Small Business Financing - How To Finance Your Business

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. In the wake of the recent financial crisis, the availability of traditional types of small business financing dramatically decreased. At the same time, alternative types of small business financing have emerged. In this context, it is instructive to divide the types of small business financing into the two broad categories of traditional and alternative small business financing options.

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Traditional Small Business Financing Options

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).

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Debt 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.

The sources of debt financing may include conventional lenders (banks, credit unions, etc.), friends and family, Small Business Administration (SBA) loans, technology based lenders, microlenders, 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 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.

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Equity Financing

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:

The sources of equity financing may include friends and family, angel investors, and venture capitalists.

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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.

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Rollover Retirement Funds to Start or Finance a 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 often called "Rollover as business startup" or "ROBS" financing. This isn't a loan: instead, the business owner forms a C Corporation, which sponsors a profit sharing retirement plan. From there, the business owner uses that company retirement plan to buy shares of his own company, thus contributing to the company's finances.

This small business financing option allows the business owner to obtain the benefits of debt and equity financing while avoiding the disadvantages such as burdensome debt payments. More than 10,000 entrepreneurs have used their retirement funds to finance their start-up businesses.

The IRS has clearly stated that the use of retirement funds to finance a small business is not "per se" non-compliant. ROBS financing is complicated, however, and the IRS has developed a set of guidelines for ROBS financing. As such it is essential to employ experienced professionals to assist with this small business financing strategy.

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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.

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