Small businesses are a dream of thousands of Americans. According to the latest data from the Small Business Administration (SBA), 234,000 businesses were started during the second quarter of 2015.
All these businesses had one thing in common: they needed money to get started (learn more about how much money you need to start a business). In order for a small business to succeed and last, it is crucial to raise enough capital.
In this article, we’ll cover the following ways to get money for a small business:
- Personal savings
- Running an overdraft
- Taking on a term loan
- Going with a loan guarantee
- Grabbing some cash locally
- Uniting with a credit union
- Borrowing from family and friends
- Business angels
- Venture capital
- Corporate venturing
- Getting a grant
- Winning money
Best Ways To Get Money To Start A Business
1. Personal savings
Obviously, the first place to start looking for money to finance your business is in your own pockets. You may not have much in ready cash, but you may have assets that you can turn into cash or use to support borrowing.
Start by totalling your assets and liabilities. The chances are that your most valuable assets are your house, your car and any life assurance or pension policies you may have. Your liabilities are the debts you owe.
The difference between your assets and your liabilities, assuming that you have more of the former than the latter, is your net worth. That, in effect, is the maximum security you can offer anyone outside the business from whom you want to raise money. The big questions are, what is your appetite for risk and how certain are you that your business will be successful?
The more of your own money you can put into your business at the outset, the more you’re truly running your own business in your own way. The more outside money you have to raise, the more power and perhaps value you have to share with others.
Now you have a simple piece of arithmetic to do. How much money do you need to finance your business start-up, as shown in your worst-case scenario cash-flow forecast? How much of your own money are you willing and able to put into your business?
The difference is the sum you’re looking to outside financiers to back you with. If that sum is more than your net worth, then you’re looking for investors. If it’s less, then bankers may be the right people to approach.
If you do have free cash or assets that you could but won’t put into your business, then you should ask yourself whether the proposition is worth pursuing. You can be absolutely certain that any outsider you approach for money will ask you to put up or shut up.
Another factor to consider in reviewing your own finances is your ongoing expenses. You have to live while getting your business up and running. So food, heat and a roof over your head are essential expenses.
But perhaps a two-week long-haul summer holiday, a second car, and membership of a health club aren’t essentials – great while you were a hired hand and had a salary cheque each month, but an expendable luxury when you’re working for yourself.
2. Running an overdraft
The principal form of short-term bank funding is an overdraft. An overdraft is a permission for you to use some of the bank’s money when you don’t have enough of your own. The permission is usually agreed annually, but can be withdrawn at any time.
A little over a quarter of all bank finance for small firms is in the form of an overdraft. The overdraft was originally designed to cover the time between having to pay for raw materials to manufacture finished goods and selling those goods.
The size of an overdraft is usually limited to a modest proportion of the amount of money that your customers owe you and the value of the stock of your finished goods. The bank sees those items as assets, which in the last resort it can use to get its money back.
Starting out in a cleaning business, for example, you need sufficient funds initially to buy the mop and bucket. Three months into the contract you’ve paid for these and so getting a five-year bank loan to cover this expenditure is pointless, because within a year you’ll have cash in the bank. However, if your overdraft doesn’t get out of the red at any stage during the year, you need to re-examine your financing.
All too often companies utilise an overdraft to acquire long-term assets, and that overdraft never seems to disappear, eventually constraining the business. The attraction of overdrafts is that they’re very easy to arrange, except in the most unusual of circumstances such as during a global credit crunch. Also they take little time to set up.
But their inherent weakness is that the keywords in the arrangement document are ‘repayable on demand’, which leaves the bank free to make and change the rules as it sees fit. (This term is under review and some banks may remove the term from the arrangement.) With other forms of borrowing, as long as you stick to the terms and conditions, the loan is yours for the duration; not so with overdrafts.
3. Taking on a term loan
If you’re starting up a manufacturing business, you’ll be buying machinery to last probably five years, designing your logo and buying stationery, paying the deposit on leasehold premises, buying a vehicle, and investing funds in winning a long-term contract.
Because you expect the profits on this to flow over a number of years, they need to be financed over a similarly long period, either through a bank loan or by inviting someone to invest in shares in the company – in other words, a long-term commitment.
Term loans, as these long-term borrowings are generally known, are funds provided by a bank for a number of years. The interest can be either variable – changing with general interest rates – or fixed for a number of years ahead. In some cases, you may be able to move between having a fixed interest rate and a variable one at certain intervals.
You may even be able to have a moratorium (break) on interest payments for a short period, to give the business some breathing space.
Provided that you meet the conditions of the loan in such matters as repayment, interest, and security cover, the money is available for the period of the loan. Unlike having an overdraft, the bank can’t pull the rug from under you if your circumstances (or the local manager) change.
