Private Funding Sources for Small Businesses

What is private funding and why is it important?

Private funding sources are generally nonbank lending sources. They include family members, angel investors, venture capitalists or private lending institutions. These are sources of cash that a business owner can access to bankroll operations, grow their business and meet cash flow needs. Private funding sources serve to help small businesses that may not otherwise qualify for a bank loan. 

“Obtaining sufficient capital could literally be the factor that makes or breaks a business’s ability to grow,” said Simon Goldenberg, an attorney who specializes in debt relief and financing law for small businesses and individuals. “Without private funding, many of those businesses could struggle to get off the ground or keep their doors open.”

Of course, with so many different types of private funding, it’s important to understand which is best for your business. Consider your plans for the funding before applying for a private loan or pitching an investor. How you intend to invest the funds may help determine which type of private funding you should pursue.

“The type of financing a company does should be dictated by what the money is going to be used for,” said Casey Berman, founder and managing partner of Camber Creek. “What is the investor going to bring other than money?”

Private equity funding for small business

For small businesses exploring their financing options, the first order of business is to distinguish between debt and equity financing, said Brian Cairns, CEO of ProStrategix Consulting. Debt financing involves taking out a loan while equity funding is a purchase of a share of the profits or control over the company. 

For many startups, securing investment is especially attractive because it does not clock any liabilities on the balance sheet. 

“The main pro with any equity funding is its limited to nil effect on cash flow,” Cairns said. “The main con is giving up partial control of the company.” 

Private equity at the startup level is often seen in two forms: angel/seed investment or venture capital (VC).  

VC

VC firms invest money in startups, usually in exchange for equity in the company. Venture capitalists analyze business plans, financial statements and other business details to determine the overall expected return on investment (ROI) before investing in a portfolio company.

Companies are most likely to attract VC if they have an immediate opportunity for growth, said Cairns, as VC firms will generally want to exit within five years. “They are looking for rapid expansion, which will drive up the valuation.”

Such high-growth enterprises represent a lot of risk, which is why VCs require a much higher ROI from their portfolio companies compared to other private equity firms.

Venture capitalists often also provide guidance to young companies, such as mentorship, access to sales networks and other development opportunities.

“If a company is looking for private funding, looking for more than just money is key,” Berman said. “In a lot of circumstances, the money might be more expensive than bank debt. However, the value that can be created through that partnership far outweighs a low interest rate.”

The downside to working with a VC firm, as with any lender looking for equity, is that you’ll be giving up a certain percentage of your company. It also means that you’ll have a third party to answer to as your business grows and changes.

“[VC firms] will likely require more reporting and oversight,” Cairns said.

Angel/seed investing

Much like venture capitalists, angel investors finance startups usually in exchange for equity in the company. Unlike venture capitalists, however, angel investors are private individuals investing their own money. Angel investors also have different ROI requirements depending on their risk appetite, which makes them a better fit for slow-growth companies. Meanwhile, some venture capitalists expect 100% growth year over year, Berman said.

“Not all money is created equal,” he said. “A venture capitalist is going to structure a deal one way, a private equity firm is going to structure a deal a different way and an angel investor is going to do a different deal.”

Similar to angel investing is seed investing, where a group of individuals or a government agency provides capital.

“They usually provide funding through a convertible note for a set fraction of the company, usually no more than 20%,” Cairns said.

Most convertible notes, or IOUs, are due in three to five years, at which point the investor can reclaim the money plus interest or convert the note into shares or equity. 

