ComplianceLegalFinanceFebruary 04, 2021

Choosing financing sources for your business

Financing options available to a small business vary based on the current life cycle of the company: startup, growing, mature, existing and aging.

Where your business is in its financial life cycle--from startup to fully mature--will often dictate the availability of certain financing alternatives.

Startup businesses often begin with only ideas and enthusiasm. One of the many issues that every entrepreneur must address in starting a small business is the financial reality involved in deciding exactly what he or she wants to do, when it can be done, and how it's going to be done.

New small businesses have trouble securing conventional financing because they present a tremendous risk to lenders and investors. The result is that nearly three-quarters of startup businesses are funded through the owner's own resources, such as personal savings, residential mortgages or consumer loans. Investments by family members, friends, and private contacts or "angels" provide most of the remaining "seed" funds for new small businesses.

The most common financial problem for startup businesses is a shortage of cash, and cash flow problems during a potentially long initial period can be fatal to the business, not to mention its owner. Any debt financing (loans) that the business can secure from traditional lenders, e.g., banks, is likely to be expensive because of the high risks assumed by the financier. Moreover, unless the business can boast a significant owner investment and marketable collateral, the availability of conventional debt financing can be almost nonexistent.

A "cash crunch" puts a tremendous focus upon things like inventory turnover, and the need for immediate revenue often becomes a daily crisis that takes priority over financing for sustained growth or development of new products. Perseverance and a willingness to investigate all sources of financing--from angels to government loan programs--are invaluable at this stage.

In contrast to startups, in many respects, the financing options available when you purchase an existing business are similar to the options for raising capital in a growing business that you already own. Debt and equity vehicles are typically more available to you than if you were starting a similar business from scratch. Because the target business has a credit history, existing assets, an established operating cycle and business goodwill, lenders and investors can be approached in the same manner as if you were seeking to expand a business you already owned.

The major distinction between financing to purchase an existing business and financing to raise funds for your own growing business is that the former offers the opportunity for seller-assisted financing. Entrepreneurs who are selling their small businesses usually realize that they may need to participate in the buyer's financing of the business sale, and they may be willing to negotiate a very favorable debt or equity arrangement with you.

A growing or mature business usually has sufficient stability in its operations so that cash flow problems are not a constant crisis. If the business is successful, internally generated money from sales and investments can fund many of the business's needs.

Typically, growing and mature businesses have more financing options available to them because of their operating history, established value, credit history, and availability of inventory and accounts receivable financing. In addition, the advantages of having established customers and suppliers, efficient internal operating procedures, more sophisticated marketing and advertising, realistic long-term business plans, and the company's emerging goodwill help improve the creditworthiness and investor appeal of the business.

Debt financing becomes increasingly available to a business as its track record supports creditworthiness. If the business has been profitable, debt financing is generally the preferred form of raising new capital for existing businesses.

Nonetheless, a growing business may be stifled by inadequate capital for expansion that stems from the reluctance of an entrepreneur to dilute his or her ownership through equity financing.

Sometimes the decision simply comes down to whether you want a profitable, growing business in which you share control or will cash out your interest at a given time, or whether you own a business that fails because you did not raise sufficient capital for the business to grow. Growing businesses can consider raising equity capital by private transfers of ownership interests; by using venture capital firms; or by selling ownership interests through formal, limited private offerings or an initial public offering.

An aging business is characterized by a conservative philosophy aimed at maintaining the business's internal bureaucracy and its market status quo. Some companies reach the point where innovation and creativity are limited to tinkering with current products and existing markets. Investment into new product lines and emerging markets represents a financial risk that a complacent ownership is unwilling to assume. Aging businesses tend to be cash-rich because less investment is being undertaken. Financing is rarely a problem for a business in this stage. The owners are generally more interested in conserving assets for the next generation and retiring to a life of leisure.

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