Understanding the Basics of Borrowing Money (Part 5 of 8)

Part 5: Equity Investment

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/ : Don't be misled into thinking that a start-up business can obtain 100 percent financing through conventional or special loan programs. Financial institutions want to see a certain amount of equity in a business.

Equity can be built up through retained earnings or by the injection of cash from either the owner or investors. Most banks want to see that the total liabilities or debt of a business is not more than four times the amount of equity. (In other words, when you divide total liabilities by equity, your answer should not be more than four.) So if you want a loan, you must make sure that there is enough equity in the company to leverage that loan.

An owner usually must put some of her/his own money into the business to get a loan; the amount depends on the type of loan, purpose and terms. Most banks want the owner to put in at least 20 to 40 percent of the total request. For example, if a new business needs $100,000, the business owner must put $20,000 of his/her own money into the business as equity. The loan amount would be $80,000. The debt to equity ratio here is 4:1.

Having the right debt to equity ratio does not guarantee you'll get a loan. There are a number of other factors used to evaluate a business, such as net worth, which is the amount of equity in a business (often a combination of retained earnings and owner's equity).