Funding Options for Small Business – Part 1

Raising initial money and subsequent financial management of business is vital and should be taken care of. The first objective is to establish how much money is needed. Look at every cost needed and divide it into fixed or variable categories. The fixed costs are those that one will have to pay, even if one makes no sales. Variable costs depend on the sales that are made. Finance requirements of a business must be very clearly shown on cash flow forecast.

Keeping these in mind,some of the funding options available to small business owners are discussed here.

Bank loans are the principal and frequently the only source of finance for nine out of ten new small businesses. Bankers look for asset security to back their loan and also charge an interest rate that reflects current market conditions and their view of the risk level of the proposal. They like to focus on the five “C”s of credit analysis, when they evaluate a loan request, namely character,capacity, collateral, capital and conditions. Having good credit history does help. A sound business plan can predict the borrower’s ability to repay the loan. The collateral helps the banker to pay off the loan in case the borrower lacks funds. Having assets exceed debts increase the capital value of the borrower. On top of all these, existing economic conditions and the strength of local currency determine the loan sanction ability.

There are different types of bank funding, overdraft, term loans, revolving lines of credit and intermediate term debt.

A brief description of each loan type is given here, as it might be useful for a business owner to match his needs with the right type of loan.

OverDraft Funding

Overdraft is the short-term bank funding secured by a charge over the assets of the business. More than a quarter of bank finance is done by overdraft. It was originally designed to cover the timing differences between acquiring raw materials to manufacturing finished goods which are sold later. They are very easy to set up and useful to establish businesses which will be able to generate cash within one year of their establishment. The only key thing to remember in overdrafts is that banks are free to make and change the rules as they see fit. In other types of loans, as long as terms and conditions are met, the loan belongs to the business owner for the duration. It is not so, with the overdrafts.

Term Loans

Term loans are long term borrowings provided by a bank for a number of years. The interest can be either variable, changing with general interest rates, or fixed for a number of years ahead. It is in these kinds of scenario a banker can be a business owner’s best friend.

Maintaining personal relationship with the banker comes to rescue in situations where the banker can give his best rates available and also suggest what might increase the cash flow into the business in the long run. Given the enormous amount of options available to the business owner, to have a banker who understands the business plan effectively and can foresee the future of the business is definitely helpful. Meeting with the banker periodically, it is also possible to change the interest rates from fixed to variable, depending on the condition and need of the business. Considering the economic conditions and the needs of the business owner, a knowledgeable banker can even provide moratorium on interest payments for a short period, to give the business some breathing space. Provided the conditions of the loan are met, the money is available for the period of the loan. Unlike an overdraft, the bank cannot change its terms if their circumstances change.

Loan Guarantee Schemes

Loan guarantee schemes guarantee loans from banks and other financial institutions for small businesses with viable business proposals which have tried and failed to obtain a conventional loan. This happens mostly due to lack of security. In such cases government guarantees 70-90% of the loan. The terms may vary from bank to bank , but the basic concept is for the government to encourage banks to be a little bolder in their approach to new and small firm lending.

In addition to bank lending there are other forms of financing available like credit unions, government funding, commercial finance companies, micro lending, personal loans, insurance policy loans, angel financing and venture capitalist financing.

Grants

Government grants are very attractive to small businesses, because unlike debt which has to be repaid, or equity which has to earn a return for investors, grants are non-refundable. Even though they are very competitive and hard to get, the non-refundable concept makes them very attractive.

There are different types of grants, direct grant, repayable grant, soft loan and equity finance.  Direct grants is a cash item used for activities like training, employment, export development, recruitment or capital investment projects. Most grants require the recipient to put up a proportion of the cost. In case of repayable grants, cash funding is offered for a project, which will be repaid out of future revenues. The grant need not be payable in case the project fails. Soft loan is one where the terms and conditions are more generous than commercial loans. In certain cases the loan may be interest free. Equity finance is when a capital sum is injected into the business and the provider does not expect any interest or repayment of the loan. The provider of equity takes a share in the business, with the hope that the value of the business will appreciate in future, enabling a sale, so that the initial investment is recovered.

In the next part, we will cover topics on Microlending, Personal Loans, Angel Investors and Venture capitalists.

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