Other types of private funding sources

Options abound for small business owners who are looking for private funding. Sure, it’s not a government grant, but when you need financing to start up your small business, there are several possible sources:

• Personal investment: Some entrepreneurs may not want to accrue debt. Instead, they use their savings (or sell an asset, such as a vehicle) to get up and running. Some use a portion of their retirement savings. Using your personal savings can be risky as you could lose your life’s savings if your business fails.
• Family and friends: Funding from family or friends could be provided as a gift, as a loan or in exchange for an ownership stake in your enterprise. Be careful, though. If the investment doesn’t pan out or you can’t repay the loan, it could cause permanent strife with those closest to you.
• Term loans and lines of credit: Term loans, in which you pay a fixed amount each month to a bank, credit union or online lender, are popular with small business owners ─ as are lines of credit, in which you draw money when you need it. Your credit score, years in business and sales revenue dictate how much you can borrow and at what interest rate.
• Crowdfunding: There are several crowdfunding websites that enable entrepreneurs to raise money for their ideas. Investors on platforms like Kickstarter or Indiegogo invest sums in exchange for helping products come to life. The companies usually offer rewards in exchange for contributions. Crowdfunding may not make you rich, but it may also serve another purpose: testing consumer interest in your product.
• Alternative financing: Term loans and lines of credit aren’t the only private funding sources small business owners can access from lenders. Merchant cash advances (MCAs) and microloans are other options. With an MCA, lenders give a business owner cash in exchange for future sales. Microloans are small loans, typically $50,000 or less, for businesses that aren’t likely to be approved for a loan from banks and mainstream lenders.

Pros and cons of private funding sources

There are advantages and disadvantages to working with private lenders. You may have access to capital more quickly, but the interest rate may be higher and you may have a demanding payment plan.

Benefits of private funding

Private funding sources provide a valuable service for small businesses through their more relaxed lending requirements and quick funding:

• Fast approval: There are often lengthy approval processes with bank loans. Private lenders are often able to expedite your application and let you know if you’ve been approved in a shorter period of time.
• Fast funding: Unlike bank loans, private capital is often in your hands much quicker. Once you’re approved, private lenders can get the money to you in a matter of days, sometimes even 24 hours or less.
• Flexible options: Private financing comes in all shapes and sizes, so you can find the option that best suits your circumstances. Private lenders offer term loans similar to banks, but they also offer services like invoice factoring, equipment loans, bridge loans, MCAs and more. Be sure to understand all of these options in detail before applying to make the best use of them, but you will have the flexibility to choose what’s best for you.
• Investor experience: If you are using a venture capitalist or angel investor, there is the added benefit of being able to get advice from those who have seen it all. Venture capitalists and angel investors typically have vast experience in how to run a business. They have a lot to offer in terms of the knowledge and resources they can provide.

Downsides of private funding

Private business loans do come with some disadvantages too. If you’re able to qualify for a bank loan, you may want to choose the conventional route instead due to these downsides. Before making a final determination whether private funding is the right option for your business, weigh the benefits and drawbacks:

• Expensive: Loans from private sources may have a different rate structure, additional fees and other costs that aren’t typical with bank loans.
• Restrictive terms: Private capital may come with restrictive terms and strings attached, so be sure to scrutinize the agreement before signing. “Some agreements will state that attorneys’ fees, collection costs and other considerable fees could be assessed on an account that enters default,” Goldenberg said. “Some go as far as requiring the borrower to sign a confession of judgment, which would allow the court to enter an expedited judgment against the borrower, without a trial, in the event of default.”
• Demanding repayment schedules: You may also encounter more demanding payment schedules with private lenders than with a traditional bank loan.

How do small businesses find private investors?

The first piece of advice for small businesses seeking investors is to be realistic about their options. VC firms tend to operate in the range of $2 million and up, whereas seed investors usually offer $100,000 to $500,000, Cairns said. 

Before you court private equity firms, it’s up to you to make sure you fit the requirements. 

“The entrepreneur has to make sure that his or her deal fits within our ‘box,’” said Lyneir Richardson, investor, professor and executive director of Rutgers University Business School’s Center for Urban Entrepreneurship and Economic Development. Next, Richardson reviews the startup’s track record and current capacity. Only then does he look into the deal itself and decide whether it’s investable ─ “in other words, if the sources and uses of capital are reasonable, if the pro forma [is] believable and if it’s feasible that I will get the projected return on my investment.”

