In order to determine how much financing your small business will need, you should estimate all the costs involved in organizing and setting it up and running your business until you start to generate sufficient income
and cash flow to cover your expenses. Once you determine the initial amount you will need, you subtract the amount of your own resources you plan to invest in the business, and the result is the amount of financing you need.
Each business is different and has different financing needs during the various stages of its organization, start-up, and operation. Some businesses may have a significant initial investment in property, plant, equipment, tools, supplies, and inventory. In other businesses it may be possible to start with much lower initial costs. What is important is to have as clear an idea as possible of how much you need to start. And although it is not a good idea to go into more debt than necessary, neither will it serve your business if the amount of financing you obtain is not enough to cover your needs.
Depending on the legal structure you decide to use, you can count on incurring certain costs to set up your business. For example, it may be necessary to seek legal or tax advice to initiate your activities. There could be permits or licenses required to operate your business. If you need to lease space for offices, workshops, a warehouse, or some other facilities, you will probably have to pay a deposit and perhaps one or more months of rent in advance. Connecting utilities such as electricity, gas, and water may also mean deposits and installation costs. You will need to pay premiums for the different types of insurance you business needs, and these premiums are paid in advance. Having a clear idea of all these types of organization and start-up costs will help you in determining how much initial financing you will need.
Working Capital Requirements
Based on the projections that form part of your business plan, you should have a reasonably clear idea about how long you will have to finance your operating expenses until you start to generate sufficient income to cover them. You will need to have readily available working capital to finance this period. How much working capital you want to keep as a reserve to cover unforeseen costs will depend on your line of business and the magnitude of your estimated costs and expenses. In any case, you should have sufficient working capital to finance your operation over the first few months.
Scheduling Your Projected Disbursements
When thinking about the financing you need, based on the projections you have made of your costs and expenses, it is important to try to separate essential disbursements from those that are more discretionary. You should go into debt only to cover those costs and expenses that are necessary to get your business started, or to finance an acquisition, expansion, or other opportunity that you know will add value to your business and produce a return that is sufficient to be able to repay the debt and leave you with a profit. Then, the essential disbursements should be separated between fixed expenses and variable expenses.
Fixed or general expenses do not depend on the level of production or business activity. These could include rent, the base charge for utilities, administrative expenses, and insurance. Variable expenses depend on the level of activity and could include materials and supplies, costs to ship products, commissions, and other selling expenses.
Once you separate your estimated expenses between fixed and variable, you can more precisely determine your financing needs. You could do a spreadsheet including all the one-time disbursements you will make, such as organization expenses, start-up costs, and acquisitions of fixed assets, and the expenses that will continue over time, such as rent, materials, payroll, and taxes. You can do this projection on a calendar basis, or as a timeline, based on when you have to disburse the funds. With this, you will have the information you need to determine how much financing you need, and when you need it.
This can be useful in scheduling your applications for loans, your use of a revolving line of credit, or taking cash advances from a credit card. By knowing when you will need the financing, you can take on debt when you need it and avoid unnecessary interest charges. Lines of credit are more flexible in this regard than traditional loans.
Debt or Equity Financing
How do you know if you should use debt or equity financing for your small business? Debt financing consists of loans that are repaid, and the business’s equity structure does not change. The cost of debt financing is interest. On the other hand, equity financing consists of capital contributions. Part of the ownership of your business is shared with the investors. The cost of equity financing is the payment of dividends or shares of the profits. Debt financing can be short, medium, or long term. Equity financing is long term. Whether you use debt or equity financing, or both, will depend on whether you want to share the ownership of your business.
When you are looking for financing, you should consider your business’s debt to equity ratio. This is the ratio between the amount you have borrowed and the amount you have invested in the business. Many times, the greater the amount you have invested in the business, the easier it is to obtain financing.
If you have a low debt to equity ratio, it may be convenient to seek debt financing. But if you have a high debt to equity ratio, it may be better to consider financing the business with additional capital contributions. When a business is overloaded with debt, it can be difficult to meet the due dates for installment payments.
Relatives, friends, and associates could be potential sources of loans, especially when the amounts involved are not large. It is a good idea to formalize and document these loans. They should be recognized as business obligations.
Banks and other financial institutions are probably the most traditional and common sources of debt financing. Banks can offer short, medium, and long-term financing in the form of signature loans, lines of credit, second mortgages or home equity loans or lines of credit, and collateralized loans for the purchase of real property, vehicles, machinery and equipment. It can be more difficult for a small business to obtain a loan from a commercial bank without some kind of guaranty.
The U.S. Small Business Administration has loan guarantee programs for small entrepreneurs. You can find information in their website at www.sba.gov, in “Financial Assistance” under the heading “Services”. Also, many state and local governments have programs to stimulate the growth of small companies due to the positive impact they have on the economy and for employment. Many of these programs offer financing or loan guarantees. You can find links to these state small business development agencies in websites such as the U.S. Department of Commerce Minority Business Development Agency at www.mbda.gov, and the Small Business Development Center Locator in the U.S. Small Business Administration website at www.sba.gov. Or you can do a web search by state with the key words “small business development”.
Depending on the size of your business, you may prefer to restrict equity financing to your own investment or those of you and your partners. This way, control over the business remains in your hands. If you need additional financing, just as in the case of loans, your relatives, friends, and associates could be potential sources of capital contributions.
A common source of third-party equity financing is from “angel” investors, and “venture capital” investors. They are individuals or groups who are willing to invest capital in exchange for a better than average return on their investment. They may specialize in a certain line of business or industry. Although they are willing to take risks, they take calculated risks, and many times prefer to invest in a business once it has demonstrated its potential for generating profits and growth.
Angel investors may be more willing than venture capital investors to invest in smaller businesses that are in the start-up stage. Many times, venture capital investors are interested in businesses that are growing and that could eventually become significant competitors on a regional, or even national or international level in a certain market.
These types of investors can take different approaches in terms of the degree of influence they want to exercise on the management of the business. In general, some are more passive, but could come to exert more influence in decision making, especially in strategically important times in the business’s development. Turning over part of the decision-making authority and a portion of earnings can be seen as disadvantages of third-party equity financing, depending on what you want to achieve with your own business.