How to Finance a Small Business?
Deciding between getting a loan or choosing equity financing can be tough. So much so that it scares many entrepreneurs before they even start a business. It does not have to be this way, though. Instead, if you are in this position, you should carefully consider a few aspects to make the best decision for your business.
Source: Wix Media
Equity versus Debt Financing
Financing options for small businesses are growing, including crowdfunding, grants, invoice factoring, merchant cash advance, venture capitalists, SBA loans, corporate bonds, personal loans, business credit cards, etc. These can be classed as either equity or debt financing options.
Generally, equity financing means selling a company share to one or more external investors. It’s key to remember that when an investor acquires equity in your company, they have the right to a share of future earnings instead of expecting you to pay back the cash with interest at scheduled times.
The most popular forms of financing for SMEs in the UK in 2023 included loans, bank overdrafts, leasing or hiring, credit cards, and government or regional grants, based on a Statista report. Nevertheless, external financing requests were not always granted. Approximately one in every five SMEs claimed that all their submissions were declined. In such cases, SMEs considered other types of financing, such as borrowing from peers, crowdsourcing, equity financing, or factoring or invoice financing. Loans from family and friends, while generally of low value, can be crucial for SMEs and should not be overlooked.
While the median of new SME credit in the EU and non-EU high-income nations fell by 4% and 0.1%, respectively, upper-middle-income countries saw a rise of 4% year on year, as shown in Figure 1 below. The Scoreboard, which incorporates the SME lending trends in approximately 50 countries calculated as the median year-on-year growth rate, increased sharply in 2022.
Figure 1. SME debt financing growth rate, 2008-2022 (Source: OECD, 2024)
Venture capital (VC) investments, on the other hand, are highly volatile, as shown in Figure 2 below. They fell drastically by 16.2% in 2022, following a historic boom year in 2021, when VC funding activity soared by 60%. This was due to interest rate hikes, which prompted wealthy investors to seek less volatile financial alternatives.
Figure 2. Venture capital growth rate, 2003-2022 (Source: OECD, 2024)
What Financing Option to Choose?
Consider the following advantages and disadvantages of equity and debt:
Also, be clear on your business goals and long-term business strategy. These will influence your financial goals, risk tolerance, and how you intend to spend the money.
Financial goals
If you need strategic guidance and know-how, equity finance may be the answer, but if you want to retain decision-making and already have the expertise, debt financing is more suitable.
Risk tolerance
Debt financing is less risky since you have ownership and control of your company, yet repayments of interest and asset-backing can be costly. Equity financing is riskier as investors retain control and ownership of the company, although you don't have to pay interest, and investors bear the risk.
Funding purpose
If you need money for a project with a foreseeable payoff date, debt financing is probably more suitable because you can pay off the loan eventually. Equity could be the answer for expansion goals that exceed your repayment capabilities.
Commitment duration
Linked with business goals and funding purpose is the duration of the commitment. While you can repay debt entirely at some point, equity is permanent. Initial investors can sell shares to different investors, and the company can buy back outstanding equity from the marketplace. The company does not usually buy all its shares from the investors.
Income level
Calculate your projected income since this is a criterion for both lenders and investors before deciding to finance your business. Loans are usually the go-to option for established SMEs with stable cash flows, while startups seeking to expand may require equity.
Business lifecycle
Also, the best option at a particular stage in the business life cycle may not work later. Most businesses have a combination of debt and equity – calculated as the debt-to-equity (D/E) ratio – since they usually start by selling equity and later supplement financing needs through loans.
Source: Wix Media
Debt finance trends
Increasing interest rates
Credit conditions illustrate the consequences of a tight monetary policy. In 2022, interest rates rose and had an immediate impact on exchange rates and bank financing costs, based on a 2024 OECD report. Banks boosted capital and liquidity requirements, causing tougher lending restrictions. Corporate lending, including lending to SMEs, was affected since banks passed this cost increase to higher interest rates almost immediately. Coupled with diminished credit availability, lending to SMEs decreased since 2022, on average in OECD countries.
Short-term lending takes precedence
After the COVID-10 pandemic, there was a shift from short-term lending to long-term lending for SMEs. The majority represented outstanding stock of SME loans, however, issued before 2022. In the last two years, the trend reversed towards short-term loans. Both the variable-rate loans (especially in the EU) and the expectation that longer-term rates will decline pushed SMEs to take short-term loans.
Access to finance remains an issue
Financing options are increasingly dependent on sustainability concerns, and financial institutions are subject to sustainability reporting obligations, putting accountability pressure on SMEs. Nevertheless, SMEs cannot always obtain sustainable funding because they don’t have easy access to data on their sustainability performance. This became a priority for financial institutions that needed to manage risks, innovate credit solutions, and fulfil reporting obligations.
Equity finance trends
Equity crowdfunding continues to grow
Amid macroeconomic, political, and global health concerns, crowdfunding remains popular. Between 2015 and 2022, equity crowdfunding increased by a factor of 14. This happened in a context where the regulation for crowdfunding platforms allows them to operate with no minimum equity requirements since 2014.
Quasi-equity could be an option
Quasi-equity, also called mezzanine capital, can overcome specific market failures not addressed by traditional debt and equity financial instruments. In a company's capital structure, quasi-equity often has a risk-return profile between debt and equity. This means that it has a higher risk than debt and lower than equity, and the return is based on the profit or loss of the underlying asset.
The shift towards green equity
Green equity refers to both venture capital and private equity funds that are primarily focused on supporting creative solutions for environmental concerns. However, 55% of SMEs cite a lack of cash as a major factor for insufficient action on climate change, and over 70% say they require extra funds to act or accelerate their efforts on emission reduction, according to a 2024 OECD report.
References:
OECD. 2024. Financing SMEs and Entrepreneurs. Available at:
https://www.oecd.org/en/publications/2024/03/financing-smes-and-entrepreneurs-2024_015c0c26.html.
Statista. 2023. Financing of small and medium enterprises in the UK - statistics & facts. Available at: https://www.statista.com/topics/5875/financing-of-smes-in-the-uk/#topicOverview.