Small businesses are rarely profitable when starting out. Therefore, you need to find a safe way to finance your business until it starts to at least support itself. The best ways to safely finance your small business are: crowdfunding your project online, tapping into personal savings and assets, working with an Angel Investor, and getting one of the many types of loans.
The size and purpose of your business will determine which source of financing is best. For example, if you have developed a design for a very clever, new household tool and need money to build a prototype, then crowdfunding may be a great option. If you have been running your small business for several years, and know it’s time to expand, then a bank loan may be the best way to get financing.
What follows is a closer look at each of the safest and best ways to finance your small business.
How To Get a Small Business Loan
There are four types of loans that you can get for your business:
- commercial loans,
- equipment loans,
- SBA loans, and
- standard business loans.
Each has a different benefit and purpose for your business depending on what the loan will be used for, your business’s income, and size. There is a significant amount of overlap in regards to what you need to provide in order to get any of these loans. This section will explain what you should do before applying for a loan, what information you should have prepared, and what types of loans you can get.
What should you do before applying for a loan?
You’ll want to have the right information prepared beforehand. Your business forecast, expense and revenue records (everything you would have if you met with an investor). Expect for the banks to ask for a report on your business’s cash flow and industry risk. You’ll also be asked about your time in business.
What credit score do banks look for before offering a business loan?
Your credit score will play a huge part in whether or not you can get a loan, and what type of interest rate you can get. Credit scores in the 650-700 range are acceptable and you may be able to get a loan, but most banks and lenders will want a score of 700-800.
Last, banks and lenders will want to know how much of your income is going to current debt. Do you have student loans, car payments, or mortgages that are adding up? Your personal debt payments should only be about a third or less of your monthly income.
What are banks looking for in companies they give loans to?
Banks want to make sure they’re giving their money to someone who can pay it back with interest. Trust becomes a key element in getting a loan, and that results in subjective decision making on the part of the lender. Banks are going to want to make sure that your business isn’t a scheme. Any business that involves lending money, pyramid business structures, or games of chance and gambling will probably be rejected by the bank.
Also, the banks are going to look at you and your business partner’s character. Have you been in trouble with the law? Do you all have good credit history?
Banks will also look for collateral. They want to know if you have assets that can be repossessed if you are unable to pay the loan. Last, they want to make sure that you have some of your own money invested in the business. This will show a great amount of confidence, and commitment from you.
What banks should you get a loan from?
Larger banks are less inclined to give out loans to small businesses because the payoff is less and there is more risk. Therefore, your best option is to find a smaller, local bank. Small, local banks will be more inclined to offer you a loan because they deal with smaller businesses and because it’s beneficial for them to know that the area around them is being developed by businesses. If a bank knows that your business will be operating near them, they may be more inclined to approve your loan.
It’s best to build a relationship with a bank before you ask it for a loan. Banks, especially smaller ones, will want to work with someone whom they are familiar with. If you have your savings or checking in a smaller local bank then you’re already off to a good start. Opening up a business checking account with a bank will get them familiar with your operation and help you build a reputation. Developing a friendly relationship with the employees of your bank will help when it comes time to get a loan. Go into the bank once or twice a month to deposit or manage your personal or business finances.
What are the Different Types of Business Loans?
Commercial Loans – These function similarly to a home equity loan. With commercial loans, you’ll take out a loan from the equity you have paid into your business. These loans can have an aggressive payment strategy that may be overwhelming for most business owners.
Equipment Loans – If your business relies on equipment such as tractors, forklifts, or machinery, then you should consider an equipment loan. With an equipment loan, you’ll be given a fixed interest loan to pay off the equipment. The equipment will be yours, and you will gain equity in it as you pay for off the loan.
SBA Loans – These loans are guaranteed by the US Small Business Administration and offered through banks. They require less aggressive repayment methods and can be used for purchasing business locations, equipment and technology or can be used for operations’ funding.
