing are available to businesses. In practice, however, qualification requirements may limit the options that are truly obtainable. The two most important limitations for a small business are personal credit score and the scarcity of equity investors.
The table below compares the basic qualification requirements for equity financing, traditional bank loans and alternative lending.
|Equity Financing||Traditional Bank Loans||Alternative Lending|
Online resources for business financing
Most traditional banks are still stuck with inefficient underwriting processes that seem designed to say "no" to small businesses, so it's inevitable that new funding options have been developed to fill the void. It's natural for these new options to make their home on the web.
Alternative financing resources such as LendVantage have introduced streamlined applications and sophisticated models that connect borrowers with potential business funding companies or lenders who have a real interest in funding small businesses. This is a perfect case of applying new methods and technology to fill a gap that is created when traditional approaches break down.
Companies like LendVantage serve entrepreneurs who are comfortable using online resources for a variety of purposes. When these small business owners have a problem it is more and more common for them to turn to online resources for a solution.
Specific advantages of online funding include:
- Streamlined processes minimize the time needed to apply
- Pre-approval can be supplied in minutes
- Borrowers are connected directly to funding partners who have an express desire to fund small businesses
- Underwriting costs are reduced, so more businesses receive financing
- Money can be deposited in the business' bank account within days.
According to Businessweek.com, alternative online lenders already account for an estimated $3 billion in annual funding to small business, and experts expect double-digit growth in the years ahead.