A lack of capital is one of the leading reasons why small businesses fail, according to the Small Business Administration. Many first-time entrepreneurs have no idea how to raise capital because they have never had to do so before. Initially, small business owners typically bootstrap the first three to six months of their business, which keeps the overhead low to nonexistent. After this initial period, however, most startups will need a serious capital investment in order to truly scale up their business venture.
Since not every startup can land a coveted spot on ABC’s Shark Tank, there comes a time when a business needs to tap other sources for startup financing. In general, small business funding depends on your business model. Small business loans, angel investors and venture capitalist firms are the three primary sources for startup financing. However, some startups are increasingly turning to alternative crowdsourcing methods, such as Kickstarter and Indiegogo.
Wondering which funding method is right for your small business? Whether you’re considering securing a small business loan or crowdsource the cost of your product demo, this guide will help you better understand your different options for raising small business capital.
Small Business Investment Options
Small Business Loans
What they are:
Small business loans may come from community banks or private lenders. If your startup is a community-based business, it may also qualify for special loan opportunities from the Small Business Administration (SBA). Small business loans, also known as debt financing, works best for startups that are high asset and high inventory businesses, such as businesses in the retail, distribution or manufacturing sectors. If your business is idea or service based, it will do better securing funds from an angel investor or venture capitalist.
How to obtain a small business bank loan:
If your business needs a bank loan, start by creating a list of banks that would be willing to lend to your business. In many cases, you may have greater success with an entrepreneurial-friendly regional bank than a corporate bank. Large banks typically offer cookie-cutter financing options, which may or may not meet your businesses’ needs. A regional bank, however, is more hands-on and willing to customize loans to meet your needs. Before approaching a bank, be sure that it is in a position to lend. Check FDIC.gov to see if the bank is under a consent order, which indicates extra regulatory supervision and restricted lending ability. Most banks will need to see a current balance sheet, a profit-and-loss statement, and a detailed budget for the next 24 months. However, even with positive cash flow, be prepared for the possibility that the bank may turn you down.
How to get a loan from the Small Business Administration:
The Small Business Administration (SBA) works with banks to guarantee loans that a bank would not otherwise make. While the SBA does not directly loan the money, the SBA will guarantee between 50 to 90 percent of a loan, usually up to $2 million. The SBA offers a variety of loan programs, including microloans, 504 loans and 7(a) loans. If a bank will not loan you money under one of their business loan programs, check to see if you are eligible for an SBA-backed loan. Contact your SBA district office; the office can connect you with SBA loan intermediaries in your state.
Venture Capitalists (VCs)
Who they are:
Venture capitalists (VCs) are professional investors that invest in high-growth, high-profitability startups, such as technology startups. VCs typically aim for a ten-fold return on their investment. VCs also take partial control over the company, such as a board seat, and will expect to provide significant strategic guidance to protect the integrity of their investment.
Why choose VCs:
VCs are major movers and shakers that invest for a living, and they expect your business to deliver some serious results. If you need a serious capital injection, then VCs are the way to go. They may invest up to $5 million in early stage ventures, and as much as $10 million in future investment rounds. However, since VCs expect a serious return on their investment, this is usually only possible if your business is going to IPO within five to seven years. Additionally, you need to be emotionally okay with relinquishing total control over your business.
Who they are:
Angel investors are high net-worth individuals who invest in entrepreneurial companies. In 2008, angel investors contributed $19.2 billion to 55,480 startups, according to the University of New Hampshire’s Center for Venture Research. Angel investors typically invest less than $100,000, with some seed round investments as low as $20,000 to $35,000. While this amount is much less than a VC firm, this lower investment also means that you will retain greater control over your business. Angel investors typically have other jobs and investment commitments; while some may want a seat on your boar of advisors, they will not micromanage daily aspects of your business.
Why choose angel investors:
Angel investors are a good resource for startup owners who have invested their personal funding resources (personal credit lines, loans from friend and family) and still need a major capital injection – but may not be ready to share company control or ownership with a VC firm.
Crowdfunding or Crowdsourcing
What it is:
In the aftermath of the economic recession, most banks stopped lending to small startups altogether. A business needed substantial collateral in order to receive a loan; unfortunately, most startups lacked this collateral. Additionally, many startups only needed a small amount of capital – such as several thousand dollars – in order to create a product demo. Crowdfunding lets thousands of people make a small investment (some times as little as $5) in your business in order to create a product demo or fund a small expansion. Investors receive a small “thank you” in return, such as a sample product, which matches their level of “investment”.
Why choose crowdfunding:
Crowdfunding can be very beneficial for small, community-based startups, especially you need immediate working capital to create a product demo or purchase inventory or supplies. Popular crowdfunding sites include KickStarter, IndieGoGo (creative projects), GoGetFunding, CrowdFunder, Appbackr (mobile app funding), and Fundable. There are many crowdfunding sites out there and most of them focus on certain niches or project types.
Alternative Small Business Funding Sources
What it is:
Seeing the need for something different and innovative in the small business loan market, there have been more and more companies offering “alternative” funding options for small businesses. Instead of using traditional banking guidelines to lend money, these alternative lenders have leveraged technology to bring a fresh approach to the way small businesses borrow. For example, an alternative lender might base their approval decision on a business’ customer base and cash flow, as opposed to strictly relying on personal credit scores. Also, while the big banks might require heavy paperwork (taxes / business operations) and collateral for a long-drawn out application process, an alternative lender may be able to provide you with a loan through a quick process that is paperless and no collateral required.
Why choose an alternative small business loan:
Many small businesses in this economy are faced with less than perfect credit and a lack of funding. Where big banks have failed to deliver on small business financing, these alternative lenders have made great strides to cater to the small business community. Companies like Kabbage, CAN Capital, and SnapCap are three of many up and coming alternative lenders. And if you want access to more lenders, there are loan matching services like Lendio and FundingCircle that specialize in small business lending.
Next Steps: Pitching to Investors
Deciding how to fund your small business is no easy task – and neither is pitching your potential investors. Whether you are pitching a bank loan officer or a panel of angel investors, delivering a clear, concise presentation is essential to your pitch’s success. Be prepared for rejection; your business may not be the right fit for an investors needs. Don’t let that deter your from continuing to seek funds for your business. When making your pitch, balance enthusiasm with realism, include the right information, and demonstrate financial responsibility. With a little practice and persistence, you’ll nail the pitch and land the funding you need to take your business to the next level.
Check out our Business Credit & Loans section for more financing options.