Conventional Loans – Unlike SBA loans, these are not backed by the federal government which puts the lender at a slightly higher risk. This often translates into higher interest rates. Conventional loans, however, can be used for all of the same purposes as an SBA loan. The main difference is that you can negotiate with the lender further down the road to adjust interest rates.
How and When to Use Crowdfunding to Finance Your Business
What is Crowdfunding?
Crowdfunding is a way of funding a project by raising money from a large number of people via the internet. Websites like kickstarter.com and crowdfunder.com are dedicated to helping people reach a large audience to gain funding for their projects.
Projects that are funded can range from artistic endeavors such as recording an album or producing an indie film, to business ventures such as getting a prototype built and even charitable causes such as raising money for a sick person’s medical bills. For this article, we’ll talk about how to use crowdfunding as a way to finance your business.
What should I use crowdfunding for in regards to my business?
You’ll want to use crowdfunding to finance a specific project, not day to day expenses. For example, if you have a great idea for a new type of diaper bag but you need funding to get a prototype made, then crowdfunding may be an option. If, however, you need rent money for your office, then your crowdfunding campaign will surely take off like a lead balloon.
How can I have a successful crowdfunding campaign?
In order to have a successful crowdfunding campaign, you must rally people to support your project. If networking isn’t for you, then you probably won’t want to take on a crowdfunding campaign. Often, people hear stories of startup ventures accruing thousands of dollars via a crowdfunding campaign. It may sound like you can set up your campaign and come back a few weeks to see thousands of dollars waiting for you to spend on your business but this is not the case.
You’ll need to have an established presence and active following on social media. If you don’t have around 500-1,000 active followers (people who share, respond to and like your posts regularly) then your campaign most likely won’t take off. If you have an email list then you can tap into that, however, the chances of your campaign being financed via your email list alone is slim (unless your numbers of active readers are around 10,000). If you can encourage your email followers to share the link to your campaign then your chances of successfully financing your business via crowdfunding will be much higher.
If you think crowdfunding is an option for your business and you have the network capabilities, here are the 7 tips you must follow in order to have a successful crowdfunding campaign.
1. Solve a problem.
The easiest product to sell is one that people already need. If potential crowdfundees can see themselves using your product and it making their lives better, then they’ll be more likely to invest. This should also impact the way you present your product. Are you selling an air freshener that will make your house smell nice? Or are you selling an air freshener that will keep the smell of the baby’s changing room from invading the rest of your house? The latter is the more enticing because it actually solves a problem that people have.
2. Be ready for action.
Whatever it is that you’re trying to gain funding for should be so well researched that literally all you need to make it happen is the crowdfunding money. You should have detailed blueprints, a manufacturer picked out, materials researched, costs assessed and target customers determined. If you haven’t set a business forecast , you’ll need to do it before vying for crowdfunding.
3. Set a ticking clock.
Most crowdfunding communities and websites will require that you set a timeframe for how long it will take you to reach your funding goal. If you don’t reach your funding goal in that time frame, you receive none of the funds. It may sounds tempting to set your funding goal out to 6 months, but 30 days tends to be the most successful time frame. This creates a sense of urgency in supporters and shows that you’re confident in your project.
4. Blow past your expectations.
Set your financial goal for what you need, not what you want. This will help because, as mentioned above, if you don’t reach your goal then you won’t receive any of the funding, but also because if you blow past your goal it will create a snowball effect. If people see that your project has surpassed its funding goal by 200%, they’ll be more inclined to invest. People want to back a winner, and exceeding your funding goal is a clever way to get people to back you.
5. Offer awesome rewards.
You need to offer scaling rewards that entice people to fund you. The most popular pledge is for $25. Depending on the crowdfunding platform you choose, you can offer up different rewards and perks or even give perks to people who get others to donate to your campaign. At lower tiers of rewards something as simple as signed card may be enough. At highest level tier, you might want to consider a signed version of your product.
6. Network on a personal level.
Be prepared to make handling emails and social media responses your top priority when you kick off your crowdfunding campaign. Your absolute top priority is to make as many people as possible aware that your crowdfunding campaign is underway. Send out personal messages on social and in email. Make sure that friends who said they would get the word out are doing so. People are going to want to ask millions of questions and you’ll also want to be available to send a personal thank you to everyone who contributes to your campaign (whether that contribution is a financial donation or even just a link share).
