Unless your new business is a money-tree farm, you will find this article very useful.
By William S. Utz
WHEN DETERMINING what type of financing to procure for your business, there are many avenues to consider. Depending on the type of business, future plans, and product(s) and service(s) offered, the choice is important. There are two main types of financing debt or equity. Debt financing is the process by which a firm borrows capital from banks and investors, promising to repay the borrowed funds within a certain amount of time or incur some type of liability, usually in the form of interest. The other type is equity financing, when an organization relinquishes ownership interest to different sources in exchange for capital. Most well-capitalized businesses use a balance of both; this helps mitigate risk and keep the cost of capital to a minimum.
Debt financing is usually done by businesses that have either established positive cash flow or have the necessary collateral (equipment, cash or an individual’s promissory note) to secure the funds from a lender. When businesses choose this method, they are obligated to pay a carrying cost on the funds. This is common among businesses that either deal in large volume inventory purchases that are later liquidated through sales channels, thus keeping the term of the loan to a minimum, or businesses that need to expand by purchasing space or equipment with a liquidation value similar to the debt outstanding (real estate, long-term-use equipment, and vehicles).
Having such a risk-free connotation, equity financing can be a great tool when expanding beyond the size and scope of what could be accomplished with conventional debt financing. In exchange for interest in the organization, a firm can raise excess capital while only being exposed with a few key liabilities. First, a firm must worry about who holds the controlling interest (takeovers, buyouts). Also, depending on the way in which the interest was conveyed, individuals can recoup their investment through multiple channels. This is when contracts detailing cash capital disbursements are important. Lastly, remember that there is a strong correlation between risk and reward. For this section, that statement is referring to the reality that if a firm relinquishes a good portion of its interest to other investors, the original owners may only be entitled to a portion of the profits, in the event that the organization performs extremely well.
There are many different types of private investors and investment groups. The most common is the accredited investor. These individuals are familiar with the investment world and have probably participated in such ventures previously. They also have certain qualifications to make them an attractive financier. Another type is an angel investor. This term has a loose meaning but basically labels an individual who has the excess expendable income to almost entirely fund the start-up, expansion or growth of a business. Both accredited investors and angel investors are private participates that are not usually affiliated with an investment group. Then, there are investment groups, such as venture capitalists (VC’s). Venture capital groups are great for companies that are interested in retaining brain-trust equity and/or a portion of the control, but not all. These groups tend to know exactly what they are looking for from their involvement. The forfeiture of controlling interest and substantial portions of revenue is not uncommon. However, by using such groups, a business’ current owners can nearly eliminate their financial risk. Due to the venture capitalists having a vested interest, expect the participation of seasoned business consultants that will take a ‘hands-on approach’ and work with the firm to achieve success.
Some businesses have the ability to approach the public through an initial public offering (IPO). This is the process by which a company works with investment bankers to build a following in a specific trading platform, then offer interest in the company on its behalf, in exchange for a portion of the proceeds. There can be great benefits as well as detriments associated with making an initial public offering. The most commonly understood perk is that, on average, a firm can collect ten times its value in one offering and in special circumstances, either the product or service is groundbreaking or there is a large emotional following in the market. In these cases, an organization can raise exponentially more. This was seen during the dot-com era, in the late nineties, when technology companies were making initial public offerings and the stock prices were driven up thousands of percent above book value, simply because of speculation of success.
The small business administration (SBA) can be an excellent source of capital. Especially for new businesses, they offer competitive loans, grants and subsidies. However, the majority of the funds are only released to businesses or individuals with specific qualifications, such as minorities, persons with disabilities, and individuals coming from a low socioeconomic background. When working this avenue for funding, you will encounter numerous waiting periods that can only be expedited by spending more money. Most of the forms necessary for different filings can be filled out digitally and submitted online, or they can be downloaded, printed and then faxed to the necessary recipient.
Before searching for financing, a good idea is to see what federal grants are available or you might qualify for. Grants will keep you from losing ownership or incurring debt. There are many different ways to acquire financing. Preparation and research will pay off well for you.