Home Funding

The Four Tiers of Small Business Financing

Tim Berry

6 min. read

Updated December 17, 2024

Too busy to read? Listen on the go and learn faster.

00:00 / 10:40

This podcast episode was created entirely by AI using content from Bplans.com. We're testing this new format and would love your feedback—do you find this a helpful way to learn about funding your business? Let us know in the video comments.

One of the most important tasks of a small business owner is determining how much funding they need, and then finding that capital for their business.

Unfortunately, most business owners are clueless when it comes to finding money, and most self-proclaimed experts they may listen to are equally misguided.

The bottom line is, you need capital for your business. Your capital needs will change over time, which is why you as a business owner need to build a strategy for capitalizing your business from the beginning.

This is where most business owners drop the ball. They come up with great concepts, a good marketing strategy, and hire the right people. But they ultimately fail because they never planned for their capital needs.

Digging your financial well

Think of capitalizing your business as digging a well. The wise business owner won’t dig a well that only satisfies short-term needs, but will dig the well as deep as possible (or at least lays the groundwork for doing so) to accommodate their long-term needs.

There are at least five layers of the financial well for your business.

It starts with the personal assets of the principals — you and your co-founders, if you have any. To me, this is the worst possible layer to rely on, though it is the most commonly used. Sometimes there is no other choice, but my preference is to build businesses using other people’s money, not my own assets.

The second layer is the three F’s: “Friends, Family, and Fools.” This is another commonly exploited source of funds.

The next three layers are where we’ll focus on, since they’re the three that allow you to tap into other people’s money (“other people’s money” is an important term in finance):

• •Credit
• •Loans
• •Investors

While there should be some order to this, usually business owners are all over the board when it comes to the deeper layers of the well. The biggest tragedy is when business owners wait until it is too late to look for capital. They usually end up out of luck.

The harsh reality is that no one wants to give you money if they know you need it. Your best bet is to dig your well before you need the water. In other words, look for funding sources before you’re desperate.

Not all money is created equal

The most important lesson I can impart to you is the fact that all money is NOT created equal. As you look at sources of capital for your business, you need to consider the following:

• •Debt vs. equity. Any capital that you receive is either going to be debt or equity. Equity requires the surrendering of ownership. You need to be clear on what type of money you are obtaining. For the most part, banks and businesses deal with debt, and investors deal with equity. Equity gives the investor a percentage of future profits. So while it may feel like free money, this is the most expensive capital you can get for your business (if you are successful!).
• •Control. Does the money reduce your control? Bringing on investors or partners will lessen your control. A lender may request financial oversight or independent audits. You need to be aware of what you are giving up.
• •Security. How is the lender or investor securing the money? Are you personally guaranteeing it? Is there a blanket lien on your assets? If you default, who will they go after for repayment?
• •Transferability. Can you transfer the capital to the next business owner? In other words, is the capital for you or is it for the business? It won’t do you much good to sell a business if all the working capital is still tied to you.
• •Ease of attainment. How easy is it to get? And how much time will you need to invest in order to secure the capital that you need? With this capital, are you adding players to your team that are invested in your success? Pierre Omidyar sought VC money for eBay, not because he needed it, but because he wanted help building a world-class team. Sometimes bringing on investors and surrendering control is exactly what you need to do.

Build a foundation for your business

Regardless of the capital you seek, you must start by building a foundation for your business. As a general rule, you need to separate your personal and business activities as much as possible.

The first step is to incorporate. You need to be a corporation (S or C) or LLC if you’re really serious about raising capital for your business.

Without the structure of a corporation, you are limiting yourself to personal loans in Tier 3 (we explain the four tiers of financing below). You’ll have no options for the other tiers, and won’t be taken seriously anyway.

Investors can’t invest in a sole proprietorship: You need to have shares or membership units if you want to bring on investors. From this, you can see that if you haven’t incorporated, you have seriously handicapped your business.

You will give life to your corporation by establishing a corporate credit profile, which belongs to the business that is separate from yourself and your personal credit profile. The process of building business credit will help to ensure that you have the fundamentals in place. The fundamentals include operating in a manner that lends legitimacy to your corporation. The business financing or credit industry has a standard of what a legitimate business should look like — if you don’t meet that standard, you are going to be shut out of many financing options. So the next smart step is to build business credit.

The four tiers of financing

There are four tiers of financing available to small business owners. It is important to be familiar with each tier, and to develop a strategy for financing your business that cleverly uses these tiers. Here is a brief summary of each:

Tier 1: Basic trade credit

The largest source of capital in the world is business or trade credit. These are companies granting business credit without the need for a personal or business credit check, and they rarely require a personal guarantee. Tier 1 is the most basic trade credit and when a corporation is rightly prepared, it will serve as a building block for establishing credit for that corporation. Going after Tier 1 financing without building a business credit profile can be a disaster, but if you are rightly prepared you can benefit greatly from this source of capital.

Tier 2: Advanced trade credit

Like Tier 1, this is the capital extended by businesses to businesses. The difference is that Tier 2 companies will conduct a business credit check before extending credit. Tier 2 usually includes larger credit lines, longer terms and in some cases can be used for equipment financing. If you need to purchase something that is created or sold by another company, chances are you can finance it with the first two tiers of financing.

Tier 3: Bank lending

This is the best-known type of business financing. Typically, these are banks offering unsecured business lines of credit. A personal and business credit check and personal guarantees are required. The most basic level of bank financing, for the most part, is credit score and business history driven. For larger lines and loans, you need to be prepared with a good business plan and financials. Banks and credit card companies are Tier 3 lenders.

Tier 4: Investors

Tier 4 is a move outside of institutional lending and commercial credit to the world of venture capitalists, angel investors and other private investors. This level requires much more sophistication and a business that is outperforming or will outperform its industry peers. As a general rule, these investors want businesses that have been around a couple of years and can provide detailed financials and growth strategies.

Find the right funding fit

Now that you understand the different financing tiers available to you, you can start determining how much funding you need. This may ultimately influence the tier that’s best suited for your business’s situation.

For a tool to create financial forecasts and write a business plan that will impress investors and secure the funding you need, try LivePlan today.

Tim Berry

Tim Berry is the founder of Palo Alto Software , a co-founder of Borland International, and a recognized expert in business planning. Tim is the originator of Lean Business Planning. He has an MBA from Stanford and degrees with honors from the University of Oregon and the University of Notre Dame. Today, Tim dedicates most of his time to blogging, teaching and evangelizing for business planning. His full biography is available on his blog.