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.
History
After the 2008 financial crisis, the availability of traditional types of small business financing dramatically decreased.[1] At the same time, alternative types of small business financing 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).
Debt 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.
The sources of debt financing may include conventional lenders (banks, credit unions, etc.), friends and family, Small Business Administration (SBA) loans, technology based lenders,[3][4][5] 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.
Rollover retirement funds to start or finance a business
In the United States, 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.[7]
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.[8]
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.[9]
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.
Alternative debt financing
Stepping into the gap between personal finance and traditional small business financing, there has been an increase in the number of alternative lenders who provide debt finance to small businesses.[10] These lenders use alternative means of "security", and advanced algorithms to offer niche lending products that are designed for specific situations.
Unsecured loan
Unsecured loans are issued and priced using alternative data sources. The majority of the lending decision happens off the back of transaction history and requires no formal collateral or security.
Different lenders use different data points to make their decisions. These can include things like:
Due to the increased risk involved for lenders in an unsecured loan, these products are generally more expensive than a traditional business loan which is backed by collateral.
- Transaction history,
- Business directors' credit history,
- Trade references,
Business finance marketplaces
To help small business owners make a decision on what types of small business loans are best for their business and needs, business finance marketplaces have established themselves as an intermediary or facilitator.
The process generally works as follows:
- 1) The business owner applies through the marketplace.
- 2) The marketplace has relationships with the majority of small business lenders in their region.
- 3) The marketplace understands the lending appetite of the various lenders and prequalifies the applicant.
- 4) The marketplace sends the final details of the applicant to the lender, based on the applicant's choice.
- 5) The lender and the applicant finalize the details of the loan.
References
- Rebel Cole. How Did the Financial Crisis Affect Small Business Lending in the United States? Depaul University, retrieved 14 February 2013^
- Jon Faust. Will Higher Corporate Debt Worsen Future Recessions? retrieved 14 February 2013^
- Patrick Clark. Alternative Small Business Lender OnDeck Doubles Its Revenue - Businessweek