What is business finance?
Business finance is all the capital that you acquire to run your business. There are many different types of business finance. However, most of the methods fall into one of these two broad categories: debt and equity.
In sticky situations, business owners will need to get a business loan in order to function. SBL has helped numerous businesses get through tough times and thus, we have decided to share more about business finance. We were able to assist them regardless of the industry they are in.
In this article, we are going to learn all about the various types of business financing methods and also understand how they work.
Without further ado, let’s dive right into it!
The majority of businesses looking for capital choose from debt, equity, or a combination of both.
What are debt and equity and how do they work for small businesses?
Debt is pretty much a loan. You can get a loan from an investor, a supportive financial institution or a bank. This is the most common type of business finance. Loans are repaid over a predefined and mutually agreed upon timeline, often with an interest paid on top of the principal amount.
– The principal amount is the amount of money the lender will give you as a loan. Usually, the business owner needs to make forecasts and company valuation documents, factoring in future expansion, to get a loan approved.
– The interest is the percentage on top of the principal amount that you will end up paying. Interest rates differ from institution to institution and lender to lender.
– The repayment timeline is the timeline of getting out of debt. Sometimes, you will need to start your repayments in monthly installments right away whereas in some cases you are given a grace period of a few months. On the other hand, options also exist where you have to make no monthly installment but pay in lumpsum after a fixed duration.
Want to know more about business loans? Read how we helped Ms Melissa Lim with her music school business here. Her music school has successfully expanded with our help!
Equity is essentially selling a portion of your company to someone else, and in return, receiving money for it. It differs from actually selling your company or business as the leadership, ideas, or operations don’t change at all. It’s still your company. The person simply becomes a stakeholder, as in he or she now holds a stake in the company.
Stakeholders also often have veto power or decision-making power in some capacity. The idea is that because they hold a stake it’s in their interest to make the company successful. And as such, they might point out certain things every once in a while. Though the level of interaction on a day-to-day basis or the amount of involvement isn’t quantified at all. It changes from person to person and depends on a myriad of factors.
Once someone has a stake, they are like a partner. Consequently, a part of the profits will go to them. This is their repayment. In this case, you don’t have to pay the amount back to the stakeholder.
An investor only becomes a stakeholder in a company if they believe in it because if the company breaks even and starts making a profit, they will make a profit share as well. But if it fails, their money is essentially lost. It is important to understand this in order to run your business finance well.
It’s not as simple as choosing between equity and debt. There are a lot of variables at play, given you are eligible for both forms of business finance.
Some of these variables include:
The first step is often to determine what you need the money for and how much of it will you be needing. Ask yourself these questions:
– What do you need funding for, specifically?
– Is it to diversify? A business expansion? A startup? Purchasing assets? Solving a cash flow problem?
– What amount will suffice? Have you ascertained the exact requirements and calculated their total costs?
– Are your needs short-term or long-term?
Being clear on these fronts will enable you to hunt for good business finance in a much more effective way. For example, if you only need funds to start and your needs are short-term, a short tenor loan will suffice. But if your needs are long-term and you wish to stay afloat even during market fluctuations for a couple of years, you most probably need to approach an investor and onboard them on the team itself.
The risk involved in your business will determine how attractive it is to a bank or an investor.
Generally, banks like to give loans to businesses that are less likely to fail. This means companies run by chain entrepreneurs or companies working in industries that are booming.
Riskier businesses, such as less recognized ones, offbeat startup ideas, or a business run by someone inexperienced or unqualified are harder to pitch to banks.
Such businesses can also be harder to pitch to investors. But not all investors are the same. Some might know about the industry or might be sold to your idea. It depends. You just have to try at a lot of places.
Have you taken any loans before? If yes, then did you repay them on time?
Existing personal or business history with an investor, lender, or bank can influence your prospects. Investors and banks will both see you in a positive light if you’ve done well with the money lent to you in the past and if you were able to use it effectively to scale your business.
Needless to mention, if you have a bad track record in repaying either personal or business debt then it affects how much you can borrow again. While it is a business loan, banks will still look at the stakeholders’ credit score before making a decision.
Note that keeping your previous financial history from any future investor or the bank is not legal.
Now, it’s time to see what you will lose in each of the cases. There will always be risk.
A bank loan will be repaid with an interest. The amount of interest is all you will lose in this case.
On the other hand, if you get an investor on board as a shareholder, then the shareholder will be paid out of the company’s profits. You need to calculate this to better understand the implications of the investment. If getting an attractive investment from an investor means a substantial stake in your company then that means you lose a substantial amount of the profits as well as a part of the decision-making power.
Last on the list is convenience. Some types of business finance are more convenient than others.
If you are new to entrepreneurship and you approach a bank for a loan with your half-baked projections, it might take months for you to get the money, if you do manage to get it at all. Without the proper documentation and experience, things can get hard. Some loans will also require you to have much more paperwork beforehand.
On the other hand, you can approach an investor. Investors are pretty relaxed in terms of their requirements. They will of course need to see paperwork but for the most part, if your idea is good and they want to invest, you can get the money faster, much more conveniently, and in a largely hassle-free way.
The convenience factor should be the last on your list of priorities.
Bank loans and stakeholders aren’t the only two methods. The world of business financing is vast.
Let’s have a look at a few other popular options you have. Note that the efficiency of any of these methods depends on you, your company, and the nature of business. A method ideal for a particular type of business can also simply fail for another.
1. Peer-to-peer lending
2. Loans from friends and family
3. Invoice financing (given you already have clients)
4. Angel investors
5. Venture capitalists and seed investors
7. Small business grants
Remember, get the most suitable loan for your business. Don’t rush into one without careful planning!