There have traditionally been two options available to aspiring or existing entrepreneurs looking to finance their small business or franchise: borrow funds (debt financing) or sell ownership interests in exchange for capital (equity financing).
The principal advantages of borrowing funds to finance a new or existing small business are typically that the lender will not have any say in how the business is managed and will not be entitled to any of the profits that the business generates. The disadvantages are the payments may be especially burdensome for businesses that are new or expanding.
Failure to make required loan payments will risk forfeiture of assets (including possibly personal assets of the business owners) that are pledged as security for the loan.
The credit approval process may result in some aspiring or existing business owners not qualifying for financing or only qualifying for high interest loans or loans that require the pledge of personal assets as collateral. In addition, the time required to obtain credit approval may be significant.
Excessive debt may overwhelm the business and ultimately risks bankruptcy. For example, a business that carries a heavy debt burden may face an increased risk of failure.
The sources of debt financing may include conventional lenders (banks, credit unions, etc.), friends and family, Small Business Administration (SBA) loans, technology based lenders such as OnDeck Business Loans, microlenders such as Accion, home equity loans and personal credit cards. Small business owners in the US borrow, on average, $23,000 from friends and family to start their business.
The duration of a business loan is variable and could range from 1 week to 5 years or more, and speed of access to funds will depend on the lender's internal processes. Private lenders such as Short Term Business Loans Australia are swift in turnaround times and can in many cases settle funds on the same day as the application, whereas traditional big banks can take weeks or months.
The principal practical advantage of selling an ownership interest to finance a new or existing small business is that the business may use the equity investment to run the business rather than making potentially burdensome loan payments. In addition, the business and the business owner(s) will typically not have to repay the investors in the event that the business loses money or ultimately fails. The disadvantages of equity financing include the following:
By selling an ownership interest, the entrepreneur will dilute his or her control of the business.
The investors are entitled to a share of the business profits.
The investors must be informed of significant business events and the entrepreneur must act in the best interests of the investors.
In certain circumstances, equity financing may require compliance with federal and state securities laws.
The sources of equity financing may include friends and family, angel investors, and venture capitalists.
Alternative Small Business Financing Options
As access and availability to traditional small business financing has declined, several forms of alternative small business financing options have emerged. While most of the options are simply adding new sources for debt and equity financing, the ability to use retirement funds to finance a new or existing business offers a new type of small business financing.
Rollover Retirement Funds to Start a Business or Finance an Existing Business
A lesser known but well-established means for entrepreneurs to finance a new or existing business is to rollover their 401k, IRA or other retirement funds into their franchise or other business venture. This financing option is sometimes referred as “rollover as business startup,” “401k small business financing,” “ROBS financing” and “retirement owned business (robs).” It should be noted that this option does not consist of the entrepreneur taking a loan from his or her retirement account.
This small business financing option allows the business owner to obtain the benefits of debt and equity financing (including retaining control of the management and ownership of the business) while avoiding the disadvantages such as burdensome debt payments. Given these benefits, it is not surprising that over 10,000 entrepreneurs have used their retirement funds to finance their start-up businesses.
While the benefits are clear and the IRS has clearly stated that the use of retirement funds to finance a small business is not “per se” non-compliant, this strategy requires compliance with technical requirements. As such it is essential to employ experienced professionals to assist with this small business financing strategy.
New Sources of Debt and Equity Financing
In the wake of the decline of traditional small business financing, new sources of debt and equity financing have increased including Crowdfunding and Peer-to-peer lending. Similar to crowdfunding, new ways to acquire debt financing from friends and family include sites like TrustLeaf, to avoid the awkwardness of asking to borrow money in person.
Small business financing (also referred to as startup financing or franchise financing) refers to the means by which an aspiring or current business owner obtains money to start a new small business, purchase an existing small business or bring money into an existing small business to finance current or future business activity. There are many ways to finance a new or existing business, each of which features its own benefits and limitations.