What is the typical way a small business is funded?

Nowadays there are so many ways to raise funding for your small business beyond dipping into your savings. From tax incentive schemes to traditional bank loans, Jonathan Amponsah, CEO of The Tax Guys, explains ten finance options for small businesses

1. Family and friends

It's common in the early stages of a business for parents, siblings or friends to financially support your business. This option is most suitable for businesses that need initial support to prove the concept can be successful, to the point where they can seek other funding.

Pros

It's a quicker funding process with flexible terms. Depending on how much interest you pay your friends and family, this could be a great investment for them.

Cons

Mixing business with family and friends' finances can damage relationships if things go wrong. You'll need to carefully assess the possible impact of business failure before proceeding.

2. Bank loans

Traditional bank loans and overdrafts are still a popular source of funding for many businesses and start-ups. Used properly, they provide a simple and effective way of financing the growth of your business. But make sure you do your research on the various types of loans, the terms and the interest rates that come with each option.

If you already have a business bank account, this option is especially suitable if you have a good relationship with your bank and you are able to make a convincing and well-researched business case. If you are yet to open a business bank account, it it worth checking whether you are likely to approved for a loan before applying as being declined can affect your credit score.

Pros

Some banks offer low interest rates, depending on your credit score. You won't have to give up any control over your business.

Cons

The process of getting bank finance can be long, tiring, and time-consuming.

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3. Crowdfunding

With this option you raise the total amount of funding you need online from the general public. People can either lend you the money (peer-to-peer lending) or take a stake (shares/equity) in your business.

It is most suitable for businesses with a great growth potential that will attract plenty of attention, and with time on their hands - it can take a while.

Pros

The larger the pool of people you can reach, the more chance of getting a good deal.

Cons

It can take a long time to hit your target, and you may have to invest a lot of effort in publicity.

4. Business angels

Angel investors are wealthy individuals who provide funding in exchange for a share in your business. Some investors work in groups, whilst others work on their own.

Business angel investment is not suitable for businesses who want to retain 100% control of their business.

Pros

Apart from the cash, angel investors will have experience and should be able to offer valuable business advice and guidance.

Cons

You're likely to have to give up control of your business to some extent.

5. Venture capitalists

These are investors who put in a considerable amount of money - generally a larger investment than an angel investor would provide - in exchange for equity in the business. Often their objective is to help the business to grow quickly, so that they can realise a good return on investment in a short time frame.

If you're a start-up with high growth potential and don't mind giving up some equity, venture capital funding is a good route to both secure funding and mentoring.

Pros

In addition to the funding, venture capitalists offer expertise to help develop the business. They can also open doors to other contacts in their network.

Cons

You're likely to have to give up a large chunk of your business, because of the significant amount of funding provided.

6. Short-term loans

Some finance outfits specialise in short-term loans (sometimes called 'payday loans') to improve working capital, boost cash flow or kick off a project.

This funding method may work for you if you're just bridging a gap and are confident you'll have the funds to make repayments on time.

Pros

The funding process is relatively quick if you qualify.

Cons

The rate of interest can be extremely high, and costs can quickly mount up.

7. Guaranteed loans

Guaranteed loan schemes, like the Enterprise Finance Guarantee, are for small businesses that don't qualify for bank lending - eg because they can't put up security or don't have a trading history. You will still have to demonstrate that your business plan is viable.

Pros

A source of lending if you've tried other traditional routes and been turned down. You may have lower repayments if the scheme is subsidised.

Cons

There are strict conditions to meet in order to qualify.

8. Incubators and accelerators

These are programmes designed to scale and grow ambitious start-ups. They provide mentoring and a small seed investment in return for equity in the start-up.

Pros

In addition to funding, these programmes offer structured training and valuable expertise to help develop your business.

Cons

The application and selection process can be gruelling.

9. Research and development grants

Did you know there could be free cash hidden in the work that you do? R&D grants are the Government's way of rewarding innovative companies. The grant either takes the form of direct cash or a reduction in your tax liability.

Pros

It's a grant - free money, no repayments.

Cons

There are conditions to meet, and you must be undertaking the right kind of work.

10. SEIS and EIS

The Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) are tax-efficient ways to secure funds backed by HMRC. When investors subscribe for shares in your business, they get tax back, and further income tax relief if they make a loss on the investment.

Pros

A highly attractive option to persuade investors to part with their money and invest in your business.

Cons

There are a fair number of conditions for both the company and the investor to meet, and you will need to carry out a 'qualifying trade'.

A word of warning

The funding options discussed all come with risks that can derail the growth plans of a business. To make the most of them, business owners need to keep an eye on cash flow, forecasts and key cash metrics including debtor and creditor days, as well as gross profit margins.

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