Learning about types of finance is a necessary reality when starting or running a small business. You’ll need to carefully pick through the types of business finance that fit your particular circumstances.
Committing to the wrong type of finance for your small business can mean not only costly repercussions but also missed opportunities to grow more effectively and cheaply.
Before you consider small business finance
Prior to taking up any types of finance available to businesses, you should consider the following:
- Figure out exactly how much business finance you’ll need for your circumstances.
- Ensure you have a solid business plan, preferably checked by a business advisor, which accounts for business finance.
- Understand how long it will take to repay the loan or type of finance you desire.
- Be sure of your ability to either finance yourself, pay the loan or keep investors happy.
- Talk to a trusted business advisor before committing to a particular type of finance.
3 Types of Business Finance
There are three types of finance for businesses. Each method of funding your business’s start-up or growth comes with unique advantages, drawbacks, requirements and structures. They are:
- Internal funding
- Debt financing
- Equity financing
Let’s discover the nature of each type and its pros and cons.
1) Internal funding
Internal funding is a type of finance that basically relies on your own savings, assets, and capital to inject necessary funds into a business venture.
This is your money.
Advantages
When you literally dip into your own bank account and spend your own cash to fund the establishment or further growth and investment of your business, you’re in complete control.
You forgo the onerous yoke of debt, which is a major advantage in any business and may allow you to take up loans more easily down the track as you’re not indebted.
You’re also free from the consideration of external investment and investors, maintaining sole oversight and management of your business and its activity. This makes control, freedom from debt and independence the primary advantages of internal funding.
Disadvantages
As with all types of finance, there are negative considerations for businesses.
Firstly, you’ll have to stump the initial cost, and this requires a deep pool of savings, which not everyone has, and which you likely worked very hard to amass.
You may also be putting potential cash flow at risk due to depleting your available cash reserves which are often used to shore up holes in income when your accounts receivable is too high, or you’re waiting for a return on investment.
Sometimes opportunity for growth requires a timely injection of cash, and by using internal funding you may have to forgo such chances.
2) Debt finance
Debt financing options involve the business owner taking on debt by borrowing money to fund their business. Debt finance includes bank loans, short-term business loans, credit cards or overdrafts.
Debt finance is an extremely popular and widespread type of business financing.
Advantages
Many small business owners will not have a bank balance large enough to fund their business goals and outlays.
As such, debt finance has the advantage of allowing would-be entrepreneurs and established businesses to fund and grow their dreams into profitable ventures, without having to stump up the initial costs.
Disadvantages
A loan will inevitably come hand in hand with interest and debt.
If a business doesn’t turn a regular profit, the burden of debt, repayments, interest and the risk of losing a securing asset can threaten financial stability and land the borrower in a precarious position.
It can also be difficult to secure larger loans without a positive lending history or assets for collateral, making them burdensome to receive.
3) Equity finance
Equity finance refers to the act of securing outside business investment from organisations or individuals who will then own a stake (or equity) in your venture.
By seeking investment in your small business through equity financing, you’ll need to convince angel investors or venture capitalists that your business will return a timely profit on their investment.
Advantages
By side stepping both debt and the tall order of self-funding, you have a very attractive form of financing on your hands which is a fair amount ‘safer’ than the other two options.
In many cases, you not only avoid debt by investing other people’s money – you also receive the benefit of their usually savvy business advice. Investors are often careful, connected and experienced in business, lending you even more advantage.
Disadvantages
Equity finance, as its name suggests, means you’ll have to forgo a certain amount of equity in your business in return for their investment.
By giving up not only part ownership, but often part-control over your business, you’ll no longer be in the driving seat and may be forced into decisions you don’t agree with and part with a portion of the profits.
Finding, courting and convincing an investor to take a risk on you is also a difficult and time-consuming task, requiring a very strong proposal and an outstanding business model.
Types of financing for small business
Some forms of business finance are particularly appealing and well suited to small businesses.
Within the three main types of business finance above, you’ll find a range of products, variations and permutations that extend your options even further.
Before even considering taking up a bank loan for example, be sure you have surveyed the market and have a solid understanding of the various methods you could alternately be using to finance your small business.
Types of business finance to think about as a small business include:
- Short term loans
- Crowdfunding
- Angel investors
- Accounts receivable financing
- Business credit cards
- Equipment financing
With an overview of the three main types of business finance in mind, it’s important to speak to a trusted business advisor about your specific lending needs, business plans and business health before making a decision.
The material in this document is of a general nature for guidance only, provided in accordance with our legal disclaimer. Please consult a professional adviser about your specific circumstances.
