Key Takeaways
- There are two ways of obtaining capital: via Equity Financing and via Debt Financing. Both kinds of financing have their own advantages and disadvantages.
- As a business owner or manager, there are a lot of sources that you can seek financing. Some examples are from family, friends, angel investors, venture capitals, institutional lenders, crowdfunding, partners, and investors. Bootstrapping is also a common way to start a business.
Equity Financing
Running a business demands effectively raising capital that is sufficient enough to finance the short-term and long-term financial needs of a business. It’s difficult to achieve the purpose and goals of your business when resources are scarce and access to capital is very limited.
You can obtain capital from two basic sources: Equity and Debt. You’ll have to choose the one which is most accessible to you at a given time. If you’re a business owner, it’s best that you consult with an accountant or financial expert and seek advice about different financing options.
Equity Financing is a method of raising capital by selling ownership shares of the company.
Equity refers to the investments made by the owners and shareholders of a business. It includes assets, such as cash and properties, that are invested in the business in exchange of ownership shares.
Advantages of equity financing
- You have no obligation to repay the capital that was raised through equity financing. There is no set amount that you should regularly pay to investors, regardless if your business earns a profit or not.
- Without any obligation to pay any loan principal and interest, you could reinvest the capital to grow the business.
- Investors won’t be expecting any short-term cash flows to receive from their investments while your business is still in its early stages. Unlike lenders, your investors won’t immediately demand any payments from you. Instead, they will be looking at the fundamentals of your business and its future ability to grow.
- Any loss suffered by your business will be shared with your other investors instead of just you absorbing all losses by yourself. The loss that they’ll absorb will reflect in the drop of the value of their equity.
Disadvantages of equity financing
- In exchange for capital received through equity financing, you give up some ownership of your business to investors. You also give up complete control over the management and decision-making of your business.
- You’ll need to share any profits earned by the business with other investors through dividends or other means of profit distribution.
Debt financing
Debt Financing is a method of raising capital by borrowing money and paying off both the principal and interest at a future date.
When equity financing is not enough to satisfy the financial requirements of your business, you may also raise capital by borrowing money or purchasing assets on credit. In exchange for borrowing money, your lender may demand interest payments for the amount loaned to you.
Advantages of debt financing
- You retain control over your business because the lender is only interested in getting paid with the full amount that you borrowed plus any interest that has accrued from the loan. The lender isn’t primarily interested in acquiring an ownership stake in your business and your relationship ends once the loan was fully paid.
- It’s faster to obtain capital through debt financing because the terms are already specified in the loan agreement at the beginning. Using credit cards when buying an asset is relatively easy as long as your available credit can cover the cost of the asset. On the other hand, equity financing could take more time, legal work and negotiations with would-be investors.
- Loan payments are usually fixed and you’ll know the exact amount you’ll need to pay each month throughout the loan term.
- Interest expenses can be claimed as deductions when computing for income taxes. This could lower the taxes paid by your business.
Disadvantages of debt financing
- Leveraging debt can be a double-edged sword. While it has the potential to grow your business, it also increases the risk of failure when your business is unable to repay the debt as it becomes due. Your business could face insolvency issues when an economic downturn happens or when consumer spending falls due to rising interest rates.
- Regardless of business performance, you still have to pay the principal of the loan including all accrued interests when they have become due.
To conclude, it’s important for you to carefully weigh the advantages and disadvantages of both equity and debt financing. You’ll need to seek the help of an accountant or financial expert in forecasting any future scenario when deciding to take any of the available financing routes.
If you’re the one doing the financial decisions for your company, you’ll need to carefully analyze the cost of each financing option and decide which one is more suitable for the business at any given time. In most cases, it’s important to have a healthy mix of both debt and equity.
Common Sources of Business Capital
When starting a business, the first step you have to do is to write a business plan (even a simple one) that outlines every aspect of your business. This includes the short term and long term goals, the details of operations and the available financing options.
Your business plan is important since lenders and investors will have to carefully study it first before deciding to risk their money on you.
So what are your options to acquire the initial capital that you’ll need to kick-start your business? Below are some of the common financing sources for your business.
Bootstrapping
Bootstrapping is the process of building a business from the ground up using the personal resources of the owner and without relying on external sources of financing. The business grows organically with the reinvestment of profits from the sale of goods and services.
“Work with what you have.” This adage is the very essence of bootstrapping.
In bootstrapping, your only source of financing to kick-start your business are your personal assets. Acquiring capital from external sources is not an option, at least in the beginning.
