A Small-Business Guide to Common Sources of Capital
There are many different sources of capital—each with its own requirements and investment goals. They fall into two main categories: debt financing, which essentially means you borrow money and repay it with interest; and equity financing, where money is invested in your business in exchange for part ownership.
Sources of Debt Financing
Commercial Banks. Smaller companies are much more likely to obtain an attentive audience with a commercial loan officer after the startup phase has been completed. In determining whether to “extend debt financing” (essentially, make a loan), bankers may look first at general credit rating, collateral and your ability to repay. Bankers also can closely examine the nature of your business, your management team, competition, industry trends and the way you plan to use the proceeds. A well-drafted loan proposal can go a long way in demonstrating your company’s creditworthiness to the prospective lender and ability to service the loan.
Commercial Finance Companies. Many companies that get turned down for a loan from a bank turn to a commercial finance company. These companies usually charge considerably higher rates than institutional lenders, but might provide lower rates if you sign up for the other services they offer for fees, such as payroll and accounts-receivable management. Because of fewer federal and state regulations, commercial finance companies generally have more flexible lending policies and more of a stomach for risk than traditional commercial banks. However, the commercial finance companies are just as likely to mitigate their risk—with higher interest rates and more stringent collateral requirements for loans to undeveloped companies.
Leasing Companies. If you need money to purchase assets for your business, leasing offers an alternative to traditional debt financing. Rather than borrow money to purchase equipment, you rent the assets instead. Leasing typically takes one of two forms: Operating leases usually provide you with both the asset you would be borrowing money to purchase and a service contract over a period of time, which is usually significantly less than the actual useful life of the asset. That means lower monthly payments. If negotiated properly, the operating lease will contain a clause that gives you the right to cancel the lease with little or no penalty. The cancellation clause can provide you with flexibility in the event that sales decline or the equipment leased becomes obsolete. Capital leasesdiffer from operating leases in that they usually don’t include any maintenance services, and they involve your use of the equipment over the asset’s full useful life.
State and Local Government Lending Programs. Many state and local governments provide direct capital or related assistance through support services or even loan guarantees to small and growing companies in an effort to foster economic development. The amount and terms of the financing will usually be regulated by the statutes authorizing the creation of the state or local development agency.
Trade Credit and Peer to Peer (P2P) Lending. Many companies overlook an obvious source of capital or credit: suppliers and customers. Suppliers have a vested interest in the long-term growth of their customer base and may be willing to extend favorable trade-credit terms or even provide direct financing to help fuel a good customer’s growth. The same principles apply to customers who rely on the company as a key supplier of resources. You may also want to explore one of the online P2P lending platforms, such as Lending Club or Lender’s Circle.
Sources of Equity Capital
Private Investors. Many early-stage companies receive initial equity capital from private investors, either individually or as a small group. These investors are called “angels” or “bands of angels”—and are a rapidly growing sector of the private equity market.
Institutional Venture Capital Firms. Perhaps the best-known source of equity capital for entrepreneurs in recent years is the traditional venture capital firm. These formally organized pools of venture capital helped create Silicon Valley and the fast-growing high-tech industry. But these funds do very few deals each year relative to the total demand for growth capital, so be ready to expand your horizons.
Strategic Investors and Corporate Venture Capitalists. Many large corporations have established venture capital firms as operating subsidiaries that look for investment opportunities (typically within their core industries) to achieve not only financial returns but also strategic objectives, such as access to the technology your company may have developed or unique talents on your team.
Overseas Investors. A wide variety of overseas investors, foreign stock exchanges, banks and leasing companies seem quite interested in financing transactions with U.S.-based companies, especially from rapid-growth economies such as China, India, Germany and Saudi Arabia. Be sure to carefully consider cultural and management-style differences as well as governance and contractual laws before you engage in any international financing transaction.
Intermediaries. Many growing companies begin their search for capital with the assistance of an intermediary, such as an investment banker, broker, merchant banker or financial consultant. These companies and individuals aren’t direct suppliers of equity capital but often will assist the growing company in arranging financing through commercial lenders, insurance companies, personal funds or other institutional sources. Investment bankers will also arrange for equity investment by private investors, usually in anticipation of a public offering of the company’s securities.