Are you a business owner (or future business owner) drowning in all the confusion of business funding terms? At some point, every entrepreneur needs additional funds to take his/her dream to the next level. It is important to understand the terms that lenders and investors use so that you do not come across as naive. More importantly, having a firm grasp of business funding terms can help you understand what a good funding offer looks like.
In this article I will explain the two broad categories of funding to give context for the business funding terms you’ll be most likely to encounter as you acquire capital for your business. Scroll to the end of the article to see a full glossary of those terms in alphabetical order along with their definitions.
Business Funding Terms: The Two Categories of Business Funding
In general, external sources for additional funds fall into in two categories: Investor Capital and Loans.
What do I need to understand about Investor Capital?
Any entrepreneur seeking capital from investors must start with a business plan.
Business plans are inherently strategic. You start here, today, with certain resources and abilities. You want to get to a there, a point in the future (usually three to five years out) at which time your business will have a different set of resources and abilities as well as greater profitability and increased assets. Your plan shows how you will get from here to there. – Entrepreneur Magazine
Business plans answer the questions who, what, where, when, and why. Most business plans begin with the why by way of a mission statement (a broad reason why your business will exist) and vision statement (a short description of the world you seek to create). The plan outlines who is involved in the business, what the deliverables (products/services) will be, who your customers will be (target audience), and what your timeline looks like for launch and profitability. The most important component of any business plan is the pro forma, a set of projected financial statements creating a clear path from start to profitability. For investors it’s all about the numbers, and the key to gaining their attention is being able to illustrate wealth potential in clear financial projections. Strongly consider seeking the help of mentors and financial advisers when constructing your business plan.
The scale of your business (i.e., how big your business will be and how quickly it will grow) will determine what kind of investor capital your business requires. For a large-scale business, you may want to consider working your way up to venture capital investing, though that will require both patience and hard work. For a smaller-scale business you may only need to solicit help from an angel investor or two. Many entrepreneurs have even gathered financial support from strangers through crowdfunding. Understanding the scale of your business is key to determining your funding needs and where you should strategically seek out those funds.
Unless you are gathering investor capital from friends and family, you will need to offer a proof of concept for your business idea. In short, you should be able to demonstrate some initial sales of your product or service and happy customers. If your business centers around a product, you will need a prototype and maybe even a patent. You will also need some sound market research. Many entrepreneurs seeking investor capital fund their proof of concept through bootstrapping (using what cash they have on hand and/or through personal loans).
When engaging investors, you will want to have a CPA and business attorney available to help you navigate any offers you may receive. By accepting investor money, you are handing over a piece of your equity (your business ownership) in exchange for startup funds. While this is a common practice that can help you turn your idea into a million-dollar business, you don’t want to get taken. Investors are shrewd business people, and they will be sure to get their cut before giving you their money.
What do I need to understand about business loans?
It is more common for entrepreneurs to seek funding from lenders than from investors. Most entrepreneurs do not want to share their business ownership with an investor, but the world of business loans has its own set of challenges.
When it comes to loans, there is the actual loan amount, the interest rate (what the lender charges you for borrowing money), the term (or how long you will keep the loan), and the type of loan itself (line of credit, secured/unsecured loan, etc.). You will want to pay careful attention to the interest rate: how much is this loan going to cost you?
When applying for loans, consider what type of loan best suits your needs. A standard loan deposits cash into your bank account, and monthly payments begin immediately. Other loans such as revolving credit lines are more flexible in that you access funds from a credit limit on an as-needed basis. With a revolving line of credit, you only pay interest on what you use.
It is not always possible to qualify for a loan, and when you qualify it may be difficult to get the funds as quickly as you need them. Therefore, it is important to understand early on which loans you would even qualify for. A great indicator of your ability to acquire funds through a loan is your credit score (also known as your FICO score). Credit scores above 650 are generally considered good by lenders. Credit scores below 620 are considered sub-par. You can still get a loan with a low credit score, but you will more than likely pay higher interest rates.
It is vitally important that you understand what the lender needs in order to qualify you for a loan. Some lenders will not offer you a business loan but may be willing to give you a personal loan. Some lenders (such as SBA lenders) require a business plan while others only want to know projected sales. Find out what the lender needs and provide the necessary information quickly. (It is often helpful to discuss lender requirements with a business development manager.)
Glossary of Business Funding Terms
As you consider your options for business funding, take some time to read and understand the business funding terms explained below.
These are businessmen/women who offer funding in exchange for equity in your company in the early stages of startup development. When seeking angel investors, it is important to have a business plan, a pitch, and a proof of concept. Read more here.