7. Develop a great sales pitch.
Your sales pitch is everything. If you haven’t already created a vision statement for your product or business, you should do it before creating your pitch. Your best strategy for creating a winning sales pitch on a crowdfunding site is to review the top projects that received the most funding and emulate the elements of their pitch (videos, images, blueprints, diagrams). You’ll want to include a short, 2 minute video that explains who you are, what your product/business does, how you developed it, who supports it, what you’ll do with the funding, and of course, what you need the (funding).
When to launch your crowdfunding campaign?
The best time to launch to launch your crowdfunding campaign is closely after tax refunds are issued. This is the time when people have the most disposable income and are more willing to spend and donate. Launching in the middle of the month is also wise because that is when people will accrue the most money, but not be focused on end of month bill payments. The time of day, and the day that you start your campaign is also important. Whatever time you start your campaign (say, 11:30 PM) is the time that the campaign will end. Your campaign will also receive a lot of traction in its last few days. If you run a 30 day campaign (which is recommended) you will want the campaign to end on a Sunday night. This will give you the weekend to make sure you’re able to contact people. People will also have free time to sit at their computer and make the donation.
How can I protect my ideas before crowdfunding?
You should meet with a patent lawyer before taking to the internet with your business project or idea. If you do in fact have an idea for a new product or device, it’s wise to get some consulting on how to protect it. It may sound discouraging that you will need to chat with a lawyer before crowdfunding, but remember that crowdfunding is the absolute last step before production. You will need to speak with a patent lawyer to protect your intellectual capital before taking your product to a manufacturer anyways.
Should You Self Finance?
Self-financing your business could involve using funds from savings, your 401K or home-equity. There are many pros and cons to financing your business with your own savings and assets. Some of the pros are that you retain more control, keep all of the profits, and are less likely to create a “balloon budget.” The cons are that your business may progress slowly, you could lose valuable assets and savings, and you won’t be as connected as you would be if you sought other methods of funding. Here’s a more in-depth look at the pros and cons of using your own savings and assets to finance your business.
Con. It’s your loss.
If you finance your business with your own savings and assets, then whatever you lose is on you. If you were to work with an angel investor, however, you will not have to pay back the money they loan or invest in your business.
If your business requires very little funding to get off the ground (perhaps all you need is a website and a cool logo), then it’s a good idea to fund it yourself. If, however, the costs are such that you have to refinance your mortgage, or invest a large amount of savings or part of your 401K, then it may be a better idea to work with investors. Otherwise, years of savings could go down the drain.
Pro. You control your business’s destiny.
When you take on money from investors to finance your business, you will lose total freedom and control of your company’s direction. The investors want to make sure that their money is being put to good use; so they will keep an eye on operations and weigh in on future endeavors. They may also insist that you create a Board of Directors which could turn your business into a more democratic decision making machine.
If you finance the business on your own, you will answer to only yourself when it comes time to make decisions. This can be helpful if you plan to have a very innovative business. If you plan to create a company that sells services and goods in a way that has never been done before, a group of investors that you have to constantly convince and persuade can slow down your progress. It could even result in you not being able to achieve your dream company. You may achieve profitability with a standard business model, and hope to move into a very innovative new business structure, but your investors may nix the idea because they are happy with simply being profitable.
Con. You are slow to gain momentum.
Some businesses require a great amount of up front funding because their industry is so fast paced. This means that shoring up the money through personal savings and then producing your product or service would take so long that your idea will be stale by the time it reaches the market. Mobile App Development is a good example of this. The industry moves so quickly that, if you have an idea which requires a great amount of money, saving a nest egg from your paycheck could take a year and by that time your idea may be old news.
If you get a loan, or work with investors, you’ll be given thousands (maybe even millions) of dollars up front. With that amount of money, you can begin building your prototype, hiring developers or employees and maybe even taking time off of work (or quitting) and dedicating yourself 100% to your business.
