Access to Capital for Small Businesses
Businesses large and small need access to capital to fund operations and grow revenues and profits. Owner investment and internally-generated cash flow are rarely sufficient to allow businesses to scale their operations. Some form of external financing is usually necessary to fund significant revenue and profit growth. Small, less established businesses find it more challenging to raise capital. Many times, small business owners are not aware of funding options available to them, or they do not meet the stringent criteria set by banks and other traditional financial institutions for businesses to qualify for financing. This forces small businesses to seek alternative forms of financing.
Small businesses are the mainstay of the economy. They create jobs and drive innovation, and fuel economic growth. Small businesses represent all sectors of the economy. However, starting and growing a business requires a significant amount of capital. Small businesses can access capital from a variety of sources, with varying degrees of difficulty based on the source. Traditional banks, credit unions, community development funds, government grants and crowdfunding are some of the sources of funding available for small businesses.
Traditional Financial Institutions
Traditional financial institutions such as banks and credit unions have long been a source of funding for businesses. However, for small businesses, the process of getting a loan from a bank can be arduous. While banks might offer lower interest rates, they usually require collateral, and the process is lengthy and time-consuming. Banks may also require personal guarantees from the owners and a good credit score. Meeting these requirements can be challenging for a small business. Notwithstanding the obstacles, banks are still good funding sources for small businesses. Businesses that do not qualify for bank financing can look to other sources, some of which we discuss below.
Community Development Financial Institutions
Community Development Financial Institutions are non-profit organizations that provide financing to small businesses in underserved communities, that have limited access to banks and other traditional financial institutions. In addition to loans, CDFIs provide assistance in other areas such as marketing and in the technical aspects of running a business. CDFIs may better serve the needs of small businesses as they are focused less on making a profit and more on promoting economic and community development. CDFIs are sometimes poorly marketed though, and many small businesses are not aware of their existence, much less to benefit from them.
Venture Capital
Venture capital firms provide financing to startup companies with high growth potential. Venture capital firms are equity investors and usually take an active role in managing the companies or closely monitoring them. This can be both a blessing and a curse. While the startup may benefit from the VC firm’s expertise it might result in a loss of control by the founders. It is not uncommon for VC firms and the owners to clash on what direction a company should take. Venture capital firms expect high returns on their investments and most small business are unlikely to meet the high-growth criteria set by these firms. Startups in the technology sector tend to receive the lion’s share of VC funding due to their high potential for growth.
Government Grants and Loans
Government grants and loans are another funding source for small businesses. The Small Business Administration provides loans and grants to small businesses through various programs. Government grants and loans can be an excellent source of funding for small businesses, as they often have lower interest rates and favorable terms. However, the application process can be daunting and may discourage small businesses from applying. However, for businesses willing to complete the process, any loan or grant received is likely to be worth the effort.
Businesses that do not qualify for traditional financing may be able to get an SBA-guaranteed loan from a bank or other financial institution. SBA-guaranteed loans are less risky for banks, so they are more likely to approve this loan for a business that does not meet their standard underwriting criteria. The SBA website has information on financial institutions that offer its loans.
The SBA also partners with Small Business Investment Companies to provide financing to businesses. SBICs are investment funds owned and managed by private individuals and licensed by the SBA. SBICs use their own capital and debt guaranteed by the SBA, to invest in small businesses that meet certain criteria.
Angel Investors
Angel investors are individuals or groups of investors who provide funding to startups in exchange for equity in the company. Similar to venture capital firms, angel investors not only provide funding but also their expertise. One drawback to angel investors is that they may require a considerable percent of the startup’s equity, due to the perceived risk in funding a startup. This may threaten the owner’s control and the company’s ability to raise additional equity financing in future, as the owner has less available for other investors.
Crowdfunding
An often overlooked source of funding for small businesses is crowdfunding. Crowdfunding allows small businesses to raise money from a large number of people through online platforms like Kickstarter, Indiegogo, and GoFundMe. Crowdfunders do not receive ownership in the company and their money is not repaid. Instead, owners promise them their own copy of the product or they get to use the service when it is launched. Crowdfunding can be an effective way to raise money quickly, and it allows business owners to test their product or service before bringing it to a wider market. Crowdfunding can be unpredictable, and success may depend on crowdfunders’ perception of the usefulness of the product or service.
Conclusion
Small businesses have multiple funding sources available to them. Each source has its advantages and disadvantages, and business owners should carefully evaluate each option before deciding. The key is to find the right balance between obtaining the necessary financing and maintaining control of the business. To qualify for funding, small business owners must have properly compiled financial statements, a business plan and financial projections to demonstrate to lenders and investors their ability to succeed in business and ultimately repay the loan or provide a reasonable return on equity investments. Small business owners should work with their accountants and CFO to ensure they can obtain proper financing when needed.