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Set Your Small Business Up for Success: Strategies, Best Practices, Insights, and Tips (Part 3)

Guide to Funding a Small Business
Nancy Bilyeau
Nancy BilyeauUpdated August 15, 2022
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.

The Essentials on Small Business Funding and Building Credit

This is the third in a five-part series on small business success. Part Two: “You Built It, Why Didn’t They Come? Questions about money come with the territory when you’re starting a small business.  At first, it’s “How will I come up with the money to launch my business?” Then it shifts to “Where can I get the money to stay afloat in the early months?” and then to “Have I got what it takes to persuade someone to finance my business’s growth?” As you can see, different dollar questions connect to different stages in the creation of a small business.

How Much Money Does It Take to Start a Business?

You don’t necessarily need a lot of money to get off the ground. According to the Small Business Administration (SBA) Office of Advocacy’s February 2022 report, just over half (50.9%) of all new small businesses start with less than $25,000 in funding. Only 12% of businesses use over $250,000 to start. In fact, when it comes to small businesses (defined by the SBA as having up to 500 employees), 24% of them got started with less than $5,000, which is the largest group in the report. The SBA says 11.7% of the businesses started with $5,000 to $9,999, and 15% started with $10,000 to $24,999. After you’ve been in business for a while, how hard is it to get financing? That’s become a hot topic. According to a June 2022 news report from the SBA, businesses are trying to ramp up post-pandemic, but banks aren’t always recognizing the needs. “Demand for small business loans is gradually increasing while banks continue to tighten supply, albeit at a slowing pace,” said the SBA report. “The share of small firms that received the full amount of debt financing requested declined across all firm sizes in 2021 compared to 2019. The largest decline was in firms that have 1-4 employees.” Small businesses need help. The SBA says that small businesses borrow mainly for four reasons: to start a business, to purchase inventory, to expand, or to strengthen the firm’s financial health. It can be a challenge to find the funding you need at any stage, but the more you know about this world, the better you're positioned to make the right moves at the right time.

Small Business Funding: Debt vs. Equity

Basically, there are two types of funding available to small businesses—debt financing and equity financing. Both types have pros and cons.

Debt Financing

You are most likely very familiar with debt financing, even if the phrase is new. Purchasing a home, buying a car, or using a credit card are all examples.  With this financing, you are taking a loan from a business, a person, or another entity and pledging to pay it back, usually with interest.  Many business owners, sooner or later, apply for a small business loan from a bank or other lender. Here’s a list of the types of debt financing:
  • Term loans
  • SBA loans
  • Business lines of credit
  • Invoice factoring
  • Business credit cards
  • Personal loans, usually from a family or friend
  • Peer-to-peer lending services
The advantage to debt financing is you can strengthen and expand your business thanks to this inflow of cash. And the lender has no control over your business. Once you pay back the loan, your relationship with this funder is over. The downside is you must pay back your debts on time to avoid catastrophe to not just your business but your credit and sometimes worse if collateral is involved. Debt financing is unquestionably risky if you are not profitable.  If you take out a small business loan and you turn no profit, you’ll still have to pay back the loan plus interest. 

Equity Financing

When you’re talking about equity, you’re talking about investors. You could be offering shares of your company to family, friends, and acquaintances in your networks in exchange for money. Depending on the planned size and scope of your startup, you could be pitching your dream to venture capitalists (employees of risk capital companies who invest money in companies) and angel investors (individuals who offer their own money in exchange for a piece of the business). The forms of equity financing are:
  • Crowdfunding (such as CircleUp, EquityNet, WeFunder, and Fundable)
  • Angel investors, high net worth individuals who provide capital for startups
  • Venture capital firms, individuals, or companies that invest in young businesses
“The amount of venture and angel capital are a relatively small part of business financing,” says the SBA Advocacy report. However, the trend is on the upswing. The chief advantage of equity financing is that there is no obligation to repay the money acquired through it. So you’re not going to spend sleepless nights worrying about loan payments and soaring interest. However, you are giving up some control of your business this way. In order to gain funding, you gave investors a percentage of your company. You’ll have to share your profits and consult with your partners any time you make big decisions.

