Business Planning and Financial Success

Personal Funds for Business Financing

The most common source of financing for small business start-ups is personal funds from savings, trust accounts or some other form of personal equity of the business owner or owners. This is the least expensive method of financing and also the easiest, as the decision to lend is made by the same person who wishes to borrow. Repayment terms can be as lenient as the business owner chooses. The obvious limitations are the extent of available personal funds and the willingness to put them at risk in a business venture.

Business owners using personal funds to finance their business must be careful not to overextend themselves. For example, using a home equity line of credit provides relatively cheap financing, but it also places the borrower's home at risk in the event of default. Some business owners are tempted to tap funds accrued in a retirement plan such as a 401(k), but in most cases this triggers a large penalty and income taxes must be paid on the distribution. Also, by law, certain retirement funds cannot be pledged as collateral on a loan.

Personal funds play a significant role in seeking other forms of financing. Most commercial lenders do not lend money to a small or medium business unless the owners of that business contribute personal funds to the venture. Just as a bank will usually not finance 100% of a new home purchase, bankers expect business owners to pledge their own funds to pay for a portion of financed purchases. For example, when banks lend to new businesses, they generally require 30 to 40 percent of the total investment to be contributed by the loan applicant. Banks require this for two reasons: first, it limits their exposure in cases of default; second, it demonstrates faith in and commitment to the business on the part of the borrower.

Other Informal Sources of Financing

Family, friends, churches, and community organizations are other informal sources of small business financing. As with personal funds, the amount of available funds is limited from these sources, and there is the added drawback that personal friendships and community ties might also be placed at risk in the event of default.

Equity Financing

Small business investment companies and venture capital organizations can also help with starting or expanding a business. Financing through an investment company or venture capitalist is different from borrowing from a lender because, instead of earning interest, they take an equity stake (part ownership) in the business, and it might be substantial. The advantage of equity financing is that this infusion of capital does not have to be repaid like a loan. The investment company or venture capitalist earns a profit through dividends paid to shareholders of the company and through appreciation in the value of the stock of the company.

As a condition of investing funds in a business, venture capitalists often have the right to review management decisions and, in some cases, appoint their own managers to oversee certain aspects of the business. While the entrepreneur typically retains day-to-day management control of the company, the venture capitalist has some control over the strategic direction of the business.

Thus, highly independent entrepreneurs must think carefully before accepting venture capital. Not only will venture capitalists be entitled to a significant portion of the profits of the company, but they also take away much of the autonomy of the entrepreneur.

Banks and Non-Bank Lenders

The most common practice for established businesses is to borrow money from commercial lenders: Banks, credit unions, or non-bank lenders. Commercial lenders are the preferred source of long-term financing for over half of all small business owners, in part because they are usually in a position to offer the lowest interest rate.

Such lenders typically charge small business borrowers the prime rate (the rate banks charge their best commercial customers), plus some additional percentage. The actual interest rate charged depends on many factors. Short-term loans generally have a lower interest rate than long-term loans. Banks usually charge a higher rate for relatively small loans, with the rate decreasing as the size of the loan increases. The creditworthiness of the borrower also affects the interest rate. Lenders charge a higher rate to borrowers whom they (the lenders) perceive as having a higher risk of default (late or non-payment of the interest or principle).

Another actor affecting the interest rate is whether it is fixed or variable. With a fixed-rate loan, the interest rate stays the same over the term of the loan. The interest rate on a variable-rate loan varies periodically over the term of the loan as market interest rates fluctuate.

Except for their accountants, small business owners cite their banks as their most important partner in financial success. Small business owners should make sure they know their bankers well, and that their bankers know them. The time to get to know your banker is before you need a loan. Regardless of their industry, small businesses should invite their banker to visit the company and give them a tour of the operations. Bankers are more likely to make loans to businesses they know and with whom they have a track record. This is especially important for small businesses that do not have a long credit history or are in new or unusual business fields that are not easily evaluated according to traditional lending criteria.

Commercial Credit

The most prevalent type of financing in the business world is commercial credit. Commercial credit involves venders delivering goods and performing services before payment is received. I many industries, buyers have up to 30 days after billing to pay for the goods or services before the payment is considered past due, although standards vary by industry. Many venders will extend even longer payment terms when asked in advanced if it means getting more business. A common practice among many venders is to provide 30-day credit with a discount for payment received within a certain time. For example, a seller might offer a 2 percent discount if the bill is paid within ten days, with the full amount due within thirty days if the discount is not taken.

Buyers who take advantage of the discount are essentially earning the equivalent of a 36 percent annual interest rate simply by paying within ten days instead of thirty days.

Of course, extending commercial credit can be a burden on the seller, because the seller is in essence providing an interest-free loan for 30 days to the buyer. Competitive pressures, however, make this a necessity in many industries.

Credit Cards

A personal or business credit card, issued by a bank or other financial institution, is becoming an increasingly common way to finance business purchases. Many small businesses use credit cards to buy office supplies, computers, travel services and other necessities for the office just as individuals use credit cards to pay for everyday purchases. Convenience and quick availability of credit make credit cards a very attractive financing option, even though interest rates on credit cards are generally higher than those on bank loans. In fact, after bank loans and vender credit, credit cards are the most common form of outside short-term credit used by small businesses. The same guidelines for responsible use of credit cards that apply to individuals also apply to businesses: businesses should avoid incurring so much credit card debt that the minimum monthly payments cannot easily be paid out of regular cash flow.

In order to serve business customers better, certain credit card issuers now offer special business credit cards that are issued in the name of the business. Having a corporate credit card can be a big advantage for a small business for a variety of reasons: