Small businesses come in all shapes and sizes, but something they all have in common is the need to secure funds to start, grow and scale their operations. Some will go down the path of approaching financial institutions for a loan. Others will seek investment to secure the funds they need. Both paths have their advantages and disadvantages.
In my work as a Business Plan Advisor, I help businesses develop and refine their business plans. These invaluable documents serve as a roadmap for the future of the business, but they’re also hugely important in securing early-stage financing. Many of the entrepreneurs I speak to are unsure of whether a loan or investment is right for their business. Unfortunately, there’s no easy answer and it often depends on circumstances. To help clarify your decision, and help you understand the choices, I wanted to discuss your options and present the key differences and advantages of both paths.
What are the Differences Between Lenders and Investors?
A lender, such as a Bank or Credit Union, agrees to give you money to use on your business on the understanding it will be repaid over a set term, with a fixed amount of interest. The lender doesn’t share in the profits of the business so they only care about your ability to repay the loan. It doesn’t matter to the lender if the business is doing well or not, they will receive the same amount in service of the loan.
If your business is doing well, your profits aren’t shared with the lender. The only way they lose out is the business defaults on the loan and the borrower can’t meet their payment obligations.
An investor gives you money in exchange for a specific percentage of the business. If the business is doing well, they stand to profit from the success. Conversely, if the business is not doing well, they are not owed anything by the business. This means they share the risk with the entrepreneur, but they stand to profit if the company is doing well.
What are the two types of Loans Available from Lenders?
For starters, it’s important to differentiate between the two types of loans that lenders may provide. These are Asset Backed Loans and Character Based Loans.
Since lenders want to remove as much risk as possible from a loan, they will often request collateral in the form of a personal or business asset. Should the borrower not be able to repay the loan, the asset is then sold off to pay the debt. Such loans are called Asset Backed Loans.
Any loan that isn’t asset backed is referred to as a Character Based Loan. These loans are given on the character of the entrepreneur. Although it’s preferable to get a Character Based Loan, they are riskier for the lender, so they tend to only be available in smaller amounts.
In British Columbia, VanCity, Futurpreneur and WeBC are three organizations that offer this type of loan to entrepreneurs.
What Does a Lender Typically Look for in a Business?
The single most important thing a lender is looking for is low risk. They want certainty and to eliminate as much risk as they can. All that matters to them is that their loan is repaid. It doesn’t matter if the business makes millions of dollars, or just breaks even. Their payment remains the same. We’ll chat later about how you can reduce risk and make your business more attractive to lenders.
What Does an Investor Typically Look for in a Business?
The priorities of an investor differ from those of a lender. They are looking for businesses with a high upside and strong potential for growth. While they try to minimize the risk to their investment, they are more risk tolerant if there’s strong potential for upside and return on their investment.
An investor will often have a stake in several businesses, and they’ve accounted for the fact that one or two of these investments might not pay off. They use the profits they receive from successful business investments to offset any losses they might incur.
How Important is a Business Plan to Attracting Lenders and Investors?
A business plan is one of the most important factors in attracting funding for a business – whether it’s a lender or an investor. The more information a business owner can provide, the more likely they are to secure the financing they need. A business plan allows you to articulate in detail what the business will do in the medium to long-term, and the actions you will take to accomplish it.
Just as important is a cash flow projection, which will show the financial implications of these decisions. All lenders, and most investors, will need to see a business plan and cash flow before providing financing.
Not only does it show your plans for the business. It also highlights you’re diligent and trustworthy, and that you have a grasp of what you want to do, and how to do it.
How Can a Business Owner Make their Business More Attractive to Lenders and Investors?
Focus on the small details and really demonstrate a mastery of every aspect of your business. It’s ok to develop versions of your business plans specifically for lenders and investors, without changing any of the facts.
For lenders, emphasize how reliable your plan is and how much thought you’ve put into it. They are looking for the safest and most secure businesses. They ideally want ones that are almost guaranteed to pay them back with the minimum of fuss.
For investors, focus on your growth potential and how you plan on reaching your targets. They want to know what’s going to happen if the business is successful, and how much growth you think you can achieve.
The facts remain the same, you’re just choosing to place extra importance on the areas they see as more important. Knowing who your audience is when writing the plan is very important.
Can Businesses Receive Funding from Lenders and Investors?
Lenders and investors are looking for different things in a business. Often, lending and investing will occur at different places along the life cycle of a business. For certain high growth business, they might not be eligible for lending early on as they’re viewed as too risky. They either haven’t shown a path to profitability, or they haven’t fully developed their product.
There might still be potential for long term growth an investor sees, and that attracts them in. That same business, once they’ve started off and proven themselves, can then tap into lending down the road if they need it. It just might be at a different stage of the business.
How Can a Business Choose Between Lending and Investing?
Investors share in the profit of a business, so it makes that type of financing potentially more expensive for a business owner. As a result of this, it’s beneficial to investigate lending first. You’ll go into a lending arrangement knowing how much you’ll have to pay in the long run. Assuming your business is successful, it will become even more cheap comparatively. When lending isn’t possible, either because it’s too early, or it’s seen as too expensive, that’s when it’s a good idea to consider investment.
How Small Business BC Can Help
SBBC’s Business Plan Advisors work with entrepreneurs to help them develop and perfect their business plans. These documents can be presented to lenders or investors to help secure the capital needed to achieve your business goals. Learn about our Business Plan Services, and how they can help your business.