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Virtually all types of business funding fall into one of two categories: debt financing or equity financing. Debt financing refers to the borrowing of money with the expectation of repaying the principal amount and any interest under specified terms. Equity financing, on the other hand, does not come with the expectation of repayment, but rather grants the investor equity in the business. Equity financing refers to the exchange of money for an agreed upon percentage of ownership (and on occasion voting rights) in a company.
There are many types of debt financing options that you can choose from, including: term loans, lines of credit and credit cards. Term loans are monetary loans that are usually disbursed in one lump sum and repaid in regular payments over a set period of time. Lines of credit and credit cards are two types of revolving credit accounts that allow money to be used at the borrower’s discretion, where interest only accrues on the money actually used.
Term loans are generally best suited for long-term investments (e.g., buying a building), whereas lines of credit are best suited for short-term financing needs (e.g., seasonal expenses) and credit cards are best suited for smaller business purchases (e.g., new computer). Several different types of institutions offer these financing options, including: commercial banks, the SBA and alternative lenders.
Debt financing options from commercial banks are the toughest option to secure. Commercial banks often have longer processing times (approximately 1-2 months) and scrutinize applications more closely than other debt financing options. Your business will usually have to have been operating for at least two years and be financially stable (demonstrated profitability and/or positive net worth). Most commercial banks will also require that you have an excellent credit score and credit history.
Many entrepreneurs, however, prefer debt financing options from commercial banks because of their relatively low rates, large lending amounts and longer repayment periods. Aside from commercial banks, many local credit unions also offer debt financing options with competitive terms.
Debt financing options backed by the SBA are still fulfilled through commercial banks. Instead of funding the loans themselves, the SBA guarantees the loan amount up to a certain percentage. This allows borrowers to have a better chance of getting approved by commercial banks. The SBA offers several different loan and microloan programs:
- 7(a) General Small Business Loans are the most common type of SBA loan that can be used to establish a new business or to assist in the acquisition, operation or expansion of an existing business. Loan amounts can extend up to $5 million, with SBA guaranteeing as much as 85% on loans of up to $150,000 and 75% on loans of more than $150,000.
- Microloans are typically funded by nonprofit community-based organizations in conjunction with the SBA. The loans can extend up to $50,000 for a maximum term of six years to help small businesses with working capital, inventory, furniture and equipment.
- CDC/504 Real Estate & Equipment Loans provide financing for major fixed assets such as equipment or real estate. Maximum loan amounts vary depending on how the funds will be used and repayment can extend up to 20 years. This loan program will also require collateral and the personal guarantees of the principal owners.
- Disaster Loans provide small businesses with low-interest, long term funding to repair or replace real estate, personal property, equipment, inventory and business assets damaged in a declared disaster.
The SBA also offers lines of credit up to $5 million through its CAPlines Program.
Qualifying for a loan is tough and many alternative lenders have entered the lending space to fill the gap between personal funding and commercial bank lending. Companies such as Kabbage and Funding Circle generally have less stringent eligibility criteria than traditional lending sources such as commercial banks. Many borrowers who would not normally qualify for financing options with commercial banks now have alternative lenders as another option.
These alternative lenders boast easier applications, quicker processing times and simpler terms. Loans from alternative lenders, however, typically have higher interest rates and are limited in terms of loan amounts and repayment periods. Most alternative lenders only offer loans up to $100,000 to $500,000, for a term of up to one year to five years. Take a look at what we’ve found to be the best business loan options out there.
Equity financing is a method of raising capital in exchange for ownership interests in a company. Companies can raise capital through crowdfunding platforms or more traditional sources (e.g., angel investors, venture capital firms and public offerings of corporate securities).
The advantage of equity financing is that investors have a direct stake in the success or failure of your business. If your business fails, you generally do not have any obligation to repay any funds. The disadvantage, however, is that you have to give up various amounts of ownership interests and potentially some control in your company. In a debt financing scenario, once repayment is complete, there are no more attachments to the funding source and no equity is ever given up.
Crowdfunding platforms such as Kickstarter and Indiegogo offer entrepreneurs a tool to raise money without having to give up equity. These platforms allow entrepreneurs to offer gifts (e.g., shirts, downloads, etc) or the finished product as a preorder in exchange for donations. The amounts that these campaigns raises, however, were generally small and could not be raised by offering equity.
It wasn’t until the Securities Exchange Commission (SEC) approved Title III of the JOBS Act in 2015, that equity crowdfunding (or crowdfunding in exchange for equity) for larger amounts really gained traction. Before Title III, only “accredited investors” could invest through equity crowdfunding platforms. An accredited investor is defined in detail in the Securities Act of 1933, but is generally considered an individual that has a net worth of at least $1 million or has an annual income of at least $200,000 each year.
Since Title III was approved, equity crowdfunding platforms such as Crowdfunder and EquityNet have positioned themselves as leaders in the space. Companies pay a subscription fee to use a specific equity crowdfunding platform and then decide how much equity to offer in exchange for capital. Regulations governing equity crowdfunding limit companies to raising a maximum of $1 million in a rolling 12-month period.
Generally, entrepreneurs looking to raise money to build a product would benefit most from equity crowdfunding (and non-equity crowdfunding). The benefit of utilizing equity crowdfunding is the ability to raise capital quickly on the company’s own terms. Most equity crowdfunding platforms allow companies to offer equity under specific terms that are generally not negotiated by the investor (unlike traditional venture capital investments). The disadvantage of equity crowdfunding is that companies may find it difficult to raise capital from traditional venture capital sources later on as many firms would not want to invest in a company that already has numerous shareholders.
Traditional equity fundraising is seen most in the technology industry given investors’ interest in a quick and lucrative exit strategy. The technology industry is a prime area for investing given the ability to scale software quicker than other products. Generally, companies go through the following stages of funding: seed, venture capital rounds and public offering of corporate securities.
Seed funding is usually capital acquired from friends, family and/or angel investors. Angel investors are very affluent individuals who seek to invest in companies in exchange for equity. Seed funding is used to transform a concept or minimal viable product into a market-ready product.
Venture capital rounds are referred to as Series A, B or C rounds, which corresponds with the development stage of the company. Series A funding is usually used to optimize the product and user-base, while trying to scale to new markets. Series B funding is often used to develop the company and grow other business functions such as sales and marketing. Series C (and beyond) funding is often used to keep a company afloat or help scale the company aggressively while staying private for as long as possible.
Many companies do not choose to go through an initial public offering (IPO) until they have reached a valuation of at least $1 billion and cross over into what many refer to as “becoming a unicorn.” Companies generally go public in an attempt to further the growth of their company by generating additional capital and increasing public awareness of the company.
Aside from debt financing and equity financing, entrepreneurs can take advantage of business incentives offered by state governments that can include grants and tax exemptions. Most state governments offer business incentives to attract businesses to operate within their states to stimulate the local economy. Grants can be offered to tackle an area that is of particular interest to a local economy. For example, New York offers grants from their New Farmers Grant Fund for new farmers of up to $50,000 to pay for 50% of eligible costs such as machinery and equipment.
Business incentives are more commonly tax exemptions or abatements. For example, Nevada offers a partial abatement of sales tax, modified business tax and personal property tax for intellectual property development companies who locate or expand their businesses in Nevada (and this is already on top of no individual or corporate state income tax). Qualifying for these business incentives are very specific to each state’s offerings. The Council of State Governments has a great lookup tool detailing business incentives by state.
In addition to business incentives, entrepreneurs can also stretch their starting capital farther by implementing special arrangements with their business partners such as equipment financing, invoice financing, merchant cash advances and drop shipping.