Learn more about how to get a business loan.
4. Going with a loan guarantee
Banks operate loan guarantees at the instigation of governments in the UK, and in Australia, the US, and elsewhere. These schemes guarantee loans from banks and other financial institutions for small businesses with viable business proposals that have tried and failed to obtain a conventional loan because of a lack of security.
Currently called the Enterprise Finance Guarantee Scheme, these government-backed loans are available for periods between two and ten years on sums from £5,000 to £2.5 million. The government guarantees 70–90 percent of the loan.
In return for the guarantee, the borrower pays a premium of 1–2 percent per year on the outstanding amount of the loan. The commercial aspects of the loan are matters between the borrower and the lender.
5. Grabbing some cash locally
Many communities, particularly those operating in rundown areas in need of regeneration, have a facility to lend or even invest in businesses that could bring employment to the area. The nearby sidebar ‘Destination London offers one such example.
Funding from these sources could be for anything from start-up, right through to expansion or in some cases even rescue finance to help prevent a business from folding, shedding a large number of jobs or relocating to a more benign business environment.
6. Uniting with a credit union
If you don’t like the terms on offer from the high-street banks, as the major banks are often known, you may consider forming your own bank.
The idea isn’t as crazy as it sounds. Credit unions formed by groups of small businesspeople, both in business and aspiring to start up, have been around for decades in the UK, US and elsewhere.
They’re an attractive option for people on low incomes, and provide a cheap and convenient alternative to banks. Some self-employed people such as taxi drivers have also formed credit unions. They can then apply for loans to meet unexpected capital expenditure either for repairs, refurbishments or technical upgrading.
Established credit unions usually require you to have a particular trade, have paid money in for a number of months or years and have a maximum loan amount limited to the types of assets people in their trade are likely to need.
Credit union usage in the UK has more than doubled in the past five years. Some 40, 258 Credit unions operate in 79 countries, enabling 118 million members to access affordable financial services. The Association of British Credit Unions (www.abcul.org) offers information and a directory of providers.
7. Borrowing from family and friends
Those close to you are often willing to lend you money or invest in your business. This helps you avoid the problem of pleading your case to outsiders and enduring extra paperwork and bureaucratic delays.
Help from friends, relatives and business associates can be especially valuable if you’ve been through bankruptcy or had other credit problems that make borrowing from a commercial lender difficult or impossible.
Involving friends and family in your business brings a range of extra potential benefits – but also costs and risks that aren’t a feature of most other types of finance. You need to decide whether these are acceptable.
Some advantages of borrowing money from people you know well are that they may charge you a lower interest rate, you may be able to delay paying back money until you’re more established and you may have more flexibility if you get into a jam.
But after you agree to the loan terms, you have the same legal obligations as with a bank or any other source of finance. Borrowing money from relatives and friends can have a major disadvantage. If your business does poorly and those close to you end up losing money, you may damage your personal relationships.
So in dealing with friends, relatives and business associates be careful to establish clearly the terms of the deal and put them in writing, and also to make an extra effort to explain the risks. In short, your job is to make sure that your helpful friend or relative doesn’t suffer true hardship if you’re unable to meet your financial commitments.
When raising money from family and friends, follow these guidelines.
- Do agree proper terms for the loan or investment.
- Do put the agreement in writing and if it involves a limited partnership, share transaction or guarantee, have a legal agreement drawn up.
- Do make an extra effort to explain the risks of the business and the possible downside implications to their money.
- Do make sure when raising money from parents that other siblings are compensated in some way, perhaps via a will.
- Do make sure you want to run a family business before raising money from them. It’s not the same as running your own business.
- Don’t borrow from people on fixed incomes.
- Don’t borrow from people who can’t afford to lose their investment.
- Don’t make the possible rewards sound more attractive than you would, say, to a bank.
- Don’t offer jobs in your business to anyone providing money unless the person is best for the job.
- Don’t change the normal pattern of social contact with family and friends after they’ve put up the money.
8. Business angels
One source of equity or risk capital is private individuals, with their own funds and perhaps some knowledge of your type of business, who are willing to invest in your company in return for a share in the business.
Such investors have been christened business angels, a term first coined to describe private wealthy individuals who backed theatrical productions, usually a play on Broadway or in London’s West End.
By their very nature such investments are highly speculative in nature. The angel typically has a personal interest in the venture and may want to play some role in the company – often an angel is determined to have some involvement beyond merely signing a cheque.
Business angels are informal suppliers of risk capital to new and growing businesses, often taking a hand at a stage when no one else is prepared to take the chance; a sort of investor of last resort. But although they often lose their shirts, business angels sometimes make serious money.
