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The Four Tiers of Small Business Financing
One of the most important tasks for a small business owner is finding capital. Unfortunately, many business owners are clueless about finding money, and the experts they listen to are often misguided.
The bottom line is that you need capital for your business. Your capital needs will change over time, so as a business owner, you need to develop a strategy for financing your business from the start. This is where many business owners fail. They have great concepts, good marketing, and the right people, but they ultimately fail because they never plan for their capital needs.
Digging your well
Think of financing your business as digging a well. A wise business owner won’t dig a well that only meets short-term needs but will dig as deep as possible or at least lay the groundwork for doing so.
There are five layers of the financial well for your business. It starts with the personal assets of the principals. To me, this is the worst layer, although it’s commonly used. Sometimes there is no other choice, but I prefer building businesses using other people’s money.
The second layer is the three F’s: Friends, Family, and Fools, another common source of funds. The next three layers are credit, loans, and investors. Usually, business owners are all over the place when it comes to the deeper layers of the well. The biggest tragedy is when business owners wait until it’s too late to look for capital. They usually end up out of luck. The reality is no one wants to give you money if they know you need it. Your best bet is to dig your well before you need the water.
Not all money is equal
The most important lesson I can give you is that all money is NOT created equal. When considering sources of capital for your business, you need to consider the following:
- Debt vs. equity. Any capital you receive is either debt or equity. Equity requires surrendering ownership. You need to be clear on what type of money you’re obtaining. For the most part, banks and businesses deal with debt, and investors deal with equity. Equity gives the investor a percentage of future profits. So while it may feel like free money, this is the most expensive capital you can get for your business (if you’re successful!).
- Control. Does the money reduce your control? Bringing on investors or partners will lessen your control. A lender may request financial oversight or independent audits. You need to be aware of what you’re giving up.
- Security. How is the lender or investor securing the money? Are you personally guaranteeing it? Is there a blanket lien on your assets? If you default, who will they go after for repayment?
- Transferability. Can you transfer the capital to the next business owner? In other words, is the capital for you or the business? It won’t be useful to sell a business if all the working capital is still tied to you.
- Ease of attainment. How easy is it to get? And how much time do you need to invest in securing the capital you need? Team. Are you adding players to your team who are invested in your success? Pierre Omidyar sought VC money for eBay, not because he needed it, but because he wanted help building a world-class team. Sometimes bringing on investors and surrendering control is exactly what you need to do.
Build a foundation for your business
To finance your business, you must start by building a foundation. As a general rule, you need to separate your personal and business activities as much as possible. The first step is to incorporate. You need to be a corporation (S or C) or LLC if you’re serious about raising capital. Without a corporation, you’re limiting yourself to personal loans in Tier 3, which we’ll discuss later. You have no options for the other tiers and won’t be taken seriously. Investors can’t invest in a sole proprietorship: You need to have shares or membership units to bring on investors. If you haven’t incorporated, you’ve seriously handicapped your business.
You will give life to your corporation by establishing a corporate credit profile, which is separate from your personal credit profile. Building business credit will help ensure that you have the fundamentals in place. This includes operating in a way that lends legitimacy to your corporation. The business financing industry has a standard for what a legitimate business should look like. If you don’t meet that standard, you’ll be shut out of many financing options. So the next smart step is to build business credit.
The four tiers of financing
There are four tiers of financing available to small business owners. It’s important to be familiar with each tier and develop a strategy that cleverly uses these tiers. Here is a brief summary of each:
- Tier 1: basic trade credit. The largest source of capital in the world is business or trade credit. These are companies granting business credit without the need for a personal or business credit check and they rarely require a personal guarantee. Tier 1 is the most basic trade credit and, when a corporation is prepared, it serves as a building block for establishing credit. Going after Tier 1 financing without building a business credit profile can be a disaster, but if you’re prepared, you can benefit greatly from this source of capital.
- Tier 2: advanced trade credit. Like Tier 1, this is the capital extended by businesses to businesses. The difference is that Tier 2 companies will conduct a business credit check before extending credit. Tier 2 usually includes larger credit lines and longer terms, and in some cases, can be used for equipment financing. If you need to purchase something created or sold by another company, you can probably finance it with the first two tiers of financing.
- Tier 3: bank lending. This is the best-known type of business financing. Typically, it involves banks offering unsecured business lines of credit. A personal and business credit check and personal guarantees are required. The most basic level of bank financing is score and business history driven. For larger lines and loans, you need a good business plan and financials. Banks and credit card companies are Tier 3 lenders.
- Tier 4: investors. Tier 4 is a move outside of institutional lending and commercial credit to the world of venture capitalists, angel investors, and other private investors. This level requires much more sophistication and a business that is outperforming or will outperform its industry peers. As a general rule, these investors want businesses that have been around for a couple of years and can provide detailed financials and growth strategies.
Hello!
I’m Andrew Brooks, a seasoned finance consultant from the USA and the mind behind phonenumber247.com.
My career is built on a foundation of helping individuals and businesses thrive financially in an ever-changing economic landscape. At phonenumber247.com, my aim is to demystify the complex world of finance, providing clear, actionable advice that can help you navigate your financial journey with confidence. Whether it’s personal finance management, investment strategies, or understanding the nuances of market dynamics, I’m here to share insights and tools that can propel you towards your financial goals.
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