Types of Small Business Financing

A small business is defined as one which is privately owned, has only a few employees and low sales volumes. Though the number of employees and the capital invested in a business is different in various countries, it is certainly not one of the major market players in its field. Small businesses are often self-financed with the entrepreneur investing all his savings to start the venture. This is also called bootstrapping in financial jargon. It also implies that the owner who uses his funds, also foregoes his own salary. Bootstrapping the business completely or partially reveals the owner’s commitment to the success of the venture.

But many prefer to get their business financed so as to ensure a smooth cash flow and minimize the personal risk in case it fails. Finding finance for a small business is not easy because of the stringent regulations and the list of requirements that need to be fulfilled. This is why many start up small businesses choose informal channels like forming a barter alliance, or signing a partnership with a supplier.

External Financing of a Small Business

There are two types of external financing available for the entrepreneur- debt financing and equity financing. The amount of financing possible is linked to the company’s debt-equity ratio. This ratio reveals the percentage of own funds and those taken as loan. It is easier to get financing for the business if a larger amount of personal funds have been used.

Debt Financing

is possible by borrowing from banks, financial institutions, or government agencies like the U.S. Small Business Administration. All of them are able to provide larger sums for investment. Informal channels of financing include family, friends, or associates, but they can only provide limited amount of funds.

Dent financing can be in the form short term loans or demand loans that are granted for a defined period, though they can be called for, at any time. Term loans are longer term and can be used for asset purchases. Banks often agree to open a Line of Credit which can be used to make multiple payments. Small businesses can even avail of a bank credit card to pay their dues, though it is one of the most expensive financing methods.

Equity Financing

is used in a limited manner for financing small businesses. Equity funding from informal sources includes family and friends, while formal channels for equity financing includes venture capitalists, who have a large pool of resources in a professionally managed fund, can take the risk of financing even a startup or running small business and like to participate in crucial decision making of the business. Venture capitalists conduct their own enquiries before they select a business that they agree to finance. They also keep tabs on the progress and profit making capability of the business, and even push for changes if the bottom line is not covered.

Equity financing can also be received from ‘angel investors’. Angel investors are rich individual with abundant funds that they are willing to invest in a business in exchange for ownership equity. They fall in a category that is between family and friends, and venture capitalists. Angel investors invest heavily in high growth small businesses.

All types of small business financing increase the chances of the venture to succeed, and ensure there is adequate cash flow for the company to function efficiently.