Many small businesses start with using personal funds as seed money. A group of one of more people dip into savings to purchase equipment, rent space, hire a logo designer, and generally get the business up and running. After a period, though, the business owners require additional funds to grow the business. A main source of funds is standard commercial lending: the business owners go to their local bank and take out a loan or a line of credit. For some owners and some lines of business, though, commercial lending is not an option. Perhaps the business owners don’t qualify for a loan. Perhaps the business is in a line that commercial lending does not support; for example, some lenders won’t loan to restaurants due to their high failure rate or won’t loan to medical marijuana facilities. In these cases, the business owners must turn to alternate sources of funding.
The owners may consider their own retirement accounts to fund the business, such as raiding their 401(k). They may take out a home equity line of credit to finance the business. These are risky propositions, obviously: tax consequences for the former and risk of losing a home on the latter. There are other options for start-up businesses, though. While not to be an exhaustive list, below are discussed some other lending options.
Friends and Family
Often, business owners turn to friends and family for funds. The business owners may ask their parents for a loan or to dip into their inheritance. Often, these are easy ways to raise funds, but asking for a loan from dad can be tricky. Introducing a loan into a family relationship runs the risk of intrafamily discord, wreaking havoc on the family dynamic. Obviously, having father suing a child over an unpaid loan is an unpleasant way to try to resolve things. The best way to have a family loan is like a bank loan- through contract. A written agreement outlining terms such as interest, repayment schedule, default and more can help a family loan succeed.
Business owners may wish to go into debt through other mechanisms such as an Small Business Association loan or a Small Business Association microloan. Alternatively, the owners may find investors willing to loan them money. Again, the contract governs: the contract spells out repayment terms, interest, and more to ensure both the borrower(s) and the lender(s) know the terms. Many people have heard the term angel investor. While an angel investor often wants convertible debt or equity (discussed below), some angel investors are willing to loan to businesses.
Another method to raise funds is to sell ownership in the business, which is called equity. For example, the business owners own 100% of the business but need $100,000 for a new machine. They find someone willing to give them $100,000, but that person wants 20% ownership of the company. The business owners don’t have to go into debt to get this $100,000, but they do have to give up a portion of their ownership interest for it. For some business and owners, this is an ideal choice. Again, important considerations must be made in giving up ownership. Now, the business owners may have another voice in the decision-making processes of the business that hinders or slows the business. Or, the owners start to fight with their equity partner, and the business suffers. Business owners typically want their expertise and knowledge used to grow the business, and having an unknown party enter the business can cause problems. A good way to protect this is to spell out what the new equity partner can and cannot do. Can the new equity owner vote? When does the new equity owner get paid? Many other considerations must be made when giving someone equity in exchange for funding.
Investors particularly like convertible debt, which provides the safety of a loan with the potential upside of equity. Generally, an investor loans money to a business on a loan basis. Then, upon an event or upon the demand of either the lender or the borrower, the loan amount can be converted into equity in the company. For example, an investor may loan $100,000 to a business at 4% interest. Then, once the company has an initial public offering of stock, the lender may convert their loan into stock. Investors particularly like this type of financing because it provides both safety (the loan) and the opportunity to make more money if the company is successful and they convert their debt into equity.
A more recent type of fundraising is crowdfunding. Crowdfunding sites such as Kickstarter and Indiegogo have allowed businesses to finance their projects through an alternate source of funding: the public pitching in piecemeal to fund a project. Everything from speakers to movies have used crowdfunding as a financing mechanism. Crowdfunding has upside for the borrowers, as they typically don’t have to repay their lenders. Often, they will offer incentives for borrowers (a t-shirt for a $100 donation, a coffee mug for a $200 donation) or offer their lenders the product they are crowdfunding. While platform requirements differ, some crowdfunding sites require that the borrowers reach their goal in order to obtain funding (this, if the business borrower has a goal of $10,000, but only raises $9,9999, they do not get any funding). Others offer loans to businesses at 0% interest. Crowdfunding is not an option for all businesses, but work particularly well for new products and ideas.