Traditional funding options for small businesses are shrinking. The 2020 Biz2Credit Small Business Lending Index reported in November 2020 that small business loan approval percentages from credit unions and small banks average 19.65%, with big banks approving at an even lower 13.3%—and each category decreasing from the month before.
However, alternative funding options for small businesses are growing. Through October 2020, approvals hit 23.3%, according to the Lending Index, improving from 23.1% in September.
What alternative startup funding options are available for small businesses?
Alternative startup funding is loosely defined as financing from sources other than banks or stock and bond markets. This type of financing draws from sources ranging from individual investors to non-bank lending companies. Interesting options are described below.
Bootstrapping with your life insurance policy
One non-bank from which you can raise funds is your life insurance company. If your whole life policy has been in place for several years, you have equity built up in the policy you can "borrow" against.
"Obviously, there has to be a provision in the policy itself," says Steve Carter, vice president and partner of Florida Pension Group, "but as long as you're the owner of the policy, you control the decisions, and there's cash value in that [policy], you can typically borrow against it. You can either pay back into your policy, or you can let it sit as a loan against the policy in perpetuity."
It's a loan you never have to pay back. And the money's not taxed at the time of the loan, unlike if you break a 401(k) before age 59.5.
One of the better-known forms of alternative financing is crowdfunding, where small amounts of money from multiple investors are pooled through internet platforms. The most common forms are:
- Donation-based crowdfunding. In this model, investors donate money without expecting financial compensation.
- Invoice trading. This is a form of receivables-based trading in which a business sells discounted invoices to a pool of individual or institutional investors for cash. This is different from factoring because multiple parties purchase the invoices instead of a single party.
- Peer-to-peer and peer-to-business lending. Similar to microfinance platforms, with this approach, individuals or businesses are anonymously connected with multiple lenders. Lenders are paid interest, which distinguishes them from traditional microfinancing.
- Revenue and profit-sharing crowdfunding. This model, which is similar to a merchant cash advance, allows a small business to receive a loan from multiple investors and issues repayment of the full amount based on future receivables.
- Rewards-based crowdfunding. Rather than receiving financial compensation, investors receive benefits like early access to new products.
Of the different forms of crowdfunding, the securities and regulation (equity) types are the fastest-growing small business funding options.
With securities crowdfunding, "businesses are basically offering a share of the gross revenue that they generate, which can be paid back to investors quarterly as the business grows and generates revenue," says Nick Mathews, CEO and co-founder of Mainvest. "This makes it a debt instrument as opposed to equity, which doesn't give ownership. It's more like equity than a term loan, and it is made to build incentives for businesses to succeed because the faster they accelerate their revenue, the higher the IRR [internal rate of return] for the investor."
Regulation crowdfunding, on the other hand, made legal with the Jumpstart Our Business Startups (JOBS) Act of 2016, allows a person to offer an equity stake to raise money from unaccredited investors as well as accredited investors, "so you go from only [accessing] 5% of the population being able to invest in you to 100%," Mathews says. "And then you can publicly promote the offering. You can put it on social media, and send an email blast to all your customers [and network]. You can get on a podcast and talk about the company and the investment opportunity. It's just easier to raise capital than relying on accredited investors."
"An average campaign might raise $350,000 from 350 people," says Jonny Price, director of fundraising for Wefunder. "And through recent deregulation, the [Securities and Exchange Commission] just raised the amount [a company] can raise from $1.07 million to $5 million. That law goes into effect in early 2021."
Funding can make or break your business. Be it traditional loans or nontraditional business funding options, you can find an approach to fit your needs.
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