Investigating the applicable options can give you guidance into the types of financing (their advantages as well as their potential downsides) you can realistically expect to obtain. But limiting yourself to a rigid financing "profile" can put a damper on your creative thinking as well as the impression you give to potential financiers.
When it comes time to meet with a potential financier, you must present the most attractive overall portrait of your business by emphasizing its strong points and explaining its weaker traits. Simply saying, "A chart told me equity financing is a good option for my long-term financing needs" won't cut the mustard with a lender.
Remain flexible while considering how the strengths and weaknesses of your business can be presented so that you can have access to as many different sources of financing as possible. And as you polish your proposals, make sure you're familiar with the two umbrella categories nearly all financing: debt financing and equity financing.
Financing basics: Debt versus equity
Thoroughly understanding the basic types of financing can reveal which options might be most attractive and realistically available to your particular business. Typically, financing is categorized into two fundamental types: debt financing and equity financing.
Five key debt financing facts
Although the sound of (more) debt is never appealing, this option is very popular among small business owners, especially owns who want to call all the shots.
Debt financing simply means borrowing money that you'll repay over a period of time, usually with interest. Like any type of financing, this option varies from lender to lender. But you can usually count on a few industry standards, such as:
- Short-term loans require payment within less than one year
- Long-term loans offer repayment over the span of more than one year
- The lender does not gain any ownership interest in your business
- Your obligations are limited to repaying the loan
- For smaller businesses personal guarantees are likely to be required, making your debt financing synonymous with personal debt financing
As you've probably surmised, debt financing is very similar to the loans you've already accumulated, such as student loans, car loans and mortgages.
If you're looking for different financing options that require less (or no) repayment options and you don't mind giving up a little control of your business, equity financing is usually another viable option for small business owners.
Equity financing basics
Rather than making you repay the capital lent to your business, equity financing involves exchanging money for a share of business ownership.
By using this method, you can obtain funds without incurring debt. Of course this method has its "cost" of:
- Diluting your ownership interests and
- Potentially losing some decision-making power as investors make their voices heard.
Understanding and securing equity financing
Debt and equity financing provide different opportunities for raising funds. To ensure you'll qualify for the most options, you'll need to maintain an acceptable ratio between debt and equity financing.
From the lender's perspective, the debt-to-equity ratio measures the number of assets—or "cushion"—available for repayment of a debt in the case of default.
Many small businesses rely on a mixture of debt and equity financing, balancing this yin and yang of the lending work. As you consider debt financing, keep these ratio concerns top of mind:
- Excessive debt financing may impair your credit rating, becoming detrimental to your ability to raise more money in the future.
- If you incur too much debt, your business may be overextended, risky and generally considered an unsafe investment.
- If your interest rate increases, you may be unable to weather unanticipated business downturns or credit shortages.
Many business owners, realizing these potential hardships of debt financing, turn to equity financing to generate capital. But, like debt financing, equity financing carriers its own concerns you'll need to consider:
- If you are not making the most productive use of your capital.
- Your capital is not being used advantageously as leverage for obtaining cash.
- Too little equity in your business may suggest you're not committed to your enterprise.
Lenders will consider your debt-to-equity ratio when they're assessing if your company is being operated in a sensible, creditworthy manner.
Generally speaking, a local community bank will consider an acceptable debt-to-equity ratio to be between 1:2 and 1:1. For startup businesses in particular, you'll need to guard against cash flow shortages that can force your business to take on excess debt, thereby impairing your business' ability to subsequently obtain needed capital for growth.
Exercise caution when making equity contributions of personal assets (cash or property) to your business. Usually your rights to that contribution become secondary to the rights of business creditors if your business fails. Alternatives to outright transfers of capital to the business may be secured loans or "straw man" transactions (you loan money to a third-party relative or friend who then loans the funds to the corporation). The insider then takes a secured interest in the property.
As you consider equity financing, you'll need to determine which business organization structure makes the most sense for your financing needs.