Small businesses entering a period of success and expansion sometimes find themselves struggling to determine how to fund that growth. There are two main options: taking on debt via loans, or raising capital using their business as equity.
There are important considerations for both. With a loan, you may risk your business if something goes wrong and you default on the loan. With equity, you don't have to pay back the money, but investors gain partial ownership in the company, which gives them a say in who and how your business is run.
Raising capital is key to growing a business, but there are risks involved when raising money. It's important to consider all of the risks before deciding on the right course of action for your business.
Risk Number 1: Raising Adequate Capital Takes Time
Raising capital—whether from venture capitalists, angel investors or even financial institutions—takes a lot of time, especially if you’re looking for a significant investment. According to the Harvard Business Review, approvals can take up to six months, and even a rejection can take a year. Business owners often underestimate the length of time it can take to secure the capital they need.
For a small business, a lot can change in those six to 12 months of waiting for capital. If business owners are focusing on finding and raising capital, there’s a risk that the business could be neglected. That neglect can lead to a drop in sales, a negative impact on company culture, or even a drop in the retention of top talent. All of that can mean a drop in profits. When that happens, the business may no longer look desirable to investors or financial institutions. Plus, as HBR says, if the attempt to raise capital fails, morale can drop across the company.
Risk Number 2: Targeting the Wrong Capital Provider
Financial institutions and investors have different approaches for providing capital to businesses. Lenders, like banks, aren’t interested in your business's story and aspirations. What they are interested in is risk management. That means they want to know if they will receive payment on their loan to your business. If you do decide to go the loan route, expect to put together a financial plan that includes debt repayment.
Investors also have their criteria when they consider funding a company. Some may be interested in companies that will get to positive cash flow, while others are more interested in companies that can grow to achieve a high valuation.
Risk Number 3: Defaulting on Your Business Loan
When you borrow money, you have to pay back the principal with interest. In today’s economic environment of low interest rates, that interest amount could be relatively negligible in the long run. Still, if you’re unable to make your loan payments, you might risk losing your business.
Under the worst-case scenario, should the bank take your business for defaulting on the loan, it may sell your business for the money owed. That can mean the business being sold for less than its actual value.
It's important before taking on a loan that you have a clear plan for how you'll be able to pay it back—otherwise, you may need to seek another option for raising capital.
Risk Number 4: Losing Control of Your Business
If you go the equity route, you raise capital by trading some form of ownership of your company. Raise too much capital and you could lose the majority hold in your company. That means an investor with a majority share—or a group of investors who together have a majority—could even remove you from your company.
Risk Number 5: Missing Growth Opportunities Due to Dividends
One way of raising capital is to offer shares to investors. In return, they may receive dividends in the form of cash payments or additional stock. This does give investors some power over your company, such as the right to elect a board of directors. The risk here is that your financial and other obligations to shareholders might come at the expense of growing and investing in your company.
Risk Number 6: Being Underfunded
The flip side of raising too much capital is not raising enough. For example, if your company already has significant debt compared to its earnings, and is over-leveraged, it may be less appealing to financial lenders or investors. Consequently, you may be less able to acquire additional capital needed to grow, invest in production and talent, or to innovate.
Capital is needed if a business is going to grow. It’s easy to get overwhelmed by your options, but knowing your audience and taking the time to plan will ensure you get the capital you need to meet your business goals.