Every young company that strives to grow reaches a point when it must choose how to finance that growth. This is not a decision to take lightly; insufficient or poorly timed financing has been the downfall of many small businesses.
The old saying that it takes money to make money is often true, but it’s equally true that not all money is smart money. Businesses must carefully evaluate their options -- and be willing to accept that what they really need might not be more cash.
Taking inventory, asking questions
Most successful companies are founded on a solid business plan. Arriving at that initial plan required a lot of examination, research, and scrutiny. Companies should apply that same thoroughness to the process of determining how, where, why, and when to pursue their financing opportunities.
Here are some questions each organization should pose to help frame their assessment.
- Why do you need money right now? For expansion? To reduce risk? The lender, no matter who it is, will demand specifics.
- How does the desired funding fit with your original business plan? How much will it allow your company to grow?
- Instead of traditional financing, can you get to the next growth level by finding a new partner with the business expertise you need?
- If a modest amount is needed, is there any way to make the company’s money work harder by more effectively managing cash flow?
- How great are the risks in obtaining financing? Different sources -- banks, financial groups, venture capitalists -- bring different expectations to the table.
- How is the competition and the industry faring? Your competitive position will impact your funding options.
- How strong is your business and management team? This is another factor given significant weight by lenders.
- How urgent is the need for funds? Obviously, you’ll be in a much better position to negotiate if your back isn’t against a wall.
Understanding financing options
At its most basic, there are two types of financing: equity financing and debt financing. Deciding which to pursue should depend on your company’s situation.
One of the most important formulas to consider is your business’s debt-to-equity ratio. This ratio clearly shows how much owners have borrowed versus how much of their own money has been invested in the business. As a general rule, the more equity you have invested in your business, the easier it will be to attract favorable financing.
If a business has a low debt-to-equity ratio (i.e. a high level of equity investment), debt financing may be a good option, especially if good terms are available. Owners may take on more risk with debt financing and generally must repay funds within a defined time period, but they retain full ownership and decision-making abilities.
However, if a business has a high debt-to-equity ratio, its best option may be to increase ownership capital by soliciting more equity investment. Investors can range from friends, family and peers to venture capitalists and other professional investment entities. An equity investment doesn’t have set payment terms, but investors become part owners of the company and may be involved in decision-making to varying degrees, depending on the arrangement.
Pursuing smart sources
Not all financing choices are smart for every business, and companies shouldn’t take the money wherever they can find it. Fast and easy money is never the best answer. For example, a guaranteed Small Business Administration loan is often better than a loan from relatives, who may later get nervous and “demand” a voice in your business.
When contemplating options, it’s important to locate the right financing sources -- sources that understand your business, your market, and your growth stage, and sources that will not unduly interfere with your plans.
Ready for the next step? Wipfli’s consultants can help your small business evaluate all of your financing options -- and put your best foot forward when seeking additional funds to fuel growth. For more information, contact your nearest Wipfli office.