Understanding the Basics of Borrowing Money (Part 2 of 8)

Part 2: Types of Financing

The Small Business Administration has published a series of links about the most common question asked by individuals looking to start a business, "How do I get money to start my business?" This series of 8 posts will begin to answer this complex question.

From http://www.sba.gov/: There are two types of financing: equity financing and debt financing. When looking for money, you must consider your company's debt-to-equity ratio—the relation between dollars you've borrowed and dollars you've invested in your business. The more money owners have invested in their business, the easier it is to attract financing.

If your firm has a high ratio of equity to debt, you should probably seek debt financing. However, if your company has a high proportion of debt to equity, experts advise that you should increase your ownership capital (equity investment) for additional funds. That way you won't be over-leveraged to the point of jeopardizing your company's survival.

Equity Financing
Equity financing (or equity capital) is money raised by a company in exchange for a share of ownership in the business. Ownership is represented by owning shares of stock outright or having the right to convert other financial instruments into stock. Equity financing allows a business to obtain funds without incurring debt, or without having to repay a specific amount of money at a particular time.

Most small or growth-stage businesses use limited equity financing. Equity often comes from non-professional investors such as friends, relatives, employees, customers, or industry colleagues. The most common source of professional equity funding is venture capitalists. These are institutional risk takers and may be groups of wealthy individuals, government-assisted sources, or major financial institutions. Most specialize in one or a few closely related industries. The high-tech industry of California's Silicon Valley is a well-known example of venture capital investing.

Venture capitalists are often seen as deep-pocketed financial gurus looking for start-ups in which to invest their money. But they most often prefer three- to five-year-old companies with the potential to become major regional or national concerns and return higher-than-average profits to their shareholders. Venture capitalists may scrutinize thousands of potential investments annually, but only invest in a handful. The possibility of a public stock offering is critical to venture capitalists. Quality management, a competitive or innovative advantage, and industry growth are also major concerns.

Different venture capitalists have different approaches to management of the business in which they invest. They generally prefer to influence a business passively, but will react when a business does not perform as expected and may insist on changes in management or strategy. Relinquishing some of the decision-making and some of the potential for profits are the main disadvantages of equity financing.

Debt Financing
Debt financing means borrowing money that must be repaid over a period of time, usually with interest. Debt financing can be either short-term, with full repayment due in less than one year, or long-term, with repayment due over a period greater than one year. The lender does not gain an ownership interest in the business, and debt obligations are typically limited to repaying the loan with interest. Loans are often secured by some or all of the assets of the company. In addition, lenders commonly require the borrower's personal guarantee in case of default. This ensures that the borrower has a sufficient personal interest at stake to give paramount attention to the business.

Loans can be obtained from many different sources, including: banks, savings and loans, credit unions, commercial finance companies, and SBA-guaranteed loans. State and local governments have developed many programs in recent years to encourage the growth of small businesses in recognition of their positive effects on the economy. Family members, friends, and former associates are all potential sources, especially when capital requirements are smaller.

Traditionally, banks have been the major source of small business funding. Their principal role has been as a short-term lender offering demand loans, seasonal lines of credit, and single-purpose loans for machinery and equipment. Banks generally have been reluctant to offer long-term loans to small firms. SBA’s guaranteed lending programs encourage banks and non-bank lenders to make long-term loans to small firms by reducing their risk and leveraging the funds they have available. SBA's programs have been an integral part of the success stories of thousands of firms nationally.