How to Fund Your Business Idea

Where do most small businesses come up with their startup financing? THE SBA Office of Advocacy breaks it down:
  • 75% Personal savings
  • 19% Bank loan
  • 10% Personal credit card
  • 7% Other sources
  • 6% Business credit card
  • 6% Home equity
  • 2% Government loan
Traditional debt financing can be tough if you’re still in the planning stages. No matter how amazing your idea is and what kind of killer business plan you’ve written, it’s not realistic to expect to automatically get a loan from a bank before your venture is off the ground.  Not unreasonably, banks want to see some revenue first. Some say you’ll need six months of operation before you’re in a position to apply for a small business loan. Others say you’re likely to need at least a year in business. Still others say you’ll be required to show two years of operation. But these rules are not set in stone.  “You can get a business loan at the beginning of starting a business,” says DeLisa Clift, a certified mentor with SCORE, the nation’s largest network of volunteer expert business mentors. “The ideal time to seek funding is when you know that you have a viable product or service that is needed and wanted by customers,” Clift explains. “You need to develop a business plan that is written to attract loans from financial institutions, family and friends, and other investors. Another ideal time to seek funding is when the business is in the growth phase, and you are looking to add more products or services and to expand your business into new markets. You can also look at non-traditional banks like Community Development Financial Institutions (CDFI) for funding solutions.” The options for getting money to support your business are:

Self Funding

Many people use their own money to pay for early expenses. It can be scary to watch your savings go down. On the other hand, you won’t lose control of your business to investors or be on the hook for a loan. And it shows passion for your idea to commit your own money. Some people say it’s smart to keep a traditional full- or part-time job while starting your business as a side hustle. But bear in mind that being overly cautious might stifle growth. In your business plan, come up with a strategy for growing your business to the point that you can quit the day job.

Friends and Family

This is a popular path to raising money for your business. Perhaps it will come as a no-strings donation, or maybe the financial support will take the form of a loan, or even an offer of money in exchange for equity.  There’s an obvious drawback, however. Mixing money matters with friends and family can end in tears. Ken Colwell, author of the bestselling book Starting a Business: QuickStart Guide, says, “I always recommend what I call the Thanksgiving Dinner test. Imagine your business doesn’t work out, and you lose all your investment funding. Would that ruin your Thanksgiving dinner, or would your family be okay with it? Is the money you’re borrowing immaterial to them, or are you risking their entire life savings? Think carefully about these questions.” Tip: For every dollar that a friend or family member gives to your business, you need to put the understanding in writing.

Crowdfunding

There are different types of crowdfunding financing available for startups. Rewards-based crowdfunding: Supporters make donations to your business and receive a token of your appreciation in return. Example: Kickstarter.Equity crowdfunding: Supporters receive equity in your company while expecting future returns. Example: Wefunder.Debt-based crowdfunding: Supporters give you a loan, which you pay back on a prescribed schedule with interest or fee. Example: Mainvest. Running a winning campaign can give you a big boost. However, not all business ideas are a good fit for crowdfunding. These campaigns demand a lot of time and effort, and it’s hard to stand out in the crowd. And you may need to wait a bit for the campaign to close and money to materialize.

Debt Financing

While a Main Street bank might shy away from giving a loan to a startup, there are strategies and options to explore, even if you’re in the earliest stages.

Business checking account

You won’t get a loan or investment of money this way, but it will establish your business, especially if you link it to a Paypal account or other system that shows money passing back and forth. Three months’ worth of business checking account activity can help you build a case for yourself to get debt financing.