Pro. You avoid building on a budget bubble.
Having thousands (or millions) of dollars coming in from investors can feel like hitting the lottery. And just like hitting the lottery, the increase in budget could hit you back. Suddenly having a surge of money can cause people to lose sight of their budget, and their priorities. It’s not uncommon for businesses to receive a surge from investors and then create an operation with a ballooning budget that can’t be sustained. Or, spending money on non-essentials like an espresso bar in your IT office.
While growing a business organically can take time, it is difficult for an organically grown business’s budget to outgrow its revenue. If the money being spent on your business is your own, you’ll be more likely to spend it wisely. You’ll also be more likely to only spend the money on what is most necessary to your business.
Con. Investors might walk away if it’s your first rodeo.
It can be a good idea to get a small amount of money from investors in the initial stages of your business. This funding would be for a miniscule amount, something you can pay back easily. The reason for doing this is because further down the road you may need a huge loan or lots of funding from investors.
If you’ve never worked with investors, you will look inexperienced and the investors may not be interested in helping you out. If they do, it may not be for the amount that you need. They may only give you a small bit of funding, just to see if you can repay the money. Having to prove yourself later in the game, when you really need a larger amount of money, could slow down your business and make you miss out on being an innovator when you’re ready to make a move.
Pro. You get it all.
One of the biggest benefits of self-financing is that the profits are yours to keep. If you work with an angel investor, you should expect share at least 20% of your business. Depending on the potential for your business’s growth and success, the number of investors, and the number of sources of funding that you are receiving, that percentage could go up quickly.
If there’s no way to get your business off the ground without investors, then keeping only 40% of a successful business may be worth more than not having the business at all. Depending on the level of success, keeping even 15% can be a huge reward. One thing you need to consider though, is how much money you will be left with at the end of the year, and the years to come until your retire, and if that amount of money is worth the massive endeavor of starting and running a business?
Con. You don’t network.
A group of investors who are backing you offers up more than just money. Most investors have a large network of people with diverse skills and experiences. When they invest in your business, they invest in its success. They will happily get you connected with anyone they can to assist in your business. This could mean consultants, developers, accountants, or any person who may be able to assist in your success. When you finance your own business, you miss out on this sudden increase in networking capabilities. It’s not to say that you won’t make your own network; it’s just that it may take a lot longer to do so.
How to Self-Finance Your Business
There are three main ways to self-finance a business. You can use cash savings, borrow from your 401K or use home equity. All three involve different levels or risk and experience in handling money. Here is a closer look at how you could use each of these three strategies to self-finance your business.
How to Use Cash Savings to Finance Your Business
Using cash savings can be one of the simplest ways to finance your business. You have total control over your cash and if your business turns out to be a loss, you lose the money, but aren’t required to pay interest on your losses like you would with a loan. The downside, of course is that you’re out of some savings.
The first step is to determine how much your costs will be in order to achieve profitability. Now, take the costs needed to achieve profitability and determine how long it will take for you to recover from that loss based on your previous, or current job’s salary. If it takes longer than three years for you to recover from the loss, you may not want to use cash savings to finance your business.
If you have been saving money for the specific purpose of starting your business, then determine how long it will take for you to achieve profitability. Multiple that timeframe by 2.5. Now, take that new, multiplied time frame, and assess whether you have enough in savings to run your business for that amount of time without seeing any profit. If you can’t run your business off of the allotted savings for the multiplied timeframe, then you don’t have enough savings.
If you determine that you could recover from the loss, and wish to go ahead using your savings to finance the business, you’re going to want to set up a separate checking and credit card account for your business expenses. Assess your expected costs at the start of every month and put that money from your personal savings into your business checking. It’s understandable that you’re going to require more money than you anticipated on a month to month basis, but by forcing yourself to withdraw from savings and put into checking you’re more likely to keep your spending under control.
