How Should You Fund Small Business Growth?
If asked what are their key objectives for their small business, most owners would put growth at or near the top of the list. After all, growth is usually a sign of small business success, and it’s also a good way for owners and executives to increase their compensation. And it sure beats the alternative: business decline.
But many owners aren’t aware of the challenges that can come with business growth. Sure, growth is exciting, and it leads to new opportunities for everyone in the company. But smart growth is carefully planned for — well in advance. Unplanned growth can lead to cash flow problems and, in a worst-case scenario, outright business failure.
Funding Business Growth
In order to grow, a business usually needs capital to support an increase in inventory, accounts receivable, fixed assets or other working capital needs. The first thing that must be accomplished in creating a strategic business growth strategy is devising a plan for funding business growth. There are three potential sources of this capital: owner’s equity, investment of personal resources in the company and outside financing.
Owner’s equity consists primarily of profits retained in the business. Many times company earnings aren’t sufficient to support serious growth initiatives. Because many owners prefer not to invest personal assets, they usually have to secure some type of outside financing.
Outside financing can generally take one of two forms: debt or equity. It’s critical to understand the differences between debt and equity as you formulate your strategic growth plans — because the funding decisions you make at this stage will have long-term repercussions on your business.
Debt is simply a loan that must be repaid with interest. Banks are the most common source of loans to support small business growth, usually via a term loan or line of credit. With a term loan, you borrow a specific amount of money from the bank at a set interest rate that must be repaid within a certain period of time. Loans are generally used to support long term purposes. With a line of credit, you are approved to borrow up to a certain amount of money whenever you need it, then repay and borrow again, making interest-only payments. Lines of credit should be used to fund capital needs that can be repaid within a year.
Equity is very different from a loan: It is the sale of an ownership interest in your business to one or more outside partners or shareholders. These investors are most commonly private equity firms, venture capitalists or angel investors.
Which Type Should You Choose?
In many situations, debt is preferable to equity if your business can qualify for a small business loan. This is because debt financing enables you to retain full ownership of your business. Right now, there may be no way of knowing the potential future value of ownership shares sold to equity investors. But in the long run, these could far exceed the cost of a business loan (i.e., the interest paid).
There are other softer costs involved in a business loan that you should also be aware of. The main one is the restrictions that the lender may place on your company’s operations — these are referred to as loan covenants. A lender will also usually want to see regular copies of your financial statements to gauge your company’s performance and financial condition and make sure you’re staying in compliance with the covenants.
In order to qualify for a bank loan, you will usually need to provide a current balance sheet and up to three years’ financial statements detailing your company’s financial history, as well as information to support your sales and profit projections. You will also probably have to pledge collateral to support the loan, such as business equipment, real estate or inventory, and possibly even your personal residence.
Going the Equity Route
If you don’t qualify for a small business loan to support your growth initiatives, you may decide to pursue equity investors like those listed above. Such investors generally seek out companies where they can earn high returns, so they will pay especially close attention to your business growth plans.
How much equity they will require in exchange for financing will depend mainly on their calculation of the risk-reward equation — or in other words, how risky is your business in relation to the potential return offered? Think about the reality TV shows with their panels of potential investors that consider proposals from aspiring entrepreneurs: They are trying to identify the businesses and entrepreneurs they believe pose the lowest degree of risk while offering the highest potential return on the money they invest.
Regardless of whether you decide to fund the growth of your business with debt or equity, be sure you take the time to plan your growth strategy carefully and deliberately before embarking on it. This includes whyyou want to grow in the first place. Growing for the wrong reasons may lead to frustration or, worse, failure.