Any profits that you earn from your initial sales are reinvested back in the business to create more products to sell. Ideally, your business should grow organically over time as you reinvest your profits regularly.
Some personal assets that you can invest in your business are your personal computer, phone, vehicle, and anything you have that can be used in the business. Remember though that any business has an inherent risk so be careful when investing all of your life savings and personal assets in it.
If you’re cash-strapped and your personal assets are not enough to cover the operating expenses of the business, you may also contribute your own time, physical labor, and skills. This is known as sweat equity.
Sweat Equity, a nonmonetary contribution of unpaid labor by the entrepreneur over a long period of time, is also equally as valuable as any monetary investments. It can be subsequently measured by the value of the equity that the owner was able to build in the business.
When deciding to bootstrap, it’s important to consider how far you can go by just funding the business yourself. If you have money, you could go farther without ever having to seek external financing. However, if you think that your funds may not be enough in the long run especially if you decide to expand your business, then you may consider other sources of financing.
Advantages of bootstrapping
- You’ll have full control and ownership of the business without incurring any liability or giving away a portion of your business to other investors.
- You’ll also be able to focus in growing your brand and business with no pressure from creditors and investors.
- If you decide to contribute your time, labor and skills in the beginning stages of your business, you’ll have first hand experience and learn more about the different aspects of your business. This will help you have a better understanding of your business and the things that may or may not work.
Disadvantages of bootstrapping
- The growth of your business could be hampered and your operations will be limited only to the extent of the personal resources that you have contributed and the profits you reinvest.
- You need to put more effort in economizing and strictly managing your resources to avoid financial problems.
- The quality of your product or service may be compromised if you decide to cut corners and minimize costs to save up on capital.
Family and friends
If the slow growth and limitations of bootstrapping don’t appeal to you, another legitimate financing option you may consider is to borrow money from your family and friends. These people are most likely to lend you money especially if you already have a good relationship with them.
Your family or friends may also opt to become investors or part owners of your business. However, it would be prudent to keep your business and ownership agreements in writing to avoid potential stress in your relationship with them.
Advantages of borrowing from family and friends
- Your loan may come with very minimal or no interest at all.
- The requirements for taking out a loan are very low as compared to banks and other institutional lenders.
- Your family and friends usually won’t be strict on collections.
Disadvantages of borrowing from family and friends
- You may lose complete control over the decisions of the business if any one of them decides to demand a large share in your business or enforce authority over its operations.
- Any failure or disagreements that could happen in the business may potentially lead to strained relationships and awkward family gatherings.
Lenders
Applying for a loan is a common financing option for most businesses. A loan may come in the form of bank loans, home-equity loans, mortgages, small business loans, peer-to-peer lending, and credit union loans. If you’re looking for an easier and faster option, you may also consider having a loan against the available limit of your credit card.
However, too much reliance on debt, regardless of the size of your business, can be risky. That’s why before entering into any loan agreement, you should carefully consider and study all available lending options. It’s important to have a plan in place for managing your money in order to avoid insolvency and financial problems in the future.
Advantages of borrowing from lenders
- You can secure large amounts of capital that is sufficient enough for the needs of your business. Though you are required to pay an interest for the amount that you borrowed, it won’t be much of an issue if your business succeeds as a result of the loan.
- Unlike equity financing, you don’t need to sell ownership shares of your business when you opt to borrow money. This gives you full ownership of your business.
Disadvantages of borrowing from lenders
- The requirements for taking out a loan may vary depending on the lending institution. Since banks are more focused on minimizing risks when they lend money, the barriers for acquiring a loan could be stringent. They would typically require financial reports that prove that your business already has an established revenue source and cash flow. The bank may also subject your business assets or even your personal assets as collaterals to your loan.
- Being unable to pay on time due to poor cash flow management may result in huge amounts of accumulated interests that could eat up on your profits and assets.
- In equity financing, you don’t owe the investor anything if your business fails. But when you borrow money, you need to pay your creditor back under the agreed terms of the loan, regardless of your business succeeding or failing.
Angel investors
Angel investors are affluent or high net worth individuals who frequently invest in startups and small businesses.
Angel investors can support your startup business and help propel its operations by providing capital that can typically be more than what a family member or friend can provide.
Advantages of financing by angel investors
- Angel investors invest their own money in smaller amounts without having to get any approval from a company’s board of directors or any executive. As a result, they don’t usually have very strict requirements as compared to those of lending institutions and venture capitalists.