Business credit card

A business credit card can give you a cash influx, and some are available for entrepreneurs just getting started, if your credit is strong. The interest could be high here, so be careful. There are cards with 0% APR introductory financing. See if you can qualify for one of those. But always scrutinize the fine print for fees.

Microloans

Yes, there are loans available for startups, but they’re not a shoo-in to get. With a favorable credit history and an excellent business plan, entrepreneurs can sometimes obtain microloans for small businesses, typically up to $50,000.   Microloans are offered by nonprofits, individuals, and alternative lenders. The purpose of a microloan is to provide entrepreneurs who otherwise wouldn’t be eligible for a business loan with access to affordable working capital. They are used to fund business ideas, expenses, or expansion.  And yes, microloans have to be repaid with interest. Moreover, you may be asked to offer collateral or a personal guarantee, depending on your credit rating. SBA’s Microloan program provides direct, government-backed loans to intermediary microlenders who can then offer borrowers necessary funding and training to start and run a small business. Some programs are specific to women, veterans, and other underserved communities. SBA loans are desirable because they often have lower interest rates than other business loans. However, practice patience. Receiving a microloan can take anywhere between 30 and 90 days. Other microloan programs include Acorn, Kiva, and Rising Tide.

Peer Lending

Peer-to-peer lending programs eliminate the bank as a middleman, making it easier for borrowers and lenders to connect via online platforms. For many borrowers, this financing offers faster approval and financing. For investors, it can be an opportunity to support businesses they believe in. The downsides: Limited regulations on peer-to-peer business lending and Interest rates can vary greatly depending on a borrower’s qualifications

Business lines of credit

Business lines of credit are similar to business credit cards. A line of credit gives you access to a set amount of funding, and you can spend as needed up to the limit. Once you repay what you withdraw, you can borrow funds up to your credit limit again. It’s possible to get a business line of credit after you’ve been in business for six months. Note: Business lines of credit have interest rates and possibly fees.

Loans for Equipment Financing

Having the right equipment could be crucial to your success, whether you’ve opened a restaurant or an accounting firm. But because of how pricey it can be, many small business owners lack the funds to purchase essential equipment and machinery. Some startups can successfully obtain a small equipment loan. It helps a lot to have good credit.

The Importance of Business Credit

Having a good credit score makes all the difference when getting your small business off the ground. If you apply for any kind of business loan, the lender will look at both your personal credit score and your business credit score if you have one. Minimum requirements vary widely, depending on the lender and type of loan. But, generally, a good personal score to get a business loan is 720 and above, while a good business credit score is often 80 or above. If you’re wondering about your business credit score, your business credit is linked to you by your Employer Identification Number (EIN), which is how the government recognizes your business for tax purposes.  You can check your credit score through Experian, Dun & Bradstreet, or FICO. Tip: None of them allow you to check it for free, but you can do so during their introductory offer period. Each of these business credit bureaus uses a slightly different “formula” for determining your credit score for small business loans, but the factors are:
  • How much debt your business has compared to its available credit
  • Whether you pay bills on time
  • How old your credit accounts are
  • Your industry
  • Your company’s size
Clearly, the better your business credit, the more opportunities you will have to grow your business. When considering funding options and risk vs. reward, always keep your business credit score in mind.

The Takeaway

If you’re interested in exploring different types of small business financing, Lantern by SoFi can help. With our online lending platform, you can compare rates from multiple small business lenders without making any type of commitment. Next in the Series:Part Four: “Being Your Own Boss: Benefits, Drawbacks, and Tips" LCSB0622032
The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

About the Author

Nancy Bilyeau

Nancy Bilyeau

Nancy Bilyeau writes about student loans, mortgages, car insurance, medical debt and many other finance topics for Lantern. A veteran of the magazine business, she has edited stories on personal finance for Good Housekeeping and DuJour magazines and has written articles for The Wall Street Journal, Readers' Digest, Parade, Town & Country and Lifetime/A&E, among others. She is a graduate of the University of Michigan.
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