The angel who backed software company Sage with £10,000 in its first round of £250,000 financing saw his stake rise to £40 million, and Ian McGlinn, the former garage owner who advanced Anita Roddick the £4,000 she needed to open a second shop in return for about 25 per cent of her company’s shares, eventually wound up with a couple of hundred million pounds from his stake in The Body Shop.
In the UK and the US hundreds of networks operate with tens of thousands of business angels who are prepared to put several billion pounds each year into new or small businesses. One estimate is that the UK has approximately 18,000 business angels and that they annually invest in the region of £500 million.
Two organizations that can put you in contact with a business angel are:
- UK Business Angels Association
- Angel Investment Network, which operates a service matching entrepreneurs to angels. Their website also has a number of useful tools to help you get investor ready.
Alternatively, you could apply to appear on the BBC’s business reality show Dragon’s Den and put your proposition face to face with 5 angels and 5 million television viewers.
9. Venture capital
Venture capital is a means of financing the start-up, development, expansion, or purchase of a company. The venture capitalist acquires a share of the company in return for providing the requisite funding. Venture capital firms often work in conjunction with other providers of finance in putting together a total funding package for a business.
Venture capital providers invest other people’s money, often from pension funds. They’re likely to be interested in investing a large sum of money for a large stake in a company. Venture capital is a medium- to long-term investment of not just money but of time and effort.
The venture capital firm’s aim is to enable growth companies to develop into the major businesses of tomorrow. Before investing, a venture capital provider goes through due diligence, a process that involves a thorough examination of both the business and its owners. Accountants and lawyers subject you and your business plan to detailed scrutiny.
You and your directors are required to warrant that you’ve provided all relevant information, under pain of financial penalties. In general venture capitalists expect their investment to pay off within seven years. But they’re hardened realists.
Two in every ten investments they make are total write-offs, and six perform averagely well at best. So the one star in every ten investments they make has to cover a lot of duds. Venture capitalists have a target rate of return of 30 percent plus, to cover this poor success rate. Raising venture capital isn’t a cheap option.
The arrangement costs almost always run to six figures. The cost of the due diligence process is borne by the firm raising the money, but is paid out of the money raised, if that’s any consolation. Raising venture capital isn’t quick either. Six months isn’t unusual and over a year has been known.
Every venture capitalise has a deal done in six weeks in their portfolio, but that truly is the exception. Venture capital providers want to exit from their investment at some stage. Their preferred route is via a public offering, taking your company onto the stock market, but a trade sale to another, usually larger, business in a related line of work is more usual.
New venture capital funds are coming on stream all the time and they too are looking for a gap in the market.
The British Venture Capital Association (www.bvca.co.uk) and the European Venture Capital Association (www.evca.com) both have online directories giving details of hundreds of venture capital providers. VFinance (www.vfinance.com), a global financial services company specialising in high-growth opportunities, has a directory of 1,541 venture capital firms and over 23,000 business angels. Its website also contains a useful business plan template.
10. Corporate venturing
Alongside the venture capital firms are 200 or so other businesses that have a hand in the risk capital business, without it necessarily being their main line of business. For the most part these are firms with an interest in the Internet or high technology that want an inside track to new developments.
Their own research and development operations have slowed down and become less and less entrepreneurial as they’ve grown bigger. So they need to look outside for new inspiration. Even successful firms invest hundreds of millions of dollars each year in scores of other small businesses.
Sometimes, if the company looks a particularly good fit, they buy the whole business. Apple, for example, while keeping its management team focused on the core business, has a $12 million stake in Akamai Technologies, whose software tries to keep the web running smoothly even under unusual traffic demands.
Not only high-tech firms go in for corporate venturing. Any firm whose arteries are hardening a bit is on the look-out for new blood. McDonald’s, for example – hardly a business in the forefront of the technological revolution – has stakes in over a dozen ventures.
It once had a 35 percent stake in Pret a Manger, but when it decided that the Pret model didn’t fit well with the McDonald’s business it offloaded its stake to Bridgepoint for £345 million – four times its initial stake; a good result for both parties.
11. Getting a grant
Unlike debt, which you have to repay, or equity, which has to earn a return for the investors, grants and awards from the government or the European Union are often not refundable. So, although they’re frequently hard to get, grants can be particularly valuable.
Almost every country has incentives to encourage entrepreneurs to invest in particular locations or industries. The US, for example, has an allowance of Green Cards (work and residence permits) for up to several hundred immigrants each year who are prepared to put up sufficient funds to start up a substantial business in the country.