For this reason, your financial projections, such as future capital requirements, revenue and profit and an ROI timeline, must be clear. Many startups avoid guesswork by paying for a third-party valuation. 

Companies should avoid going overboard on the metrics, however, as precision, not volume, is key. Richardson said one of the most common mistakes he sees during pitches is a PowerPoint presentation overloaded with text. “I want the entrepreneur to clearly communicate a concise story that I can understand, believe and get excited about.”

Additional advice on how to get a loan

Getting a loan from an angel investor or venture capitalist will likely stem from networking. Some firms reach out to startups, but if you’re starting a business, it’s a good idea to network and search for investors.

If you need funding fast, you may be able to get an MCA, where a lender advances you cash against credit card receivables, as well as traditional short- and long-term loans. Depending on which lender you work with, you may not get the same attention and mentoring that you would with angel investors or venture capitalists.

Goldenberg said one of the most important parts of any small business loan agreement is understanding the terms of the loan. Be aware of personal guarantees, Uniform Commercial Code-1 liens and other forms of collateral before you agree to the loan.

“The bottom line is if you see a term that you don’t feel comfortable with, don’t sign the agreement,” he said. “You might not be able to back out of it.”

What steps should a small business take before looking for investors?

Equity funding may be the favored option of debt-resistant small businesses, but it carries the major downside of the relinquishment of control. On the other hand, few small businesses possess a credit score or sufficient collateral to secure a bank loan. 

Luckily, cash-strapped small businesses can benefit from other types of lending.

Alternative lenders

Alternative online and fintech lenders can be a great funding option for small business owners. They provide short-term, high-interest-rate business loans for entrepreneurs looking to quickly expand with capital. The biggest draw of these lenders, however, is their flexibility.

Alternative lenders rarely require equity like angel investors or VC firms do. Instead, they provide loan agreements that mirror conventional banks but usually have much more relaxed requirements to qualify and higher interest rates. Alternative lenders also have various loan packages and types, such as invoice factoring, MCAs, lines of credit and equipment leasing. This flexibility makes alternative lenders the most viable option for some businesses.

The downsides to alternative lenders are the high interest rates and potentially demanding loan agreements. Therefore, though these loans can be easy to qualify for, they’re best for businesses that have the cash flow needed to cover these short-term loans. Alternative lenders have the most demanding loan terms and agreements compared to venture capitalists, angel investors, conventional banks and loans through the United States Small Business Administration program. While this can be a good avenue for financing, it’s important to assess the overall risk to your business.  

Securing debt financing

The advice for convincing lenders is not too far off from the advice for convincing investors, as both seek assurance of future repayment. 

“You often hear that venture capitalists tend to invest in people more than in the ideas they bring. This holds in the world of small business lending as well,” said Alex Kaschuta, lending manager at Fundsquire. Kaschuta judges what she calls “investability” based on the trustworthiness of the manager, how they run their operations and their industry knowledge.

As for the most common mistakes in pitching, Kaschuta, like Richardson, is also frequently confronted with too much information. “Sometimes, borrowers will throw everything but the kitchen sink at the lender in the course of the due diligence process in the hopes that it will bolster the case for them,” she said. On the contrary, “if we request seven documents and receive 20, we might see that as a sign of desperation and be ─ most often justifiably ─ put off.”

Find the right financing for your small business

Finding the right type of financing for your business means knowing what you need the money for and which lender makes the most sense for you to partner with. If you’re starting a new business, a VC firm can give you the guidance you need to get off the ground. Alternative lenders are best for short-term, high-interest-rate loans for any type of business.

Regardless of the type of financing you need, the best way to find financing is through networking and connecting with investors of all types. Once you target a few, you can partner with the one that makes the most sense for your business.

Tejas Vemparala and Max Freedman contributed to this article. Source interviews were conducted for a previous version of this article.