Financing options available to businesses
Business financing options are varied – you can take on a term loan, borrow against invoices, seek out an angel investor, or even use crowdfunding. If you need to raise capital to establish your start-up or drive growth, choosing the finance source that fits you best is crucial.
In this guide, we'll look at the different types of business finance, along with pros, cons and examples.
What is financing?
Financing is the umbrella term for any method of funding your business, whether for day-to-day operations or expansion. You can finance your business through borrowing, known as debt financing, or with the help of investors buying into your business. Both finance categories include a wide range of options – it's about finding the one best suited to your business size, goals and stage.
Why is financing useful for businesses?
Financing is useful for business because it helps fund growth over and above your capacity from your income. If you're running a company that isn't yet profitable enough to support expansion, financing can bridge the gap and help get your new initiatives off the ground. It's also vital to building a new business, giving would-be business owners the capital to realise their ideas. Finance can also be useful if you've hit a rocky patch with cash flow and need money to pay your bills while your revenue grows.
What are the different types of business financing available?
The two main types of business financing are debt financing and equity financing. Debt financing involves borrowing cash to fund growth. Equity financing involves getting funds from investors and handing over a portion of the business in return.
A range of options exist in each finance category, each with its pros and cons.
Debt financing is any capital-raising that comes from borrowing – including bank loans, loans from non-bank lenders, lines of credit, peer-to-peer lending and invoice financing. As with any loan, money has to be repaid with interest, often through monthly payments on a short or long-term schedule. While some business owners are wary of taking on debt, it can be an easy way to raise the capital you need to get established or expand operations.
Pros of debt financing
Accessible to all kinds of business
Repaying on a schedule makes planning simpler
No need to give up equity in your business
Cons of debt financing
Funds must be repaid
Some lenders require collateral to secure the loan
Your credit rating may affect the type of loan or lender you can access
Term loans are a traditional borrowing option, often used to buy tangible assets like equipment or property. Much like mortgages, they give you a lump sum upfront, which you pay back over a set period. Loan lengths, terms and interest rates vary depending on the lender, the amount borrowed and your ability to make payments.
Pros of term loans
Lower interest rates than credit cards or other loan options
Scheduled repayments make planning simple
Cons of term loans
Money has to be repaid
You may need to pay break fees or penalties to change the terms of the loan
Interest adds up over time
Line of credit
A line of credit is a bit like a credit card for your business. You apply, get approved for a certain amount and then spend money as and when needed. Like a credit card, you only pay interest on the amount used – not the total available – making lines of credit a flexible option for accessing additional finance.
Pros of lines of credit
Easy to use
Interest is only paid on the amount used
Cons of lines of credit
Balance needs to be paid each month
May have higher interest rates than term loans
Invoice financing lets you borrow against unpaid invoices, giving you an advance to bridge the gap in your payment cycle. Invoice finance providers lend you the cash amount owed on the invoice, often supplying funds within a few hours. When the invoice is paid, you’ll need to repay the amount advanced, plus any fees or interest applicable, within an agreed timeframe.
Pros of invoice financing
Quick, simple way to access funds
Helps maintain cash flow even if invoice payments are slow
Cons of invoice financing
Usually provides smaller sums than a term loan or line of credit
Only accessible to B2B businesses that use commercial invoicing
Peer-to-peer lending connects individual lenders and borrowers outside of banks or financial institutions. Both parties join a peer-to-peer lending platform, pick the loan and terms that work for them, and manage repayments through the platform.
Pros of peer-to-peer lending
Accessible to most borrowers
Cons of peer-to-peer lending
Fees and interest rates may be higher than traditional lenders.
Most lenders have a minimum loan amount.
Angel investors are wealthy individuals who invest in start-ups and other small businesses. Working with an angel investor is a form of equity finance, as the funding is exchanged for an ownership portion or shares in your business. These investors are often entrepreneurs or successful business owners, which means they can spot growth potential and provide mentorship as well as funding.
Pros of angel investors
Quick source of capital
No need to repay funds in cash
May get mentorship or guidance from the investor
Cons of angel investors
Loss of equity in your business
Pressure to make a profit quickly
Venture capital (VC) is equity finance designed to drive rapid growth. VC firms tend to focus on start-ups and small businesses in high-growth sectors where they can make a strong return on investment. Venture capital firms may manage funds that high-net-worth individuals, banks and other financial institutions invest in.
Pros of venture capital
Access to significant start-up funds
You may get support, connections and guidance from venture capitalists
Can be more accessible than a loan
Cons of venture capital
Loss of equity and control
High expectations from VC firm
With crowdfunding, you get small amounts of money from a large group of people rather than a large lump sum from one lender. While this form of funding is associated with friends and family chipping in to support a small business, it can also be used to gather funds from outside investors.
Unlike traditional crowdfunding, equity crowdfunding involves multiple investors offering funds in exchange for shares - or the promise of future shares - in your business. Each investor usually provides a relatively small amount of funding and receives a relatively small portion of your equity as a result.
Pros of equity crowdfunding
Accessible to anyone
No need to repay funds
Cons of equity crowdfunding
Funds are usually limited
Loss of equity
Must have an exciting or innovative idea to get people interested
Incubators and accelerators
Incubators and accelerators nurture small businesses through the start-up phase in exchange for equity. Most programs offer focused guidance and support for a short period – often three months – to help your business develop or refine your product, connect with investors and suppliers, and finally present your prototype. Some accelerators also provide limited funding to help you get started.
Pros of incubators and accelerators
Intensive support and guidance
Limited timeframe drives rapid growth
Cons of incubators and accelerators
Funding is usually limited
Loss of equity in your business
Most accelerators require a well-established business concept, not just an idea.
Mezzanine capital financing
Mezzanine capital financing combines debt and equity financing for a ‘best of both worlds' funding solution. You take out a loan from a specialist lender as normal, but the loan agreement conditions are slightly different. If you default on the loan, the lender has the right to claim the loan amount as equity in your business. This means while you don't risk bankruptcy or penalties if you miss payments, you risk losing a portion of your business.
This type of financing is often used to fund a specific expansion project or acquisition.
Pros of mezzanine capital financing
Interest can often be added to the main portion of the loan, and smaller loans can be restructured into a single senior loan.
You can use mezzanine financing to fund large projects and rapid expansion.
Cons of mezzanine capital financing
Potential loss of equity
Lenders may require a board position or other input
Interest rates are generally higher than other forms of debt
Financing options FAQs
What is the best financing option for a business?
The best financing option depends on several factors – your risk tolerance, the size of your business, your funding needs, your credit score and whether you're in a start-up or growth phase. There's no single option that works best for every single business owner.
What is the most common source of business financing?
The most common source of small business financing is bank lending, probably because other sources of finance aren't as accessible. Many small business owners self-fund their start-up costs as well.
What is the most affordable source of business financing?
The most affordable source of business financing is self-funding – you personally cover business costs, and can choose not to charge the business interest. Debt finance is initially more expensive than equity finance, because you need to pay interest and establishment fees. However, giving away a share of your business may be more expensive in the long term.
Business finance basics with MYOB
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