How to Use Your 401K to Finance Your Business
It’s risky to tap into your 401K to finance your business. One way that you can do it is by starting your new business as a C Corporation with no issued stock. Then create a retirement plan and roll over the 401K from your previous employer into the one you created at your new business. Now use the money to buy shares in your business.
You can also take out a loan from your 401K. Most limits are set so that you can’t take out more than 50% of your account value. In some cases, though, you can take out 100% of your account if it contains less than $10,000. Your employer will have an interest rate set, so you’ll have to contact the employer or your accountant to find that out. From there, most 401K loans need to be repaid within 5 years.
This is a complex method of financing and it isn’t recommended for people who don’t have a firm grasp on financing, bookkeeping and building businesses. If this is your first business, it’s strongly recommended that you avoid this method.
How to Use Home-Equity to Finance Your Business
You can use the equity in your home to finance your business (or other projects) in a similar way that you would take out a loan or use a credit card. With home-equity, you have two options: to take out a home-equity loan or to open a home-equity line of credit.
With the home-equity loan, you’ll be given a lump sum of money that you must pay back by a certain date. The interest rates on a home equity loan are usually higher than they are on a mortgage, but lower than credit cards and other types of loans. The challenge with taking out a home-equity loan is that you must know exactly how much money you need. If you come up short on your estimate, you may not have enough money to get your business off the ground. Equally, if you take out too much, you will have to repay the interest on an unnecessarily larger loan. Home-equity loans are almost always offered at a fixed interest rate, so calculating how much you will need to repay the loan is less complex.
By opening up a home-equity line of credit (HELOC), you are essentially using your home equity as a credit card. You can borrow the money as you need, but you will pay a higher, variable interest rate. Opening a HELOC can be beneficial if you aren’t sure what amount of funding you will need, or if you are using the HELOC to finance an ongoing operation until your business turns a profit. For example, you might consider using a HELOC to help pay your business’s rent and utilities until you start to see profits coming in.
What is an Angel Investor?
Angel investors are individuals who invest in startup businesses using their own money and are often affluent and have executive experience. They tend to work with businesses that are just starting out, sometimes in the incubation stages, and offer much smaller amounts of funding than venture capitalists do. In addition to financial support, they often provide experienced advice and network connections.
Angel Investors face a great risk when it comes to choosing companies to work with. Few companies become successful enough for an angel investor to see 5 times the return of his or her investment within 5 years. Often, though, angel investors work with small startups as a way to stay relevant to a growing industry, help usher in a new generation of entrepreneurs, share knowledge and help business owners who are just starting out.
Most small business owners who seek investors will end up working with angels. The standard amount of money that business owners receive from angel investors is between $10,000 and $25,000. If you do end up getting an angel investor to work with you, this funding will usually cover the first “round.” A timeframe will be given, and at the next round, angels may help you acquire more funding, or they may personally invest more in your business.
For example, a group of angel investors may put $15,000 towards your new coffee shop business in the first round of investing. They then determine a timeframe. After that timeframe is reached, the angels will assess how far you’ve come, if you’ve hit your goals and whether or not they want to invest further. If you have plans for opening another coffee shop, or even starting a franchise, the angels may then help you work with Venture Capitalists. The venture capitalists tend to provide more money which comes from a collective pool from outside sources.
Aside from the financial benefit of working with an Angel Investor, you’ll have access to a large network of experts. Most angel investors work in groups and are well connected after years of executive work and investing. An angel investor may be a good option for you if you’re an expert in your field, but have little business experience.
For example, if you’re a coffee aficionado, but have little business experience, the angel investors may help connect you with a good accountant, a consultant who can offer advice on how to manage employees and operate you company, and an advertising expert who can help get the word out about your business. These are business elements that you will need in order to be successful, but to find these skills and resources could take a lifetime.
