Starting And Managing Your Business101: Financing The Company

By: Richard E. Korb [1]

One of the main concerns associated with starting your own business is financing the company. The main sources of financing small business include debt financing and equity financing.

Debt financing involves borrowing money from relatives, friends, or commercial lenders on the promise to repay the money with interest. In other words, debt financing is a loan. Debt financing might be short-term, with repayment due in less than one year, and long-term, i.e. when the repayment is due over a period greater than one year. Long-term loans are usually used for making major business expenses such as purchasing real estate, equipment, etc.

The main advantages of debt financing include:

-         Unlike equity financing, when you sell part of your business to an equity investor and provide them legal right to be informed about important business decisions, the lender has no management control over your business in the case of debt financing. In other words, you retain control over your business.

You can deduct the interest rate as a business expense.

-         If you borrow from relatives, you can establish flexible terms of repayment or lower interest rates.

The main disadvantage of debt financing is the fact that you have to make regular loan payments. In addition, large amounts of debt can make your business less attractive to investors and cause you problems if you don’t pay the money back. If you borrow money from a commercial lender, you might be required to provide property as security for the loan. Therefore, you also run the risk of losing valuable assets if you don’t make loan payments.

Bank financing is one of the most common forms of small business financing. Banks would want to see two forms of repayment, your cash flow and “collateral”, i.e. personal or business assets that can be sold and used for paying your loan back in case if you are not able to make a repayment. A lender might require you to sign a promissory note, a document that indicates the amount of money and the interest rate that you owe to the lender, as well as the repayment schedule. In addition, you might be asked to have a co-signer in case if you don’t make loan payments.

Commercial bank financing can exist in the form of a term loan, i.e. when the loan has to be paid back over a specific period of time. A revolving credit loan is another option to consider. In that case, the lender must lend money from time to time as requested by you in accordance with the loan’s terms and conditions.

Equity financing is another option that you might consider when making a decision on how to finance your business. Equity financing is based on an exchange of money from a lender for a share of ownership in your business. The main advantage of equity financing, therefore, is the absence of debt or the necessity to make regular payments. As long as your business is profitable, your lenders will receive their money.

However, a significant setback of equity financing is the loss of control over your business. By selling a part of your business, you are providing partial control over your business to your shareholders. As shareholders, equity investors have a say in how you run or manage your business. Your shareholders have a right to be informed about significant business decisions and management. Therefore, you always have to take into account the interests of shareholders when running your business. Equity investors have a right to vote to elect your board of directors and might sue you if their rights are compromised.

Friends and family members can act as equity investors. Professional equity financing is available in the form of “venture capitalists”, i.e. groups of wealthy citizens or financial institutions specializing in one or a few closely related industries. Venture capitalists usually demand a greater return on their investment because they invest in higher risk companies and bear the risk of not getting the money back.

Another way of financing your start-up business is getting financing from “angel” investors, successful entrepreneurs who invest in businesses and expect a substantial return on their investment. Usually both angel investors and venture capitalists expect to play a substantial role in running and managing your business.

Equity investors invest significant amount of money in your business and, therefore, bear a high risk of losing the money if your business is unprofitable. As a result, if your business succeeds, equity investors earn a lot more than they would have by giving you a loan.

Which option you should choose: Debt Financing or Equity Investment?

When considering what type of financing you need, you should think about your long-term goals and ask yourself how much control you want and whether you can handle disagreements with shareholders if, for example, you choose equity financing. You should also consider whether you need more capital or can manage existing cash flow, as well as the degree of risk you have to bear when choosing the type of financing.

Another factor to consider when choosing what type of financing you need is the debt-to-equity ratio, i.e. the ratio between the amount of money you borrowed and the amount of money you invested in your business. If the amount of money you invested is greater than your debt, then you might consider debt financing. However, if you already have a high proportion of debt to equity, you should increase equity investment. If you have just started your business, equity investment might be a better option because you do not run the risk of getting into large amount of debt even before your business started and have to repay the lenders only if your business becomes profitable. However, once you have gained experience and your business has existed for a number of years, you might consider debt financing for ongoing business needs. In addition, once you have established business credit history, it might be easier to borrow money from a bank. Your personal tax situation is also likely to affect your decision. If you are not sure what type of financing is best suited for your needs, you should consider consulting with an accountant.