Many small business failures are caused by the incapability to raise capital. In this article you will find various alternatives for increasing capital and also the steps you should take to decrease the need for outside capital.
The majority of small business failures are caused by insufficient capital. This article is focused on two concepts. First, it will provide various alternatives for raising capital. Second, it will highlight steps to reduce the need for outside capital.
To raise capital, you’ll need a solid business plan that describes your business and provides complete financial information. Without such a plan, it’s virtually impossible to secure bank loans or other investors. If you lack the expertise to prepare the plan, hire someone who does. It will definitely be worth it in the long run.
Methods For Raising Capital
1. Personal Assets
Many businesses start with a self-infusion of money because they can’t obtain outside financing. It may come from savings or selling assets such as stocks, bonds, real estate, or personal property. Another option is to refinance your house or establish a home equity line of credit. You may also be able to borrow against the cash value of a whole life insurance policy. Be aware of the risks of all of these approaches before considering them.
2. Friends and family
This is a common way to get financing but it’s loaded with risks. If your business fails, your friends and family will likely lose most or all of their investment. Are they prepared for that possibility, and are you prepared for the consequences? Since you don’t want them telling you how to run your business, you’re better off taking debt rather than giving them equity. If you go this route, disclose all the risks and have everyone sign a promissory note. Strictly follow accepted professional standards when structuring and documenting all such loans.
3. Credit cards
We’ve all the heard the stories of millionaires who started their companies with a cash advance from their credit card. What we don’t always hear about are the thousands who have gone bankrupt by running up debts they could never repay. The finance charges on cash advances are oppressive and will grow exponentially if you only make the minimum payments. This is a high-risk approach that could easily sink your company if you can’t generate enough cash to quickly pay off the advance.
If you’re still employed have an existing 401(k), you may have the option of taking a loan against it and paying yourself the principal and interest. Premature withdrawals are subject to penalties and taxation. However, it’s possible to structure a transaction whereby your 401(k) from a previous job invests in your company by buying an equity stake. If you’re willing to risk your retirement savings in your business, you’ll need professional help to set up a tax-free investment that maintains your control over the business. The team should include an attorney, accountant, valuation specialist, and brokerage firm.
5. Traditional bank loan
It pays to have an established relationship with a local bank. If you’re known and trusted, that goes a long way toward getting you money. In addition to your business plan, they’ll evaluate your character, collateral, and capacity to repay the loan. They typically offer intermediate or long-term loans with a set maturity date, fixed interest rates, and a monthly repayment schedule.
6. Small Business Administration
An SBA-backed loan guarantees as much as 80 percent of the principal. The loans are targeted toward small businesses that can make payments from cash flows but may not otherwise qualify for a traditional bank loan. This is usually due to a lack of collateral or the need to extend the repayment period and lower the monthly payments.
The SBA-developed Microloan program is targeted to businesses with relatively small capital requirements. It’s administered by 170 nonprofit organizations around the country which act as loan intermediaries. Business plans are not always required, and personal tax returns are often substituted for financial statements for startups.
The SBA also licenses the Small Business Investment Companies (SBIC) and Specialized Small Business Investment Companies (SSBIC). They have their own private capital and focus on entrepreneurs who have been denied the opportunity to own a business because of economic or social barriers.
7. Community Development Financial Institutions
CDFIs make loans to businesses that are typically "unbankable" in locales needing economic development. If your company can’t meet traditional loan standards due to insufficient collateral or past credit problems, many communities have funds available to lend if you can demonstrate job creation and commitment to the community.
8. Privately-guaranteed loan
This is an option for startups that are having difficulty obtaining a traditional bank loan. It’s similar to a loan backed by the SBA except that it’s guaranteed by a private entity or individual. The loan comes from a commercial bank and the guarantee period is usually one year. At that point, the original loan is either paid off with new capital or a follow-on loan is created based on the current business fundamentals. This approach allows you to maintain control over your company without surrendering equity.
9. Royalty financing
This is an advance against expected sales of services or products in exchange for a percentage of the sales. Unlike a loan, this arrangement gives the investor a defined stake in the product. It’s most often used where the product has high margins and easily marketable demand.
There are no scheduled payments and the advance doesn’t show up as debt on your balance sheet. It’s a contingent liability that may or may not ever happen. Although you’re giving up a share of your expected profits, you still own 100% of your business.
10. Angel investors
Angel investors are individuals who invest in high-growth companies that are willing to relinquish some control and ownership. This can be expensive because these investors may want a significant share of equity to compensate for their risk. Some may also want a retainer as a management consultant. Most will also want an exit strategy that allows them to cash out their investment at some point, either through a buyout or public offering. To find prospective angel investors, contact the chamber of commerce, SBA, commercial banks, business attorneys, or your state economic development agency.
11. Online funding
There are many websites featuring “crowd-funding” that offer two basic models for raising financing. “All or Nothing” has a defined collection time period. Once the period has expired, pledged money is only collected from contributors if the original monetary goal is met. “Keep it All” awards all money collected to the entrepreneur regardless of the goal. Many entrepreneurs are now using these approaches to raise capital from investors around the world.
Reducing Capital Needs
Keep your capital requirements to a minimum by eliminating capital purchases as much as possible. In addition to saving you money upfront, this also limits your risk while you’re trying to build your business.
Wherever possible, lease or rent what you need. This includes workspace, equipment, tools, and vehicles. If things don’t work out, you can terminate the agreements and limit your losses. Carefully control your inventory to minimize the cost of storage and insurance.
Financing options for large businesses include institutional venture capital, initial public offerings, asset-based loans and reverse mergers. These are time-consuming and require specialized assistance from finance professionals.
This article only scratches the surface of different approaches you might consider. Since all businesses are unique, do your own research or consult a financial advisor before committing yourself. It’s critical that you understand the risks, total cost, and tax implications of any approach you take.