How to Get an Angel Investor to Fund Your Business
The preparation needed when soliciting to angel investors is not much different than what you need for crowdsourcing. You have to provide solid information that can substantiate the reasons why your business will be successful. You should have the following information ready to present to an angel investor:
- A vision plan, mission statement and elevator pitch
- Evidence of outside interested (pre-orders, blog following, customers)
- An assessment of the market your business will operate in
- A well described list of what you need to get your business off the ground
- Clear examples of how you are an expert in your field as well as the experience levels of your teammates
If it’s possible, you will want to have a prototype or working model ready. You can get creative with this. For example, if you are trying to get funding for a coffee business, you can send the investors small samples of your coffee beans along with a professionally designed infographic explaining how to brew it.
Or, if you’re trying to start an exercise video subscription service, you could provide the investors with a brief video demonstrating several exercises that the investors may find helpful. By offering up samples such as these, you can show the investors that you have a product or service that is valuable and that you are passionate about what you do. Remember, people often become angel investors because they like to help others who are passionate and motivated.
Your initial communication with the investor will either be a handshake and personal introduction (this is the best kind) or via an email. If you are going to email an angel investor, you will want to start off by saying how you came across their contact information. Next, you will want to provide a short list of what your business does, the problems it solves and any proof of market. After that, provide information showing how you are an expert in your field. You should attach your executive summary in the email.
It’s worth mentioning that angel investors often prefer to work with businesses that are in a close geographic location to them. This could be for several reasons, one being that angels are interested in generating business to help improve their community. When talking with an angel investor, it’s helpful to mention the impact your business could have on the surrounding area.
If possible, include information such as:
- How many local jobs will your business create?
- Could it help bolster business in a dwindling location?
- Would you be making use of a vacant building or purchasing resources from a local source?
The other reason that angel investors want to work with businesses that are in their geographic location is because they often intend to have a hands on relationship with the company. The angel will want to meet regularly – weekly at first and then monthly. So it’s helpful to look for investment groups in your area.
When it comes to finding angel investors there are two routes: a personal connection and introduction, or by researching and reaching out on your own. If you have a connection, you can always ask to be introduced at a social gathering, or to have an introduction made via email. From here, you will want to present all the information that you normally would (mentioned above) to the angel investor.
How to Find Angel Investors
If you have no personal connections to angel investors, you can find angel investing groups. These groups consist of multiple investors who often hire managers to sort through potential investment opportunities. The managers will weed out investment opportunities that seem weak, risky or out of line with the standard businesses that the angel investment group typically works with. You will most likely go through one of these managers if you reach out to an angel investor that you do not know.
Angel investment groups will also put on events where they can meet potential business owners. These events usually have an admission fee or require some sort of acceptance based on your business idea. Here, you can network with other business owners and the angel investors. It’s good to have your elevator pitch ready but you should also ask ahead about what materials you can bring to the event. You should definitely have design blueprints, branding and marketing materials, or videos of product demos on your phone.
What Business Organizational Structure do Angel Investors Work With?
It’s difficult to work out investments with a sole proprietorship because the owner is technically entitled to the entire business. If you’re going to seek angel investors, be sure to establish your business as an LLC or Corporation . This will allow you to distribute shares and divvy up ownership.
Should You Finance Your Small Business Through a Credit Union?
After the recession of 2008, credit unions began to increase the amount of lending they gave to small businesses. Credit unions differ from banks because they are owned by their members, whereas banks are owned by stockholders. Because credit unions are non-profit, members see higher interest rates on the money they put into savings (that’s a good thing). Also, loans are given out with much lower interest rates.
Some of the disadvantages of credit unions are that they offer few options in regards to types of checking and savings accounts and credit cards. There are also fewer locations, unlike well-known banks that have multiple branch locations within a town. Additionally, the popularity of credit unions is relatively new in comparison to traditional banks. As the economy recovers, and the government works with traditional banks, the popularity of credit unions may change.
Credit Unions require some form of membership and acceptance. Acceptance can sometimes be based on something as simple as being a resident of a certain geographic location or having a certain occupation (teacher’s credit union). If you’re interested in joining a credit union to get a loan, you need to start by searching for credit unions in your area. From there, you need to find one that you can apply for. Remember that some credit unions will accept people who are immediate family of potential members.
So, if your parent is a teacher, then you may be able to apply to that credit union.