Most healthy businesses need business financing at some point. Startups have to deal with starting costs and ongoing businesses have to finance growth and working capital.
Deciding to take on some kind of debt is quite common, but financing options depend on what kind of business you have. Its age, position, performance, market opportunities, team, and so forth are very important. So you should tailor your funding search and your approach. Let’s walk through how to conduct a funding search and define some common options.
Common small business financing myths
Before we get into the most viable options for start-ups and established businesses, let’s dispel some popular funding myths, just so we can get them out of the way. Don’t get discouraged at this point. Better to deal with realities that you can work with rather than myths you can’t.
Venture capital is a growing opportunity for funding businesses
Actually, venture capital financing is very rare. I’ll explain this more later, but assume that only a very few high-growth companies with high-power management teams are venture opportunities. Many people use the phrase “venture capital” when they really mean “outside investors” or “angel investors.”
Bank loans are the most likely option for funding a new business
Actually, banks don’t finance business startups. Banks aren’t supposed to invest depositors’ money in new businesses, due to the potential risk involved. We’ll talk more about that in a bit, but more often than not you need some sort of monetary traction to acquire a bank loan.
Business plans sell investors
Business plans won’t automatically convince investors that they should fund your business.
Yes, a well-written and convincing business plan (and pitch) present your business to investors in detail; but they are investing in your business, not just a plan. Normally you have to have a team in place, have made progress toward idea validation, or—better still—traction (paying customers). So you’ll need to do a lot of work before you get investors.
Nobody invests in ideas or plans. There are rare exceptions, in which investors know an entrepreneur well and are ready to invest in them at an early stage. In that case, they are investing in the entrepreneur, not the plan.
How to prepare your business for funding
Let’s start with a quick reality check. Like so many things in business, a lot about business financing depends on your specific details. Realities go case by case, depending on the growth stage, resources, and other factors.
Are you a startup or an ongoing business?
The outlook for funding depends a great deal on the specifics of the business.
For example, many ongoing businesses have access to standard business loans from a traditional bank that would not be available to startups. Also, high-tech high-growth startups have access to investment funding that would not be available to stable, established businesses that show only slow growth.
Develop or refine your business plan
I’m not saying you shouldn’t have a business plan. You should.
Your business plan is an essential piece of the funding puzzle, explaining exactly how much money you need, and where it’s going to go, and how long it will take you to earn it back.
Investors will look first to a summary, and then a pitch; but if you get through that screening, they’ll want to see a business plan for the process of due diligence. And even before that, during the early stages, they’ll expect you to have a business plan in the background, for your own use.
Most commercial banks require a business plan as part of a loan application. A plan is also required for applying for a business loan guaranteed by the Small Business Administration (SBA).
Everyone you talk to is going to expect you to have a business plan available. They may not start their discussions with you by looking at the plan, but don’t get caught without one when they ask to see it.
How to find funding for your business
The process of looking for money must match the needs of the company. Where you look for money, and how you look for money, depends on your company and the kind of money you need. There is an enormous difference, for example, between a high-growth internet-related company looking for second-round venture funding and a local retail store looking to finance a second location.
In the following sections of this article, we’ll explore six different types of investment and lending options. This should help you determine which funding options are viable for your business and which investment options you should pursue first.
1. Venture capital
The business of venture capital is frequently misunderstood. Many startup companies complain about venture capital companies failing to invest in new or risky ventures.
People talk about venture capitalists as sharks, because of their supposedly predatory business practices, or sheep, because they supposedly think like a flock, all wanting the same kinds of deals.
This is not the case. The people we call venture capitalists are business people who are charged with investing other people’s money. They have a professional responsibility to reduce risk as much as possible. They should not take more risk than is absolutely necessary to produce the risk/return ratios that the sources of their capital ask of them.
Who should pitch to venture capitalists?
Venture capital shouldn’t be thought of as a source of funding for any but a very few exceptional startup businesses. They can’t afford to invest in startups unless there is a rare combination of product opportunity, market opportunity, and proven management.
Venture capital professionals look for businesses that they believe could produce a huge increase in business value within just a few years. They know that most of these high-risk ventures fail, so the winners have to win big enough to pay for all the losers.
