BCS: Helping business clients with opportunities and through crises since 1995

Financing Fundamentals for Small Businesses

A Brief Overview of Options to Raise Funds to Start or Grow Your Business

In Brief:
Although the individual methods are diverse, there are two main categories of financing: debt and equity.  It is most common for a business to use a combination of these two categories.

Equity Financing:
Equity financing is the process of funding a business through investors. Types of equity financing include funding obtained from traditional capital investors, venture capitalists (including angel investors), and the more recent advent of crowd funding investors.  At its core, it entails raising funds through selling a portion of the business. The investors’ return can be contractually structured to vary from (1) share price appreciation, (2) to payments in the form of regular dividends, (3) to a distribution from the sale of a business.

The main benefit of equity financing is that a business does not have to incur debt.  Additionally, the business is not required to make monthly dividend payments or distributions, so there is often more cash on hand for operating expenses.  These two benefits permit the timeline for business growth to be more organic.

The primary drawback to consider is that a portion of the business enterprise is now owned and controlled by the investor(s). This will require more compromises regarding business decisions as more items will be required to be put to a vote.

Debt Financing:
Debt financing is the process of funding a business enterprise through a loan.  The lender will be contractually secured for the amount of the principal plus interest. Types of debt financing include financing from banks, loans obtained from the U.S. Small Business Administration, and franchisor loan funding.

The main benefit of debt financing is that a business owner can retain full ownership of the business enterprise.  Additionally, the interest paid on debt financing is tax deductible.  This can operate to make it a more economical option than equity financing

The primary drawback to consider is that the repayment timeline for debt financing is harder to control. There always exists a risk of default, especially for smaller businesses with unpredictable expenses. Moreover, creditors are paid prior to equity holders in any bankruptcy action

There is no loan so ubiquitous to burgeoning entrepreneurs as a loan available through the U.S. Small Business Administration  (“SBA”).  For most small businesses, the most common types of SBA loans include: the SBA 7(a) Loan and the CDC/504 Loan.

SBA 7(a) Loan:
As of 2021, startups can qualify for an SBA 7(a) under certain stringent terms. Most small business are eligible, excepting those engaged in real estate investments, lending institutions and charitable work. For a standard 7(a) Loan, the maximum loan amount is $5 Million with a down payment of 10-20%. The SBA will guarantee 85% for loans up to $150,000 and 75% for loans greater than $150,000. This leaves the maximum exposure for the SBA at $3.75 Million.

The 7(a) loan allows the borrower the most flexibility of any SBA loan.  A borrower may acquire funds for a wide variety of purposes, including: short and long term working capital, refinance debts and the purchase of capital investments.  The term of the loan will be 10 years for all loans, except those loans for the purchase or improvement of lands or building assets.  In these specific instances the term can increase to 25 years. Prepayment penalties may be assessed.

CDC/504 Loan:
The CDC/504 Loan is the second most common SBA loan and is generally utilized for larger, more long-term projects from companies that need to scale up quickly with employees. This loan is not for startups. With these loans, certain Certified Development Companies work with the SBA and other private lenders to provide financing to small businesses.  The structure is such that the SBA 504 will only fund up to 50%  of the Total Loan Value, but there’s no upper limit on the funding amount. The second half of the loan is disbursed from a Certified Developing Company (CDC). They will put up around 40% of the total loan value, leaving the borrower with a standard 10% down payment.

The CDC / SBA 504 loan has some unique requirements: The borrowing company can’t have a net average income of greater than $5 million during the last two years. The borrowing company’s net worth must be less than $15 million. The personal assets of the business owner matter as a company can be denied the loan where the total loan amount sought is more than the personal assets of the business owner. If the loan will fund new construction, the business must currently occupy a minimum of 60% of the property and then occupy at least 80% within 10 years.  Most importantly, for every $65k issued, the borrowing company has to create or retain one job.

This loan is generally used to purchase land (may include improvements), construct or improve facilities, or to purchase large equipment.  The CDC/504 Loan is treated generally as a second mortgage on a tangible asset.  The term of this loan is also 10 years for all loans, except those involving real estate.

The capital needs of a business will vary based on a multitude of factors.  For most businesses the struggle entails determining how to (1) calculate the capital needs of a new business which may not see a profit for six (6) months or more or (2) obtain sufficient capital through growth stages.   A well-prepared  business should be able to rely on a carefully-crafted business plan to determine the capital amount needed for product development, marketing, equipment, supplies, administrative expenses, facilities and labor costs. Then, with the right combination of equity and debt financing, a small business can take powerful financial steps to stay solvent from the start-up stage through growth.