What is the Most Common Form of Financing?

Learn about the five most common forms of financing for small businesses: personal savings financing, bank loans, equity funding, venture capital investors and government grants.

What is the Most Common Form of Financing?

Most people are familiar with debt as a form of financing because they have car loans or mortgages. Debt is also a common way of funding for startups, as it must be repaid and lenders want to be paid an interest rate in exchange for using their money. While there are many sources of funding for businesses, here are the five most common. The most popular type of financing for small businesses is personal savings. The two drawbacks to this method are the amount of personal savings you have and the amount of personal savings you are willing to risk.

Angel investors, who are usually wealthy individuals such as friends and family, finance more than 30,000 small businesses each year in the United States. Short-term financing is often obtained through a bank loan. This type of loan can be requested at a lower interest rate compared to informal sources, and firms with a lower net worth can also obtain it. Banks and other commercial lenders are also popular sources of business funding, but they require a solid business plan, a positive track record, and sufficient collateral. Equity funding involves selling a stake in your company to investors who expect to share your company's future profits. This can be done through an agreement with a venture capitalist or through equity crowdfunding.

Business owners who choose this path won't have to pay in regular installments or face high interest rates; instead, investors will be partial owners who will be entitled to a portion of the company's profits. Venture capital investors prefer companies that have a competitive advantage or a strong value proposition in the form of a patent, proven demand for the product, or a very special (and protected) idea. To convince an angel or venture capitalist to invest, entrepreneurs need a company with a solid financial base, something like a functional product or service, and a qualified management team. It can also take the form of equity financing in which the friend or family member receives a stake in the company. Assistance usually consists of a government guarantee of repayment of a loan from a conventional lender. When creating a financial plan, entrepreneurs may find it useful to compare their potential business or business with industry standards in the same or related industry. Many companies use both types of funding; in this case, you can use weighted average cost of capital (WACC) to compare capital structures.

This means creating and executing a formal loan document that includes the amount of the loan, the interest rate, specific repayment terms (based on the startup's projected cash flow) and the guarantee in case of default. Government grants from federal and state governments are often available in the form of grants or tax credits for emerging or expanding companies. There are other ways to get funding as well, such as crowdfunding sites, commercial credit cards, or bank lines of credit. Preferred shareholders receive a predetermined dividend before common shareholders receive a dividend.