Annual Sales Forecast
For startups, calculating annual sales is based on market research. For existing businesses, polished financial statements inform future sales projections. In short, forecasts are realistic (worst case) and goal-oriented (best case) predictions of business sales over the next 3-5 years. When calculating annual sales forecasts, it is important to know that investors (and SBA lenders) will want to see both a best case and worst case scenario. Some lenders will want to understand your ability to pay back by seeing a single, goal-oriented sales forecast figure. Read more here.
This is a financial statement offering a snapshot view of your (and your partners’) equity in the company. It demonstrates a simple formula wherein business equity equals company assets (liquidate-able equity, equipment, inventory, accounts receivables, etc.) minus liabilities (company debts). Read more here.
When establishing your business, you must file your business and receive an EIN number. The IRS will ask you to decide which kind of business entity you would like to form (sole proprietorship, limited liability company (LLC), S corporation, or corporation). It is best to consult with your CPA to determine which entity is best for you. Read more here.
This is an exhaustive plan for the launch or expansion of your business. It typically follows a strict format with the most important component being your pro forma (i.e., your projected financial statements). A business plan is helpful for your own due diligence but not always necessary unless you are working with the SBA or seeking investors. Read more here.
When speaking of scale most lenders/investors want to understand the size of your business: will it generate $100k or $2 million in annual sales?; will you be hiring yourself and a couple others or will you need a large staff of 20 or more employees?; is there more than one location? etc. Often scale is discussed in terms of your plans for growth. Read more here and here.
When someone with poor credit history needs to acquire a loan, they occasionally will seek out someone else with good credit history to co-sign, that is, to assist the applicant in personally guaranteeing the borrowed funds. The co-signer assumes responsibility with the principle applicant for the debt. Though often an emotional decision for everyone involved, co-signed business loans are quite common and sometimes the only option for an entrepreneur with poor credit. Read more here.
Credit Bureaus/Credit Report
Banks and lenders use credit reports through a credit bureau (such as Equifax, Experian, or Transunion) in order to perform due diligence on a loan candidate. Most reputable lenders use credit reports in one form or another, often performing “hard inquiries” on an applicant’s credit report before issuing a loan. Read more here.
Credit Check Total (CCT)
CCT is the most thorough 3-bureau credit report available to consumers. It is often used by unsecured lending programs to pre-qualify funds without putting a hard inquiry on your credit. Experian monitors CCT so as to prevent identity theft. Read more here.
Rather than gathering startup capital from professional investors, entrepreneurs can solicit funding from the general public by showcasing their business cause. There are a variety of crowdfunding platforms, and applicants who see the greatest results are active users of social media and email newsletters. Read more here.
When determining your target audience (those most likely to buy your product/service), it is important to identify sub-groups within your target audience. Customer segmentation ensures that you communicate more specifically to the right people at the right time. Read more here.
Balance to Limit Ratio
A major factor on your credit report is the amount of credit you have available versus the amount of credit you are using. For example, someone with three credit cards totaling available credit (credit limits) of $15,000 will show a utilization rate of 75% if he/she carries balances on those credit cards totaling $11,250. Ideally, a borrower should keep his/her utilization rate (or balance to limit ratio) below 50% of the available credit. Read more here.
In its simplest sense, equity refers to the value of what you own in an asset (such as real estate) or a business. You can have one business owner who possesses all the business equity or several business partners who each possess of percentage of business equity.
Equity injection refers to the money you plan to invest in your own business. This is funding you’ve saved or already earned, not funding you borrowed or received from an investor. Not all funding options require equity injection.
Through the use of credit bureaus and credit reports, lenders can identify a credit score (the FICO) indicating a loan applicant’s ability to assume debt and pay back that debt. Scores range from 300-850, with 650 or higher being the score that most lenders consider good. Read more here.
This financial statement is also known as a P&L Statement. It presents in detailed format a business’ revenues/sales, expenses, and subsequent net income. Net income/loss indicates that business’ profitability. Read more here.
Lending is a business, and in order for lenders to make money, they charge interest – a percentage of the amount owed on an annual basis – on the money they lend. Financial advisers refer to the interest rate as a cost of capital (COC). Interest rates on business loans can range from 5% – 90%+. Read more here.
An installment loan is a loan with a fixed interest rate, loan term, and monthly payment. Some installment lenders allow borrowers to reduce their loan amount (thereby decreasing either the length of the term or the size of the monthly payment) through prepayment, or making payments larger than the monthly payment. Read more here.