Typically, they focus on newer products and markets that can reasonably project increasing sales by huge multiples over a short period of time. They try to work only with proven management teams who have dealt with successful startups in the past.
If you are a potential venture capital investment, you probably know it already. You have management team members who have been through that already. You can convince yourself and a room full of intelligent people that your company can grow ten times over in three years.
If you have to ask whether your new company is a possible venture capital opportunity, it probably isn’t. People in new growth industries, multimedia communications, biotechnology, or the far reaches of high-technology products, generally know about venture capital and venture capital opportunities.
2. Angel investment
Angel investment is much more common than venture capital and usually is far more available to startups, and at earlier growth stages too.
Although angel investment is a lot like venture capital (and is often confused with it), there are important distinctions. First, angel investors are groups or individuals who invest their own money. Second, angel investors tend to invest in companies at earlier stages of growth, while venture capital typically waits until after a few years of growth, after startups have more history.
Businesses that land venture capital typically do so as they grow and mature after having started with angel investment first. Like venture capitalists, angel investors normally focus on high-growth companies at early stages of development. Don’t think of them for funding for established, stable, low-growth businesses.
You should also be aware that angel investment was affected by the 2012 JOBS Act that loosened some restrictions and allowed what we now call crowdfunding. Traditionally, angel investment was limited by U.S. securities and exchange regulations to individuals meeting some minimum wealth requirements, called “accredited investors” in the legal wording. Crowdfunding is the accepted term for individual investment in startups by people who don’t meet the legal wealth requirements.
Under certain conditions, startups and even non-high-growth small businesses can solicit investment from a wider range of investors. Details are still fuzzy on a lot of this, so, when in doubt, check with a good attorney first.
How to find angel investors
Your next question, of course, is how to find the “angels” that might want to invest in your business. Some government agencies, business development centers, business incubators, and similar organizations will be tied into the investment communities in your area. Turn first to your local Small Business Development Center (SBDC), which is most likely associated with your local community college.
You can also post your business plan on websites that bring angel investors together. The two most reputable sites in this area are:
Be careful dealing with anyone or business firm offering to find you startup investment if you hire them to act as front or negotiator for you, or do your business plan, or your pitch presentations and such. These are shark-infested waters.
I am aware of some legitimate providers of business plan consulting, but legitimate providers are harder to find than the sharks. Real angel investors want to deal with the startup team founders, not brokers, or finders, or consultants. Finders’ fees had a place in startup investment a few decades ago, but have become obsolete.
3. Commercial lenders
Banks are even less likely than venture capitalists to invest in, or loan money to, startup businesses. They are, however, the most likely source of financing for established small businesses.
Startup entrepreneurs and small business owners are too quick to criticize banks and financial institutions for failing to finance new businesses. Banks are not supposed to invest in businesses and are strictly limited in this respect by federal banking laws.
The government prevents banks from investing in businesses because society, in general, doesn’t want banks taking savings from depositors and investing in risky business ventures; obviously when (and if) those business ventures fail, bank depositors’ money is at risk. Would you want your bank to invest in new businesses (other than your own, of course)?
Furthermore, banks should not loan money to startup companies either, for many of the same reasons. Federal regulators want banks to keep money safe, in very conservative loans backed by solid collateral. Startup businesses are not safe enough for bank regulators and they don’t have enough collateral.
Why then do I say that banks are the most likely source of small business financing? Because small business owners borrow from banks. A business that has been around for a few years generates enough stability and assets to serve as collateral. Banks commonly make loans to small businesses backed by the company’s inventory or accounts receivable. Normally there are formulas that determine how much can be loaned, depending on how much is in inventory and in accounts receivable.
A great deal of small business financing is accomplished through bank loans based on the business owner’s personal collateral, such as homeownership. Some would say that home equity is the greatest source of small business financing.
4. The Small Business Administration (SBA)
The SBA guarantees loans to small businesses and even to startup businesses. The SBA doesn’t make loans directly; it guarantees loans so commercial banks can safely make them. They are normally applied for and administered by local banks. You normally deal with a local bank throughout the process of getting an SBA loan.
