Financing a small business is a process, not an event. Cash flow is variable, economic landscapes shift, and consumer demand is fickle. These are all factors that drive funding needs. Successful small business owners understand this and prepare for it. This article will explain how to navigate the complexities of growth financing. Some key takeaways:
- Small business lending challenges and stock market volatility can negatively impact initial public offerings (IPOs) and equity financing.
- Debt financing preserves equity and ownership control, but can be expensive and should be viewed as a short-term financing solution.
- Properly vetted equity financing can add investor expertise and additional knowledge to your company’s ownership team.
The current lending landscape poses significant challenges for small business owners.
Post-pandemic restrictions and cautions have eased, and interest rates have decreased, but uncertainty over federal economic policies remains a cause for concern. Lenders have incorporated these factors into their risk analysis and approval processes for small business loan applicants. The process is going to be more rigorous now than in the past.
Stock market volatility adds another piece to this puzzle. Privately-owned businesses aren’t impacted, but public companies in the $5 million to $20 million range are taking a hit, so traditional lenders are reluctant to finance them. Combined with a decline in investor confidence, this is also affecting IPOs and equity financing.
The first step to prepare for financing is to ensure you have the correct business structure.
For example, a sole proprietor may be limited to personal loans and bootstrapping as their primary sources of funding. Corporations with an ownership group, financial statements, and tradable equity can approach corporate lenders and venture capital firms for funding. C-corporations are the most popular structure for that type of financing, but not the only structure.
There are steps that you can take as a limited liability company (LLC) and an S corporation. Talk to your tax professional or give us a call.
Come to lenders prepared to provide administrative, accounting, financial, and strategic documents and plans.
Traditional banks, credit unions, and online lenders will want proof of ownership, organizational agreements, bank statements, financial statements, and a comprehensive business plan. You’ll also want to provide financial projections and revenue milestones that account for “what if” and “worst case” scenarios. My team and I can help you put those together.
Lenders and investors value key performance indicators (KPIs) over pitches.
Lenders and investors will want to see KPIs to get a better understanding of your revenue, expenses, profit margins, and cash flow. Your ideas are important, but are unlikely to be unique. You’ll need a solid financial plan to obtain financing.
Preparing KPIs requires a team of accounting, business, and financial professionals. We can help.
Let’s break down the basics of debt financing.
A sole proprietor can apply for an unsecured personal installment loan to cover operating expenses, but let’s not get confused. A personal installment loan is not growth financing.
Significant funding is required for established small businesses to expand and scale their operations. That could require the services of a corporate lender or venture debt fund.
Interest rates may be manageable with business loan interest deductions.
Interest rates are always a factor, but the terms and conditions of the lending agreement could offset some of that cost. Business loan interest is also tax-deductible. That doesn’t make it an irrelevant number, but it will minimize its impact.
Consult with my team or another qualified CPA with financial and business advisory expertise before signing the loan agreement. You’ll need guidance throughout the process.
What are the pros of debt financing?
- You maintain ownership and control.
- Business loan interest is tax-deductible.
- Payment schedules are predetermined.
- There is no equity dilution.
What are the cons of debt financing?
- Regular payments can become a cash flow problem.
- Covenants can be restrictive.
- Personal guarantees are often required.
- Future borrowing capacity may be limited.
Now, we’ll move on to equity financing.
Properly vetted equity financing can add investor expertise and additional knowledge to your company’s ownership team. That’s the potential trade-off for relinquishing equity shares or ownership control, if you’re selective about who you bring into your circle.
Equity financing comes with concessions and additional steps.
First and foremost, we have to understand that accepting equity financing is not the same as borrowing money. It involves taking on a new partner. That’s a significant concession and potentially a risky move.
There are a few extra steps for this type of financing. You’ll need a capitalization table (cap table) that shows the breakdown of your current equity and how issuing new shares or selling existing shares will impact it. It’s also best practice to notify existing shareholders about your plans. Some corporations require shareholder approval before any type of equity deal.
What are the pros of equity financing?
- There is no repayment obligation.
- You will gain access to investor expertise and networks.
- Risk is shared with new investors.
- More capital is available for growth.
What are the cons of equity financing?
- Dilution of ownership and control may be an issue for you.
- The goals of investors may not be aligned.
- Equity financing requires complex legal structures and associated attorneys’ fees.
- Overall, the cost of capital is higher.
Consider reward-based and equity crowdfunding.
Crowdfunding is another option if you’re looking to raise growth capital without small business financing.
Reward–based crowdfunding is a system where contributors pledge money in exchange for early access to products, exclusive merchandise, or personalized experiences. It’s not usually employed after the startup stage, but can be useful for growth funding.
Equity crowdfunding is a form of equity financing. The difference is in the number of investors a company is willing to take on. Rather than focusing on a single venture fund or angel investor, the business would be listed on a crowdfunding platform, such as StartEngine or SeedInvest. Your board of directors determines the target funding goal and the number of available shares.
So, let’s review your choices.
Your funding choices include debt financing, equity financing, and crowdfunding. Each has its pros and cons. Debt financing involves interest payments but no equity dilution.
Equity financing dilutes shareholder equity, but it can also bring new investor expertise to your firm. A third option is crowdfunding, which can be reward-based or equity-based.
Raising money for a small business is a full-time job if you want to grow and scale at crucial moments. Examples of this include new product launches, expanding into different states or countries, and expanding your development team. Assessing the financing landscape and understanding your options is essential during these times.
Call my office for step-by-step guidance through the financing process.
Acquiring any type of financing requires accounting and financial expertise. You may have some of that at your firm, but an outside professional can give you an unbiased analysis of your capital acquisition. My firm specializes in this.
Schedule a discovery call to get started.
Talk soon,
Jeremy A. Johnson, CPA