Financing Your Business | Print |

To start your business you must purchase licenses, pay for permits, engage professional services (e.g. legal, accounting, insurance etc.), do leasehold improvements, buy furniture, fixtures and equipment etc. You may require initial retail inventory, an opening stock of repair parts, accessories or office supplies such as business cards, letterhead, envelopes, staples etc. Once you start operating, you must replenish these retail or parts stocks and pay the day-to-day wages of your employees (i.e. working capital requirements). There are financial strategies to satisfy these needs and to approach the various sources of this financing (i.e. lenders & investors).

Money that finances business is called capital. Bank loans approved for day-to-day business operations (working capital) have characteristics that make them differentfrom those approved for equipment purchases (long term capital or capital assets). A bank loan officer can often assist you in finding a workable combination of these different types of capital. Using loans approved for purposes other than those for which they were approved is considered an abuse of your loan privilege.

Not All Money Is the Same

There are two types of financing: equity 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 funds come from personal moneys of the partners (such as savings, inheritance or personal borrowings from financial institutions, friends, relatives and business associates) and from stockholders of the shares in a corporation. These funds are normally unsecured and have no registered claim on any of the assets of the business, freeing those up to be used as collateral for the loans (debt financing). Higher equity creates " increased leverage." Leverage reflects the business ability to attract other loans and investment. An equity position of $30,000 may enable the business to obtain debt financing of up to three times that amount, $90,000. A fully-leveraged business has no further ability to borrow money.

Equity Financing

Most small or growth-stage businesses use limited equity financing. As with debt financing, additional equity often comes from non-professional investors such as friends, relatives, employees, customers, or industry colleagues. However, the most common source of professional equity funding comes from 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.

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

There are many sources for debt financing: banks, savings and loans, and commercial finance companies, are the most common. State governments have developed 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. The JBDC assessment program encourages banks and non-bank lenders to make long-term loans to small firms by reducing their risk and leveraging the funds they have available. The JBDC’s program has been an integral part of the success stories of many of firms nationally.

In addition to equity considerations, lenders commonly require the borrower's personal guarantees in case of default. This ensures that the borrower has a sufficient personal interest at stake to give paramount attention to the business. For most borrowers this is a burden, but also a necessity.

Long Term Debt

"Term" refers to the time for which money (a secured loan) is required and the period over which the loan repayment is scheduled. A long term loan is arranged when the scheduled repayment of the loan and the estimated useful life of the assets purchased (e.g. building, land, machinery, computers, equipment, shelving, etc.) is expected to exceed one year.

Short Term Debt

Short term loans usually take the form of operating term loans (less than one year) and revolving lines of credit. These finance the day-to-day operations of the business, including wages of employees and purchases of inventory and supplies.

 

Business Guide