Small business financing
The examples and perspective in this article deal primarily with the United States and do not represent a worldwide view of the subject. (March 2019) (Learn how and when to remove this template message)
Small business financing (also referred to as startup financing - especially when referring to an investment in a startup company - or franchise financing) refers to the means by which an aspiring or current business owner obtains money to start a new small business, purchase an existing small business or bring money into an existing small business to finance current or future business activity. There are many ways to finance a new or existing business, each of which features its own benefits and limitations. In the wake of the financial crisis of 2007–08, the availability of traditional types of small business financing dramatically decreased. At the same time, alternative types of small business financing have emerged. In this context, it is instructive to divide the types of small business financing into the two broad categories of traditional and alternative small business financing options.
Traditional small business financing options
There have traditionally been two options available to aspiring or existing entrepreneurs looking to finance their small business or franchise: borrow funds (debt financing) or sell ownership interests in exchange for capital (equity financing).
The principal advantages of borrowing funds to finance a new or existing small business are typically that the lender will not have any say in how the business is managed and will not be entitled to any of the profits that the business generates. The disadvantages are the payments may be especially burdensome for businesses that are new or expanding.
- Failure to make required loan payments will risk forfeiture of assets (including possibly personal assets of the business owners) that are pledged as security for the loan.
- The credit approval process may result in some aspiring or existing business owners not qualifying for financing or only qualifying for high interest loans or loans that require the pledge of personal assets as collateral. In addition, the time required to obtain credit approval may be significant.
- Excessive debt may overwhelm the business and ultimately risks bankruptcy. For example, a business that carries a heavy debt burden may face an increased risk of failure.
The sources of debt financing may include conventional lenders (banks, credit unions, etc.), friends and family, Small Business Administration (SBA) loans, technology based lenders, microlenders, home equity loans and personal credit cards. Small business owners in the US borrow, on average, $23,000 from friends and family to start their business.
The duration of a business loan is variable and could range from one week to five or more years, and speed of access to funds will depend on the lender's internal processes. Private lenders are swift in turnaround times and can in many cases settle funds on the same day as the application, whereas traditional big banks can take weeks or months.
The principal practical advantage of selling an ownership interest to finance a new or existing small business is that the business may use the equity investment to run the business rather than making potentially burdensome loan payments. In addition, the business and the business owner(s) will typically not have to repay the investors in the event that the business loses money or ultimately fails. The disadvantages of equity financing include the following:
- By selling an ownership interest, the entrepreneur will dilute his or her control over the business.
- The investors are entitled to a share of the business profits.
- The investors must be informed of significant business events and the entrepreneur must act in the best interests of the investors.
- In certain circumstances, equity financing may require compliance with federal and state securities laws.
The sources of equity financing may include friends and family, angel investors, and venture capitalists.
Rollover retirement funds to start or finance a business
A lesser-known but well-established means for entrepreneurs to finance a new or existing business is to rollover their 401k, IRA or other retirement funds into their franchise or other business venture. This financing option is often called "Rollover as business startup" or "ROBS" financing. This isn't a loan, instead, the business owner forms a C Corporation, which sponsors a profit sharing retirement plan. From there, the business owner uses that company retirement plan to buy shares of his own company, thus contributing to the company's finances.
This small business financing option allows the business owner to obtain the benefits of debt and equity financing while avoiding the disadvantages such as burdensome debt payments. More than 10,000 entrepreneurs have used their retirement funds to finance their start-up businesses.
The IRS has clearly stated that the use of retirement funds to finance a small business is not “per se” non-compliant. ROBS financing is complicated, however, and the IRS has developed a set of guidelines for ROBS financing. As such it is essential to employ experienced professionals to assist with this small business financing strategy.
New sources of debt and equity financing
In the wake of the decline of traditional small business financing, new sources of debt and equity financing have increased including Crowdfunding and Peer-to-peer lending. Unless small businesses have collateral and can prove revenue, banks are hesitant to lend money. Oftentimes, start up companies and businesses operating for less than a year do not have collateral and private money lenders or angel investors are a better option. Private money lenders and angel investors are willing to take more risk than banks recognizing the potential upside. Private lenders can also reach a decision faster with approvals only going through one tier rather than being overlooked by many levels of management.
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- Ianthe Jeanne Dugan and Ruth Simon (8 January 2014). "Alternative Lenders Peddle Pricey Commercial Loans". WSJ.
- "Need A Business Loan? Impress The Algorithm, Not The Loan Officer". Forbes. 27 March 2013.
- Laura Entis (20 November 2013). "Where Startup Funding Really Comes From (Infographic)". Entrepreneur.
- "Rollovers as Business Start-Ups Compliance Project". irs.gov/. Retrieved 10 November 2019.
- McManus, Brian; Matthews, Mark. "Examinations of Rollovers as Business Start-Ups (ROBS) Arrangements: A Guide to Surviving IRS Scrutiny". BNA, Inc.
- Julianelle, Michael. "Guidelines regarding rollovers as business start-ups" (PDF). U.S. Internal Revenue Service. Retrieved 6 November 2015.