How to Finance a Business
You have an idea for an exciting new business. You’ve done your research and you’ve written a business plan. Now it’s time to answer the big question – how to finance a business. Let’s take a look at your options and the things you’ll need to consider in your quest for business funding.
Business funding is a broad concept. It can be used to describe many the financing needed for various business situations, like starting a new company, expanding a current business, or covering cash gaps. For now, we’ll focus on business funding as it relates to financing a brand-new business.
Things to Consider When You Finance a Business
Before you dive head first into your financing options, take some time to really understand what you’re financing. This is imperative. Obviously, you need to know how much funding is required to get your business off the ground. We’ll get into that a bit later. But you also need to have an idea of how those funds will be allocated.
Whether you’re borrowing money from a bank, working with a group of investors, or getting a loan from your parents, you’ll need to be able to explain what the money will be used for in specific terms. Here are some aspects of your business that could require startup capital.
Renting or buying space
If your business will be headquartered in your garage or a spare bedroom, great. You probably won’t need to worry about money for a workspace. But look into the near future – if your business grows the way you intend, can you sustain it in your garage?
For those who need a space, like an office, warehouse, or workshop, check out your options for renting or buying and keep those figures in mind for your overall financing needs.
Unless you’re running a one man show, you’ll need employees. And unless you have a network of people lined up to work for you, you’ll have to post jobs, work with recruiters, and run background checks – all of which cost money. Many people don’t realize, there are costs associated with hiring employees, not just paying their salaries. If you’re in the market for executives, senior management, or high-level tech gurus, your costs will be even higher.
Depending on your business model, you may require inventory to get started. Since you can’t make money without first having inventory, these costs will be part of your business financing.
Whether it’s a simple laptop or a multi-million-dollar piece of machinery, the costs for your equipment will likely come from your startup funds. Keep a running list of all the equipment you’ll need, not just the big stuff.
Managing the Customer Journey
Not so long ago, customer service was just something that happened when a consumer called your company. Nowadays, customer experience is a huge part of the success (or failure) of any business. When you’re figuring your startup expenses, don’t forget to include the cost for consultants or third-party tools like surveys to manage your customer’s journey.
Working Capital and Day-to-Day
Remember those employees you hired? Well, they’ll be expecting a paycheck, whether your business is turning a profit or not. Consider how much financing you’ll need to sustain your employees’ salaries and benefits.
And don’t forget the day-to-day costs of running a business. Incidentals come up all the time and it’s important you have an operating fund to keep you covered.
How Much Funding Do You Need?
Now that you have a nice list of the specific costs associated with starting your business, it’s time to figure out how much money you’ll really need.
Unfortunately, there’s no magic number or special formula that will help you decide how much financing your business needs. There are some guidelines you can follow, though. Start by estimating the amounts you think you need for each of your expenses. Then compare those estimates to the following criteria.
What’s the ROI?
Figure the approximate return on investment for the funding amount you estimated. If result is an unacceptable ROI, you might need to reconsider your amounts in some areas. And remember, certain expenses will be just that – expenses. Things like your daily operating budget won’t have a measurable ROI.
How Quickly Can You Pay Off the Debt?
Debt is a pretty common part of starting a business. But no one wants to be in debt forever. Think about how long it will take you to pay off the amount you’re thinking of financing. If the term is longer than you’re comfortable with, you might need to scale back on the funding in some areas.
Will You Incur More Debt Later?
Your initial answer is probably, “Of course not!” But don’t be so hasty. Incurring more debt isn’t always a bad thing – Like when your business explodes, and you need more inventory. Other times, you might fall a little short and need some help bridging the gap.
In any case, be conscious of the potential need for more financing in the future. Be honest about whether you could manage both debts and how you would do it.
Types of Funding Available
Business funding generally falls into three main categories – debt financing, equity financing, and bootstrapping.
There is no better or worse option. Each type of financing has its place in different business scenarios. The type of funding you choose will depend on your business model, your goals, and your resources. Here’s how each of them works.
Debt financing means you’re borrowing money. The word debt might make you cringe, but not all debt is bad. Most businesses in the world have been in debt at some point, that’s how most of them got started.
Business loans from a bank and borrowing money from friends or family are both examples of debt financing. In these cases, the amount you borrow must be paid back (with interest if you’re working with a bank.)
When you fund your company with debt financing, you have the distinct advantage of maintaining complete control of your business.
Equity financing means you sell part of your business to investors in exchange for funding. There’s no loan, interest, or repayment involved.
Angel investing is the phrase commonly used for startups. Angel investors give business owners money to start their companies and in exchange, the investor is given a portion of the business.
While there’s no repayment needed for equity financing, you are relinquishing part of your business to your investors. Some investors may be totally hands-off, trusting you to handle all the business. Other investors may wish to be involved in some of the decision making.
The word bootstrapping means using your current resources in a situation. The term can be applied to all sorts of scenarios. In the case of financing your business, bootstrapping means you rely on your own personal finances to get your business off the ground.
It’s an attractive thought, considering you won’t be in debt to anyone nor will you have to sell any shares in your company. And you’ll be in complete control of your business. It can be a hard road to travel though, especially if your personal resources are limited.
How to Decide on Financing
Every business is different, and so is every funding situation. The type of business financing you choose will depend on many different factors. And there’s no rule that says you can only use one type.
Many startup owners opt to take on a few investors, get a small loan, and invest some of their own money.
Here are a few of the things you should take into consideration when deciding on which financing option(s) to choose.
Consider How Much Capital You Need
If you only need a small sum to get your business off the ground, bootstrapping could be an option for you. Larger amounts may require loans, investors, or both.
Reflect on Your Own Finances
The idea of bootstrapping is enticing, but it’s not for everyone. If your personal finances can’t sustain running a business and taking care of your other responsibilities, you may need to investigate other financing opportunities.
Admit Your Tolerance for Risk
Bank loans must be repaid. If your company fails, no matter how sad the situation, the bank still wants its money. If this thought terrifies you, think long and hard about your approach to financing your business.
Think About Your Relationships
What happens if you’re unable to pay back your family and friends? Will this effect your relationships? Before accepting loans from people with whom you have close ties, be realistic about how it could play out.
Check Your Credit Score
Thinking about a loan? Your credit score will be a factor is financing through a bank.
Decide on Your Willingness to Work with Investors
If you choose to go with equity financing, you’ll be giving up part ownership in your company. This is a perfectly acceptable trade-off for some business owners while others may be totally against the idea. Before you enter into an agreement with investors, be sure you understand the short-term and long-term effects it may have on your business.
Once you’ve settled on the amount needed to finance your business, you can begin approaching banks or investors for funding. Be careful during this process. You may be surprised when you’re offered more money than you actually planned for.
It will be tempting to accept a larger loan or a higher amount of investor funding. But doing so could be detrimental to the long-term health of your business. Taking out a big bank loan means a longer term of payments and more money paid toward interest. Signing on more investors than you need will result in losing more and more ownership in your company.
You worked long and hard on your business plan and you should give equal attention to your financing plans. Be honest and precise about the money you need and use the funding according to your plan.