Fund Your Small Business

Determining your plan for funding your small business is a critical and practical way to ensure you will have enough financial resources to get off the ground. Most successful small businesses have negative cash flows in their first months or years of operation, meaning you will likely pour more financial resources into the business than you receive in profits. This is absolutely natural. It takes time to build a customer base, a solid brand, and hire employees. Having a carefully crafted funding plan will give you a much better chance of success during those early years, helping you keep the business afloat while you shape it into a profitable operation. In this article, I will discuss the steps to creating a sound funding plan for your small business, and various ways you may obtain the funding you need!

Determine Your Financial Need

The first step in creating your funding plan is to calculate costs you will incur before and during the course of your business. Remember, although your business will probably earn some money in its initial stage, the goal of the funding plan is to address gaps between what you must spend and what you are generating during and before that initial phase. Many small businesses fail, not because their product is bad, nor due to unhappy customers or bad pricing, but simply because they could not time their cash flows right. Good funding negates this risk. This way, you have enough cash to launch and operate your business until it starts earning you profits.

There are two types of costs you must think about.

1. Costs you will incur before the business starts making money, called pre-startup costs.
2. Costs you incur until the business is profitable. Again, this number will not be the total amount of expenses you must pay until you become profitable. You just need to obtain funding for the difference between what you expect to earn and what you expect to spend during that initial phase of business.

For now, I am just going to discuss these two. However, some owners who are making a profit will choose to obtain extra funding, not because they need it to pay their costs, but because they want to dramatically expand the business. I will cover this in the “expand” section. During the planning phase, you do not need to worry about this type of funding.

There are many different kinds of costs you can incur that fall into either the pre-startup or ongoing costs categories. The following is not an exhaustive list by any means, but I hope it will help you get a sense of the full scope of costs you may need to pay: rent, travel, utilities (electricity, water, etc.), telephone bills, marketing, software subscriptions, employee wages, legal fees, business and licensing fees, office supplies, interest (on loans), raw materials (for businesses who manufacture finished products), and taxes.

I will explain how you can practically create a funding plan in step 3 and give you an example!

Determine How You Will Obtain Funding

There are three main ways you can obtain funding for your small business. The first is through your own personal checking or savings account. This method allows you to avoid creating liabilities, which are promises to repay a person or institution like a bank. It also allows you to avoid giving up equity, which is the claim you have to the profits and assets of your business. This is why many small businesses are at least partially self-funded. However, you assume a great deal of risk, depending on the amount you choose to self-fund. There are many horror stories of individuals withdrawing large amounts from their retirement plans, selling their houses, and depleting their savings accounts, only for their business to fail. This is why you may want to consult a financial advisor before you commit a significant amount of your own funds to your business. At the very least, take responsibility for the risk that you may lose your entire investment. Also, if you begin generating profits, use that positive cash flow to continue reinvesting in the business. We will discuss this more in the “expand” section, but I just want you remind you that the goal is not simply to survive small business ownership, but to create a cycle of growth that propels your business to new heights.

The second way to fund your business is through investors. Investors are individuals or institutions that supply their own funds to businesses, usually in exchange for equity and decision-making power. In other words, these investors share the profits and assets of the business with you. This type of investment is known as a venture capital (VC) investment, and is usually only offered to businesses that seem to be growing very quickly, called high-growth businesses. The advantage of receiving such investments is no liabilities are created. However, you must be willing to give up some of your decision-making power to these investors. Please understand that it is in the best interest of the VC firm or institution for you to succeed. However, you must recognize that these firms/individuals generally take highly aggressive growth strategies that may conflict with your personal approach to conducting business. If you find an individual or firm willing to contribute VC funds to your business, ensure your goals, personalities, and growth strategy align.

Note: Experts generally recommend that you create a formal, written contract with any investors in your business. This allows you to avoid misunderstandings or lawsuits, and provides clarity with regards to if and how the investors expect to receive repayments.

Some small business owners also accept investments from friends or family in exchange for a share of equity, but this comes with its own set of challenges.  What if the business fails and your loved one loses their entire investment? What if they have no relevant business knowledge but try advise you on certain issues because they feel a certain degree of decision-making power is owed to them? Any situation which involves financial losses is very sensitive, and no amount of money is worth ruined relationships. Please be careful accepting such investments.

The third way you may choose to fund your business is through small business loans. I will write some articles on building lines of credit, creating forecasts, calculating start up costs, and creating a business plan. Assuming you already have these documents prepared, you can begin your search for a small business loan. There are many banks and credit unions that offer traditional business loans. However, these may not all be available to you if you have a weak credit report, a lack of history operating the business, or little income (through the business or other means). If this is your situation, use Lender Match to find loans backed by the Small Business Administration (SBA). SBA-backed loans are loans that the SBA guarantees it will pay back to the bank if you fail to repay the loan. This takes the risk out of the loan for the bank, so they are more willing to issue it. The SBA has several exciting programs and initiatives to help small business owners fund their ventures. You can find their official website at Small Business Administration.

There are a few important things to understand when it comes to loans.

1. The principal amount represents the amount of money you receive from the bank or credit union. This is after you have subtracted any money paid to the bank upfront, called a down payment. If the total loan amount is $100,000 and the down payment is 10%, you pay $10,000 upfront and receive $90,000 as the principal amount.
2. The term of the loan is the amount of time you have to repay the loan. Loan terms can range widely, depending on the specific loan. You can find anywhere from two-year personal loans to 30-year loans for houses.
3.  The interest rate is the cost of borrowing the principal. It is usually expressed on an annual basis, called annual percentage rate (APR). For example, if the principal is $100 and the interest rate is 5%, the cost of borrowing the $100 is $5, assuming the loan term is one year. In total, you will be expected to pay back the interest and principal, equal to $105.
4.  The maturity date is the date on which the entire principal ($100) must be paid off. This is usually done in installments of one month, so you probably won’t be paying the entire $100 on the maturity date, just the last portion to settle the debt.
5. An amortization table is a table that details how much interest and principal you must pay to satisfy your loan by the maturity date. Understanding the specific mechanics of amortization is not really necessary. However, it is important to obtain an amortization schedule for your specific loan so you know when cash will be leaving the bank, which will allow you to plan ahead.

Develop Your Funding Plan

The first step in creating a funding plan is compiling a list of all the relevant pre-startup and ongoing expenses your business will face until you expect to become profitable. A complete list of the expenses you expect to face broken down by each category is called your “itemized expenditures.” It is wise to be conservative with this estimate, meaning it is better to overstate your anticipated expenses than understate them. You do not want to run out of cash just as your business begins picking up steam. That is why experts recommend you add 10-20% to your projected expenses to ensure you have room for unaccounted-for expenses that arise.

The next step will be to select your method(s) of funding for the business. If you select more than one method, determine how much funding you will obtain from each source. Part of your consideration for the amount of funding you choose to obtain from each source should be the timing of your anticipated expenses. Generally, small business owners fund the very early stages of the business with personal funds. This allows the owner to build an operating history for banks to view when the owner applies for a loan. It also allows the owner to shorten the length of time the loan is taken out, thus reducing the interest that needs to be paid.

Last, in a software like Microsoft Excel or Google Sheets, plan out your repayment schedules for any loans that you take out, as well as any payments that investors expect to receive (as defined in your contract). Remember to include any interest you are expected to pay on loans. Loans are generally paid in monthly payments, called installments. Banks are generally required to issue repayment plans for SBA-backed loans to provide owners with clarity and transparency regarding their obligations for each month. If you take out a loan for which the bank is not required to issue a repayment plan, simply request one and most banks will be happy to issue one as part of their customer service commitment.