For startup loans, the SBA will normally require that at least one-third of the required capital be supplied by the new business owner. Furthermore, the rest of the amount must be guaranteed by a reasonable business or personal assets.
The SBA works with “certified lenders,” which are banks. It takes a certified lender as little as one week to get approval from the SBA. If your own bank isn’t a certified lender, you should ask your banker to recommend a local bank that is.
5. Alternative lenders
Aside from standard bank loans, an established small business can also turn to accounts receivable specialists to borrow against its accounts receivables.
The most common accounts receivable financing is used to support cash flow when working capital is hung up in accounts receivable.
For example, if your business sells to distributors that take 60 days to pay, and the outstanding invoices waiting for payment (but not late) come to $100,000, your company can probably borrow more than $50,000.
Interest rates and fees may be relatively high, but this is still often a good source of small business financing. In most cases, the lender doesn’t take the risk of payment—if your customer doesn’t pay you, you have to pay the money back anyhow. These lenders will often review your debtors, and choose to finance some or all of the invoices outstanding.
Another related business practice is called factoring. So-called factors actually purchase obligations, so if a customer owes you $100,000 you can sell the related paperwork to the factor for some percentage of the total amount. In this case, the factor takes the risk of payment, so discounts are obviously quite steep. Ask your banker for additional information about factoring.
6. Friends and family funding
If I could make only one point with budding entrepreneurs, it would be that you should know what money you need and understand that it is at risk. Know how much you are betting, and don’t bet money you can’t afford to lose.
I’ll always remember a talk I had with a man who had spent 15 years trying to make his sailboat manufacturing business work, achieving not much more than aging and more debt. “If I can tell you only one thing,” he said, “it is that you should never take money from friends and family. If you do, then you can never get out. Businesses sometimes fail, and you need to be able to close it down and walk away. I wasn’t able to do that.”
The story points out why the U.S. government securities laws discourage getting business investments from people who aren’t wealthy, sophisticated investors. They don’t fully understand how much risk there is. If your parents, siblings, good friends, cousins, and in-laws will invest in your business, they have paid you an enormous compliment. Please, in that case, make sure that you understand how easily this money can be lost, and that you make them understand as well.
Although you don’t want to rule out starting your company with investments from friends and family, don’t ignore some of the disadvantages. Go into this relationship with your eyes wide open.
Maybe, your idea and your situation are a better fit for crowdfunding—that is, creating a profile and pitching your business idea or product on a site like Kickstarter. In fact, this method of raising money has become so popular that there are dozens of crowdfunding sites to choose from, all offering different terms and benefits.
Things to consider before taking on business financing
Sadly, financing and investment involve money; and money breeds some predatory business practices, scams, and such. So here are some reminders to help you avoid the pitfalls.
Be cautious about who you get funding from
Don’t take private placement, angels, friends, and family as good sources of investment capital just because they are described here or taken seriously in some other source of information. Some investors are a good source of capital, and some aren’t. These less established sources of investment should be handled with extreme caution.
Get it in writing
Never, spend somebody else’s money without first doing the legal work properly. Have the papers done by professionals, and make sure they’re signed.
Don’t spend before you receive funding
Never, spend money that has been promised but not delivered. Often companies get investment commitments and contract for expenses, and then the investment falls through.
Don’t jump to friends and family when you’re in a tough spot
Be aware that turning to friends and family for investment is not always a good idea. The worst possible time to not have the support of friends and family is when your business is in trouble. You risk losing friends, family, and your business at the same time.
Financing is complicated
Most businesses are financed by home equity or savings as they start—bootstrapping. Only a few high-growth startups can attract outside investment. Venture capital deals are extremely rare. Borrowing will always depend on collateral and guarantees, not on business plans or ideas. And business borrowing is normal for ongoing businesses with an established history, but not a normal option for startups.
What might be the next steps to take depends a lot on your specific business. Generally, high-tech startups might explore angel investment or friends and family first, while steady ongoing businesses should start by asking their small business banker. But always remember, your business is unique.
Editor’s note: This article was originally published in 2018 and updated for 2021.