Financing is the backbone of any business, whether it is small or big. With cut-throat competition out there, it is a challenge that is faced by every industry — it is more apparent for small businesses due to their size and the uncertainty regarding its return on investment. So, they often do not qualify for conventional financing.
The above chart shows that most small businesses (32%) are started with cash. From purchasing a physical location to advertising your products and offering online services, every small business needs capital at the initial stage. First, it's raising the capital and then comes its management.
Most entrepreneurs launch their company on a shoe-string budget. According to a recent financial survey of startups, 64% of businesses started with less than $10,000. Raising $10,000 is relatively easy for larger, more established firms while smaller companies find it rather challenging to cough up such a large sum. When it comes to financing small businesses, there seem to be several factors at play.
Mentioned below are some of the financing options and challenges associated with them that are faced by small businesses.
1. SBA Loans
A Small Business Administrative (SBA) loan refers to the amount of money borrowed from a bank or a financial institution to start or expand a small business. When determining how to get an SBA loan, the qualifications considered are quite a few. With the necessary tools, no company is rejected from securing such loans. However, a small business faces challenges when they opt for an SBA loan.
Challenges Faced In SBA Loan Financing
• Banks and Financial Institutions are not willing to offer loans to small businesses. A survey has revealed that banks denied 82% small business loan applications in 2013. Banks and financial institutions deem small business loans as far riskier than lending to big firms.
• There are certain charges associated with processing a loan application that is borne by the borrower. These charges are the same for small businesses opting for smaller amounts as for big companies that are seeking to secure massive amounts. For a small business, these charges and fees are enormous, which may become a burden on the business itself.
• Banks and financial institutions demand higher interest rates from small businesses to cover higher risks associated with them. It can be depicted from the graph below, where 46% of the SMEs faced such an issue.
• Often banks will require personal guarantees/mortgage on individual properties of the owner of a small business.
2. Debt Financing
The term Debt Finance refers to a situation when a company sells bills, bonds, or notes to investors to raising working capital for the firm. The investors who purchase these bonds/bills/notes also receive a promise from the business that they will get their money back along with interest at an agreed rate within a stipulated time frame.
Challenges Faced In Debt Financing
• A small business is hampered by the unavailability of records, which could be presented to the lenders to determine the creditworthiness of the borrower. There is an aura of uncertainty around the future performance of the small business which does not go well with the investors who seek security for their investment along with the stipulated returns.
• Most small businesses are unable to provide a valid credit score from a reputable agency.
• Investors would want security for their investment before disbursing funds to the small business. Since debt financing is risky, security can be obtained through detailed business plans, the financial strength of its owners/directors and a list of business's assets (if there are any).
• As a rule of thumb, an investor would not increase the amount of debt to a small business until there is a corresponding increase by the company towards the collateral. It means that every time you go to the investor for a loan, they would require you to put in more equity into the business. Most of the time, this is not possible for the owner.
• Investors are reluctant to offer short and medium-term loans to small businesses since a long- term loan can be secured with the help of mortgages. Small businesses, on the other hand, rarely seek long-term investments because they are more expensive and do not suit their business model.
• Investors usually demand higher interest from small businesses compared to their larger peers. From the investors' point of view, the higher rate of interest covers the higher risk involved in working with a small business. For the company itself, the higher rate of interest becomes an extra expense.
3. Equity Finance
Equity financing is a process in which capital is raised through selling shares of the company at stock exchanges. The company offers ownership to the public (investors) so that they can raise money in an equity financing deal.
Challenges Faced In Equity Financing
• The stock market does not trust small businesses. Even if the stock market allows them to offer shares, it will be of little value. Consequently, the company will be forced to issue more shares to raise just a small amount of money.
• A typical investor in the stock market has a choice of investing in big established firms who have a proven track record of paying good dividends. In the presence of such firms, it is implausible that an investor will invest in a small business.
• Even if an investor chooses to invest money in a small business, he will not be able to resell those shares in the market when he needs cash.
Face The Finances
It's true that financing a small business is indeed a tough nut to crack. Once you have considered the viability of each financing option, it can help overcome your problems. The rise in capital ensures money management in the form of reduced debt and cash flows, which can help your business survive in tougher times.
You need all the help you can get to improve funding for your small business. Read more articles on money management and ditching debt right here on the Frugal Finance Blog!
