Just as diversifying your income is important, a small business should not be dependent on one source of financing.
Having multiple sources of finance will allow you to better weather downturns if one source dries up. Different sources of finance have different pros and cons. Having numerous sources will make it easier to balance these and get the kind of funding that’s best for your business.
What Are the Sources of Finance for Small Business?
The primary sources of finance for small businesses are:
- Personal assets
- Friends and family
- Angel investors and venture capital
- Business incubators
- Banks, including credit cards
Which Source of Finance Is the Best?
It depends. Some people are not comfortable asking friends and family for a loan, and this can lead to problems and damaged friendships later. But on the other hand, the fact you are taking money from family might also mean you work harder.
Some people use credit card debt to bootstrap a business. If you have good credit, this is an option. Be aware that credit cards have some of the highest interest changes for any loan. Not making payments on the card or using a significant part of your credit limit can affect your credit rating.
If you are considering using credit cards to finance your business, see if you can get a line of credit instead, as that usually has a lower interest rate.
Personal assets are a good option if you have the money or resources to spare. The danger is, because it’s your own money, it’s easy for your business to become a hobby. If you are using your own money, it’s essential to treat it like a business and monitor how much you are putting into it versus the return.
Angel investors and Venture capital are other options. However, venture capital is different from other investments like angel investing in that venture capital firms want to make a profit sooner and have stricter payback terms.
Business incubators can help by providing business expertise, as well as office space to work in, as well as access to specialized equipment. You do have to have an existing business to be invited to join an incubator.
Government grants and loans are other options too. Government grants usually have generous repayment terms (or none in the case of grants). However, they are created to stimulate growth in regions, provide jobs or other economic goals. You have to apply for them, and this can be a long process.
Top Sources of Finance for a Small Business
Here’s an overview of seven common sources of financing for start-ups:
Your first investor should be yourself – either with your cash or with collateral on your assets. Having skin in the game proves to investors that you have a commitment to your business and that you are ready to take risks.
Friends and family (“love money”)
Investors and bankers call this “patient capital“, meaning it’s money that will be repaid later as your business profits increase.
When borrowing from family, you should be aware that:
- Family and friends rarely have huge amounts of money.
- They may want to have a say in how your business runs.
- A business relationship with family or friends can lead to all kind of problems down the road. This is the main reason people avoid borrowing from family and friends. If you choose this method, make sure you deal with contracts and agreements before problems develop.
Angels are generally wealthy individuals or retired executives who invest directly in small firms owned by others. They tend to keep a low profile. To find them, you can contact specialized associations. In Canada, the National Angel Capital Organization (NACO) is one source of information.
Angel investors are:
- Often are leaders in their field. They usually contribute not only their experience and network of contacts but also their technical or management knowledge.
- Angels tend to finance business with investments in the order of $25,000 to $100,000.
- In exchange, they usually reserve the right to supervise the company’s management practices.
- This often involves getting a seat on the board of directors and an assurance of transparency.
Venture capital gets a lot of press, but it is not necessarily the best source of finance, depending on your industry.
Getting venture capital involves giving up some control or equity in your business to them. Venture capitalists expect a healthy return on their investment, often generated when the company goes public.
Venture capital firms focus on:
- Finding technology-driven businesses and companies with high-growth potential
- Invest in sectors such as information technology, communications and biotechnology
If you are considering venture capital, have a look at the Business Development Bank of Canada’s (BDC) venture capital page. BDC gets involved in start-ups with high-growth potential, preferring to focus on significant interventions when a company needs a large amount of financing to get established in its market.
Unlike Angel investors, Institutional venture capitalists prefer more substantial investments, in the order of $1,000,000.
Business Incubators / Business Accelerators
Business incubators are usually created for one of two reasons:
- Focus on the high-tech sector (biotechnology, information technology, multimedia, or industrial technology) by providing support for new businesses in various stages of development.
- Local economic development incubators. They focused on things like job creation, revitalization and hosting and sharing services.
Getting into an incubator usually involves being invited to join. Incubators look for future businesses to share their space. An incubator can provide administrative, logistical and technical resources (such as lab equipment or other specialized equipment) so that a new business can develop and test its products more cheaply before beginning production.
Government Grants and Subsidies
Federal and Provincial government agencies provide grants and subsidies that may be available to your business. However, getting grants can be hard. There is much competition, and the criteria for awards are often stringent.
Also, most grants require you to match the funds you are being given.
What you need to provide to apply for a grant
- A detailed description
- The benefits of your project
- A detailed work plan with full costs
- Details of relevant experience and background on crucial managers
- Completed application forms when appropriate
- Demonstraight need for grant
Bank loans are the most used source of funding for small businesses.
Bankers are looking for companies with a good track record, cash flow, and that have excellent credit with a solid business plan. Also, banks will typically require a personal guarantee from the entrepreneurs. You should also be aware of the interest rate.
As an alternative to commercial banks, the BDC offers start-up financing to entrepreneurs in the start-up phase or first 12 months of sales.