Line of Credit
Businesses or individuals can often acquire through their bank a specified amount of borrowed funds that they can access on an as-needed basis. No payments are required on the line of credit until the borrower accesses the funds. At that point interest is charged on the amount used up to the specified credit limit. The most common form of a line of credit is the credit card. Read more here.
Loan stacking is strategically acquiring multiple loans for one borrower and is a common practice among those seeking to solicit loans from online lenders. Generally speaking, loan stacking is a very dangerous form of combination funding (collecting loans from more than one source). The greatest danger to loan stacking is a lack of accountability where these loans and their obligations are not reported to the credit bureaus who would inform lenders that you are over-stretched. Many borrowers resort to loan stacking through online lenders when they cannot acquire loans from traditional sources (i.e., their bank). An alternative to loan stacking is to better understand the world of unsecured credit in the form of personal and business credit cards with promotional interest rates. This serves to offer the borrower more flexibility with reputable lenders (i.e., banks) and heavy, responsible use can quickly build a positive credit history. Read more here.
In a particular industry where there are competing businesses, each business will possess a market share. That is, each business achieves a percentage of total industry sales (i.e., that business’ market share). Read more here.
If you have a unique business/product idea, you may need a patent to protect it from replication by a competitor. Researching for a patent should be a key task in your proof of concept stage when seeking investor capital. Read more here.
Lenders offering loans to a business based on that business’ financial performance are issuing business loans. On the other hand, lenders offering loans to individuals for a variety of personal reasons are issuing personal loans. Most startups or new businesses are not able to secure business loans since there is no business performance to show. In such cases, many entrepreneurs use personal loans to fund their business. Read more here.
The main financial statements for a business are a balance sheet and income statement. In cases of a startup looking for investor capital, a pro forma constructs these financial statements in the form of projections based on market research or proof of concept. Read more here.
Proof of Concept
Any entrepreneur seeking high-stake investors (i.e., venture capital investing) must first produce a self-funded proof of concept. This would include (but is not necessarily limited to) product prototype, initial sales, and market research. Read more here.
Profit & Loss (P&L) Statement
This financial statement is also known as an Income Statement. It presents in detailed format a business’ revenues/sales, expenses, and subsequent net income. Net income/loss indicates the business’ profitability. Read more here.
Most credit lines are loans in the form of revolving debt, meaning that a total credit limit is available on an as-needed basis, and the borrower pays back on only the funds being used. A credit card balance is the most common example of revolving debt. Read more here.
Small Business Administation (SBA) Loan
The federal government will back entrepreneurs to secure lower-risk business financing through 7(a) loans, also known as SBA loans. The requirements are stringent, and the process for securing an SBA loan takes anywhere from 2-24 months. In terms of cost of capital and interest rates, SBA loans are the best loans available to business owners. Read more here.
A target audience is your ideal customer. You can have more than one target audience. HubSpot has popularized the concept with their “buyer personas.” This may not seem a relevant addition to business funding terms, but when it comes to investor capital, investors will always want to know that you know your customer.
A term loan is similar to an installment loan in that there is a set borrowed amount deposited into the borrower’s account with a set pay back schedule over a period of time (the term). Read more here.
When lenders speak of a secured loan, they look for collateral to guarantee the loan: some form of liquidate-able asset valued greater than the loan amount. An unsecured loan is not backed by collateral but by a borrower’s reputation to pay back borrowed funds. Unsecured lenders frequently look at a borrower’s FICO score when approving loans. Read more here.
Venture Capital (VC)
The “big leagues” of angel investing is venture capitalism. Wealthy business tycoons create platforms to hear entrepreneurs pitch their business for the opportunity to secure high-stakes investment capital. Startups that have already built a business with decent sales and want to accelerate the scale of the business have a chance among VC investors. Read more here.
Yes, there’s a ton of jargon in the business funding world. And, no, it’s not easy to wrap your mind around it.
When it comes to funding your business, what you don’t know can hurt you. Lending institutions or advisors are so used to the jargon of their industry. They may not think to pause and explain their terms or walk through a concept. If you’re not intentional about asking the right questions, it can be easy to get lost in a sea of acronyms, opaque terms, and undefined phrases.
Coda: Intentional Entrepreneurs is committed, not just to helping you get funding, but helping you understand it every step of the way – including the business funding terms. By working with us, you will be able to improve your business in two ways. First, we provide access to funding. And second, we help to grow your personal knowledge.
Funding is helpful, but growing your personal knowledge is invaluable.
We welcome you to schedule a free consultation call at anytime.