8 Tips to Understand Business Financing & Its Potential Risks
One of the largest risks of owning your own business is the financial risk involved. Almost 50 percent of new businesses fail within the first five years. Having enough funding is essential to make it through this period. If you don’t have the funds personally to supply to the business, you should think about raising financing so that you don’t have to reduce your budget on marketing or operations. Read on to learn more about financing a business, and common problems you might face.
1. Cash Flow and Business Failure
The first two years of a business is critical because almost 66 percent of new businesses fail within this time frame. One of the main reasons for failure is because the owners don’t have a good enough business plan, or don’t have the money to follow through with it. When you don’t have enough cash flow, you can’t pay for marketing, inventory, or staff. Without a client base, you don’t have the revenue to support any growth. This is why it’s important to secure financing from the very beginning. In most cases, it’s easier to get a business loan on day one of your brand-new business than it is to get one a year in with a revenue stream that is lacking.
You have a lot of choices when it comes to financing your business. To avoid being overwhelmed, you can break down your options into three categories. Of these, you can look for the best type that will work for your company based on its funding needs, size, and ability to secure financing.
2. Debt Financing
Debt financing is where you take out a loan. How you do this will be based on the size of your business, how much you need, and your credit. The ideal place from which to obtain a loan is with a bank or other finance institution. Other alternatives include loans from family members or an equity loan taken out against your personal home. If you go this route, make sure you do it properly and lend the money from your personal finances to your business.
3. Equity Financing
Equity financing is when investors have the opportunity to take an ownership interest in the company. When you sell shares of your company, you offer ownership to one or more investors in exchange for equity financing. This can be done via the stock exchange with a publicly traded company, or privately through the distribution of shares of a corporation or limited liability company where you issue shares to investors who “buy” a part of the company.
4. Lease Financing
Lease financing is commonly done for business vehicles, office equipment, and machinery. It’s similar to a loan; you will make regular payments but at the end of the contract, instead of keeping the item(s), you return it to the leasing party. At that point you can enter into a new contract for new or different equipment.
5. Inadequate Collateral
Collateral can be personal assets, company vehicles, machinery, or land. In most cases a bank will only lend up to 75 percent of the value of collateral. So if you need a $100,000 loan but only have $100,000 in collateral, the bank will likely only lend you as much as $75,000.
6. Too Much Debt
Any lender will want to see that you don’t have too much debt in relation to your equity.
7. Working Capital Deficiencies
If you don’t have enough cash flow and working capital to support your expenditures, you may be able to get a line of credit but you will have to show you have the means to generate the capital needs as quickly as possible.
8. Cannot Afford Payments
If your company has a cash flow problem, you won’t be able to afford the loan payments. Banks want to see that you have a debt-service ratio of 1.25:1 in order to lend you money.