Explore options for small-business financing

It’s important to look at the pros and cons of each type of financing, and determine how much money is needed before making a choice. Figuring out the amount of financing necessary entails developing a good business plan, which will benefit you and will be de rigueur for most financing arrangements. Books, Web sources, software and classes can assist in the writing of a good business plan.

Don’t be too conservative in estimating the amount of financing you need. Undercapitalization leads to one-third of all small-business bankruptcy filings, according to the U.S. Small Business Administration. Some experts recommend estimating a realistic amount and then adding 10 percent to it just to be sure nothing was overlooked. Others suggest having enough funds in reserve to pay your personal living expenses for at least one year so as not to put a drag on your new business cash flow.

Each of these financing options has pros and cons, so it’s critical to develop a detailed, well-conceived business plan in the beginning, so you can determine your best funding options.

Personal savings

The nice thing about this option is that no one will turn you down. Of course, you may not have sufficient savings or you may not want to risk your personal savings, although some financing options may compel you to anyway.

Loans from friends or family

This is a popular choice when you can’t get standard financing. Still, it can come with great peril because of the emotional bond for both parties. Expect some strained times if things go sour, and be sure everyone thoroughly understands the risks upfront. Show friends and family your business plan and put the loan in writing.

Put it on plastic

Credit cards are easy to get and you don’t give up control or have relatives or friends peering over your shoulder. But using credit cards can be expensive and risky borrowing, especially if you fall behind on your payments. That’s why business experts often recommend limiting the use of cards for smaller, temporary cash needs you can pay back more easily, while using other financing for larger, longer-term expenses.

Commercial loans

Bank loans are often desirable because rates can be among the lowest, and a bank loan can make you look good to other lenders. The problem is that many small businesses have a tough time getting bank loans because banks are pretty conservative lenders. You’ll need to show them a solid business plan, a good personal credit rating and prospects for steady cash flow. You may be asked to guarantee the loan with personal assets, something not all entrepreneurs are willing to do. Shop around. Banks have different lending standards, and one may lend where another won’t.

Personal loans

Personal loans from banks are easier to get and often don’t require collateral. But interest rates are likely to be double or even triple a commercial loan rate, and lenders may balk at using the loan for a small business. Some entrepreneurs finance their businesses with home-equity loans, but that puts your home at risk.

Federally backed loans

The SBAprovides an array of loan options through private lenders (again, shop around). The main program, 7(a), provides funding for start-ups or existing businesses, for everything from land to equipment to working capital. A microloan program ($350,000 or less) is available for small firms that employ no more than five workers, particularly firms with minority, low-income or disabled owners.

Equity partners

Bringing in other investors is an option many small-business owners are loath to do, but may have to do out of necessity. Financing options from private investors can be complicated, and you’ll likely want assistance from an attorney with experience in this area.

The advantage of equity partners is that with a good plan and a promising business, you might be able to bring in much-needed cash for a venture that lenders might shun because of high risk or a lack of stable cash flow. On the downside, you dilute ownership, and investors are likely to offer lots of advice and criticism. Also, the process of lining up investors can take much longer than other forms of financing.

This article was produced by the Financial Planning Association and provided by William O. Woody, ChFC, of Stovall Woody Associates.

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