Commentary

8 best financing options for a small business

A small business's financing decision should be based on the owner's assessment of the cash flows, demonstrated capacity to handle credit, costs versus profit opportunity and repayment thresholds. The good news is that technology allows small business owners to access various forms of capital quickly and efficiently.

Image courtesy of iStock

September 9, 2019

Vincent Ney is a founder and CEO of Expansion Capital Group, serving American small businesses by providing access to capital and other resources.

By Vincent Ney

It's no secret that over half of small businesses close their doors within the first five years. One of the critical problems that often occur has little to do with the innovation, ingenuity or work ethic of the small business owners themselves, but rather the lack of access to sufficient capital to cover the ebbs and flows of their operation and its associated costs.

Scaling any idea or enterprise, to me, is less often about "entrepreneurship" — and other catchy terms we can print on a business card — and more about meeting the demands of others, like payroll and customer expectations. Simply put: small business owners need capital resources — they need cash.

Historically, small businesses have had limited options to access capital: savings, friends and family, credit cards, traditional bank loans or the occasional SBA loan. Enter the financial crisis of 2008-2009, which ushered in a new regulatory environment that contracted these historic capital resources, thereby creating the market-driven need and demand for non-traditional banking options.

Consequently, we find ourselves operating in a new era, one in which enterprising non-bank funders have brought novel and different capital products to the small business market. This has been largely accomplished through an ambitious mix of "fintech" and financial innovation. These previously unavailable financing options give small businesses more resources to consider than ever before. Now their next step is to explore them and consider how their small business might decide on the best option for their specific needs.

The 8 best options

As we contemplate these innovations, here's a quick list of some of the best financing options available to small businesses in 2019:

1. Business term loans: These are best for businesses looking for working capital, equipment purchases or to purchase inventory or other fixed assets. For short-term loans, it can often be matched to a specific project and repaid to coincide with the completion of that project in six to 12 months. For longer-term loans, the repayment can be stretched out to three to 10 years, but these often require higher levels of collateral coverage or a personal guaranty by the business owner.

Pros: These are great products for larger one-time investments with targeted cash flow that payments can be matched.
Cons: Larger dollar amounts and a longer payback term will require increased time, energy (think: bank meetings and interviews) and documentation.

2. Equipment financing: This is best for one-off purchases like equipment and machinery.

Pros: No upfront spending is required; if the business owner has impaired credit, the fact that an asset is involved as collateral can make it easier versus purchasing the equipment; and it's tax-deductible.
Cons: Overall, the cost is usually more expensive in the long-run; the cost inclusive of fees if the lease is terminated early can be substantial; and the borrower must take into account all terms and conditions that can be complicated (i.e., who handles and addresses a break-down in the equipment?)

3. Small Business Administration loans: These are best for business owners who need capital for a variety of longer-term business expenses. The loans are government guaranteed so the process can be daunting and is processed through a bank that has an SBA loan program.

Pros: Cost and longer-term repayment; it is a great product for owner-occupied real estate.
Cons: Requirements are strict; the process is time-consuming (60 to 180 days); there are high upfront fees; and the loans require strong personal credit scores.

4. Business line of credit: This option is best for businesses with more volatile sales and cash flow. It offers flexibility to draw down and repay based on the needs of your business. It is often secured by accounts receivable and inventory. Some LoCs offered by "fintech" operators do not require business collateral but do require a personal guaranty.

Pros: The borrower can access credit quickly (assuming a facility is in place) to solve urgent issues or expenses; the credit is great for managing working capital needs and the business' short-term cash flow needs.
Cons: Reporting can be much more intensive versus other products available; upfront and ongoing fees can be expensive, especially if the LOC is rarely drawn down.

5. Revenue-based financing: This is a financing option where the repayment schedule is tied to the future revenue of the business. The genesis of the product is that the funder operates as more of a partner and is taking some level of "equity-risk." If the revenue decreases or the business fails, the repayment is either stretched out, or in the case the business fails, the funder has no recourse. Small businesses can utilize this product for project financing, working capital, growth investments or short-term needs.

Pros: This option offers quick access to capital. The repayment risk mirrors the revenue, and there is no business or personal recourse except in the case of fraud.
Cons: Products are generally 12 months or less; the cost is more expensive given level of risk with limited recourse; and reporting can be intensive as changes to payment schedules require bank and financial verification.

6. Invoice factoring: The business can turn its unpaid invoices into immediate cash. The invoice factoring company collects directly from the customers and distributes capital to the business, net of its fee.

Pros: These are good options for managing cash flow; typically, a short-term financing product (30 to 90 days).
Cons: The cost can be expensive, especially if repaid much quicker than anticipated; notifying customers to change their payment instructions to the factoring company can be disruptive; it requires technology integration or a higher level of reporting; and the business' customers will be dealing directly with the funder if they delay payment — not you as the business owner.

7. Angel investors/venture capital: These are best for small businesses that want to scale quickly.

Pros: An entrepreneurial background provides increased insights and foresight versus dealing with alternative finance providers, banks or the government; there is usually a larger investor network to leverage for additional funds or additional business; and capital remains in the business (versus interest costs).
Cons: Higher rates of returns are expected (typically at least five times their investment). It also requires giving up equity in the business; the process will be intensive; it is typically reserved for high visibility, disruptive companies pursuing large addressable markets on a national or global scale; and it will require operating agreement additions to governance to protect their investment in the case of underperformance.

8. Bootstrapping: This is best for businesses with principals that have savings or expendable income who want to preserve equity ownership and cash in the business.

Pros: This maintains an ownership position and keeps all cash generated either in the business or available for dividends.
Cons: Growth is limited to the owner's cash position; it risks missing market opportunity because the business is thinly capitalized; and it can be challenging if a short-term need requires more cash than available.

While the pros and cons of this list provide a guide to financing in 2019, any financing decision should ultimately come down to your assessment of the cash flows of the business (today and in the near term), demonstrated capacity to handle credit, costs versus profit opportunity (positive ROI), and repayment thresholds.

The good news is that enabling technology allows small business owners to access various forms of capital quickly and efficiently. There is no day like today to explore options to fund entrepreneurial dreams.