- Angel investors believe in the passion and the capability of the entrepreneur behind the startup business and could even go beyond investing by providing mentorship especially if your business is in an industry or area that they understand very well or have an expertise in.
Disadvantages of financing by angel investors
- Angel investors may demand an ownership share in your business in exchange of providing capital. This could result in yourself losing some control over the business if they also involve themselves in the decision-making process.
Venture capitalists
Venture capital or VC is a form of equity financing that is provided by venture capitalists to startups or businesses with a potential to grow long-term and earn above-average return on investments. It is a form of high risk and high reward investment for VC firms or funds who raise money from institutional investors and wealthy individuals.
If you think your business has a great product, a large market, a good management team, and a high potential to succeed and grow, then you probably have a higher chance of getting funded by a VC.
VCs take risks and invest in startups or businesses with big ambitions and with a potential to succeed and earn them a massive return on their investments. The capital they inject into the business is used to keep the business afloat and help it expand.
Advantages of venture capital
- Acquiring capital from VCs is a good way to get large sums of money for businesses who don’t have access to bank loans, equity/bond markets or private equities.
- VCs can provide valuable guidance and support and take an active role in monitoring the progress of the startup business they invested in.
Disadvantages of venture capital
- Venture capitalists exchange money for equity in the business. They could involve themselves in the business and in some cases, takeover control from its founders.
- The VC’s focus is on immediately recovering their investments since they typically exit the business within a few years through initial public offerings (IPOs), mergers or acquisitions.
Crowdfunding
Crowdfunding is a form of financing where a large number of interested individuals raise capital to finance a business venture by donating or investing small amounts of money.
If you don’t want to go through the traditional route of financing from banks and VCs, another source of capital you may consider is crowdfunding. This alternative financing option has created opportunities for many entrepreneurs and startup businesses to raise any level of capital from groups of individuals who have a shared interest in the business.
The internet has made crowdfunding easier and more accessible to individual investors and businesses. Many online companies offer a platform for crowdfunding to help businesses raise funds from the collective efforts of interested individuals from anywhere in the world. Some angel investors also participate in crowdfunding platforms.
In exchange for their capital contribution, investors in crowdfunding either receive equity shares of the business or get the opportunity to be the first ones to enjoy the product or service on its initial launch. In debt crowdfunding, investors receive their money back with interest.
Advantages of crowdfunding
- You have access to a wider pool of individual investors using social media and internet platforms dedicated to crowdfunding.
- You could get valuable and immediate feedback from the crowd that could help with validating your idea or product and make improvements. Investors can also track the progress of your business through the crowdfunding platform.
- Crowdfunding is a faster way to raise funds compared to more traditional routes. You only need to build your business profile that includes everything that investors need to know about your business. In this way, you won’t need to pitch your business idea and pursue individual investors separately.
- Social media and crowdfunding platforms can be a good source of marketing for your business. Your investors can also become your loyal customers and advocates.
Disadvantages of crowdfunding
- You may risk losing complete control of your business especially with equity-based crowdfunding.
- The reputation of your business could be damaged if your project fails.
- You may need a lot of time and hard work in building up interest towards your idea or project. This also involves posting persuasive content and spending time and money for prototypes of your product.
- Your business or product idea could be stolen by anyone if you fail to protect it with a patent or copyright.
Partners and shareholders
While going solo may have its merits when it comes to complete control of all aspects of your business, having partners or investors could open more opportunities when you’re looking to raise capital to expand your business.
You may find a cofounder or a partner who’s willing to work with you and contribute capital and/or labor to the business. A cofounder or partner may also have valuable skills, experience or knowledge which could be very useful in building your business.
If your business is a private corporation, you may look for more investors who will buy shares of your company as a private shareholder. As your business grows and begins to look towards expansion, you may consider transforming your business into a publicly-listed company and raise huge amounts of capital by selling company shares to the public.
Advantages of having partners or shareholders
- With a cofounder or partner, you’ll share capital, profits, skills, and management roles that could be beneficial to your business especially when you’re just starting out.
- Huge amounts of capital could be raised by selling shares to the public.
Disadvantages of having partners or shareholders
- Just like any other equity financing option, you could lose complete control over the management and decision-making of your business.
Review Questions
- What are the different ways that a business can obtain financing or capital?
- What is the main difference between debt financing and equity financing?
- What are the advantages and disadvantages of debt financing and equity financing?
- As a business owner, what do you give up when you obtain capital thru equity financing?
- What is the main advantage of equity financing over debt financing when your business suffers a loss that was caused by an economic downturn?