In the UK, if you’re involved in the development of a new technology you may be eligible for a grant for research and development. Under the scheme you can claim 60 percent of eligible project costs up to a maximum grant of £75,000 on research projects; 35 percent of costs up to £200,000 on development projects; 35 percent of costs up to £500,000 on exceptional development projects; and 50 percent of costs up to a maximum grant of £20,000 on micro-projects.
The most obvious is the direct (cash) grant, but other forms of assistance are also available including free or subsidised consultancy, which could help you with market research, staff development or identifying business opportunities, or with access to valuable resources such as research facilities.
Grants often come with strings attached including you needing to locate in a specific area, take on employees or find matching funding from another source.
Though several grant schemes operate across the whole of the UK and are available to all businesses that satisfy the outline criteria, myriad schemes exist that are administered locally.
Thus the location of your business can be absolutely crucial, and funding may strongly depend on the area into which you intend to grow or develop. Additionally, extra grants may well be available to a business investing in an area of social deprivation, particularly if it involves sustainable job creation.
Keep yourself informed about which grants are available. Grants are constantly being introduced and withdrawn, but no system lets you know about them automatically.
12. Winning money
If you enjoy publicity and like a challenge then you can lookout for a business competition to enter. Like government grants, business competitions are ubiquitous and, like national lotteries, they’re something of a hit-or-miss affair.
But one thing is certain: if you don’t enter you can’t win. More than 100 annual awards take place in the UK alone, aimed at new or small businesses, and are mostly sponsored by banks, major accountancy bodies, chambers of commerce, local or national newspapers, business magazines and the trade press.
Government departments may also have competitions for promoting their initiatives for exporting, innovation, job creation and so forth. The nature and amount of the awards change from year to year, as do the sponsors.
But looking in the national and local press, particularly the small business sections of The Times, Daily Telegraph, Daily Mail and The Guardian, and on the Internet, should put you in touch with a competition organiser. Money awards constitute 40 per cent of the main competition prizes. For the most part, these cash sums are less than £5,000. However, a few do exceed £10,000 and one British award is for £50,000.
Deciding between debt capital and equity capital
At one end of the financing spectrum lie shareholders – either individual business angels who put their own money into a business, or corporate organisations such as venture capital providers (also known as venture capitalists or VCs), who provide equity capital that buys a stake in a business. These investors share all the risks and vagaries of the business alongside you and expect a proportionate share in the rewards if things go well.
They’re less concerned with a stream of dividends – which is just as well because few small companies ever pay them – and instead hope for a radical increase in the value of their investment. They expect to realise this value from other investors who want to take their place for the next stage in the firm’s growth, rather than from any repayment by the founder.
Investors in new or small businesses don’t look for the security of buildings or other assets to underpin their investment.
Rather, they look to the founder’s vision and the core management team’s ability to deliver results. At the other end of the financing spectrum are debt financiers – banks that try hard to take no risk and expect some return on their money irrespective of your business’s performance.
They want interest payments on money lent, usually from day one. They too hope that the management is competent, but they’re more interested in making sure that either you or the business has some type of asset such as a house that they can grab if things go wrong.
At the end of the day, and that day can be sooner than the borrower expects, a bank wants all its money back, with interest. Think of bankers as people who help you turn part of an illiquid asset such as property into a more liquid asset such as cash – for a price.
Understanding the differences between lenders, who provide debt capital, and investors, who provide equity or share capital, is central to a sound grasp of financial management.
In between the extremes of shareholders and the banks lie a myriad of other financing vehicles, which have a mixture of lending or investing criteria. You need to keep your business finances under constant review, choosing the most appropriate mix of funds for the risks you plan to take and the economic climate ahead.
The more risky and volatile the road ahead, the more likely taking a higher proportion of equity capital is to be appropriate. In times of stability and low interest, higher borrowings may be more acceptable. As a rule of thumb, you should use debt and equity in equal amounts to finance a business. If the road ahead looks more risky than usual, go for £2 of equity to every £1 of debt.
If your business sector is viewed as very risky, and perhaps the most reliable measure of that risk is the proportion of firms that go bust, then financing the business almost exclusively with borrowings is tantamount to gambling.
Debt has to be serviced whatever your business performance, so in any risky, volatile marketplace, you stand a good chance of being caught out one day. If your business risks are low, profits are probably relatively low too.
High profits and low risks always attract a flood of competitors, reducing your profits to levels that ultimately reflect the riskiness of your business sector. Because venture capitalists and shareholders generally look for better returns than they can get by lending the money, they’ll be disappointed in an investment in a low-risk, low-return business.
So if they’re wise they don’t get involved in the first place, or if they do they don’t put any more money in later.