Unless your business has the balance sheet of Apple, eventually you will probably need access to capital. In fact, even many large-cap companies routinely ask for capital infusions to meet short-term obligations. For small businesses, finding the right funding model is vitally important. Take money from the wrong source and you may lose part of your company or find yourself locked into repayment terms that impair your growth for many years into the future.

Debt Financing
Debt financing for your business is something you understand better than you think. Do you have a mortgage or automobile loan? Both of these are forms of debt financing. For your business, it works the same way. Debt financing comes from a bank or other lending institution. Although it is possible for private investors to offer it to you, this is not the norm.

Here is how it works. When you decide that you need a loan, you head to the bank and complete an application. If your business is in the earliest stages of development, the bank will check your personal credit.

For businesses that have a more complicated corporate structure, or have been in existence for an extended period time, banks will check other sources. One of the most important is the business' Dun & Bradstreet (D&B) file. D&B is the best-known company for compiling a credit history on businesses. Along with your business credit history, the bank will want to examine your books and likely complete other due diligence. Before applying, make sure all business records are complete and organized. If the bank approves your loan request, it will set up payment terms, including interest.

If the process sounds a lot like the process you have gone through numerous times to receive a bank loan, you are right.

Debt Financing Advantages
The lending institution has no control over how you run your company, and it has no ownership. Once you pay back the loan, your relationship with the lender ends. That is especially important as your business becomes more valuable.

The interest you pay on debt financing is tax deductible as a business expense, and finally, the monthly payment as well as the breakdown of the payments is a known expense that can be accurately included in your forecasting models.

Debt Financing Disadvantages
However, debt financing for your business has some downsides. Adding a debt payment to your monthly expenses assumes that you will always have the capital inflow to meet all business expenses including the debt payment. For small or early stage companies that is often far from certain. Second, since the recent recession, small business lending has slowed substantially. Although it is improving, it's still not easy to receive debt financing unless you are overwhelmingly qualified.

The U.S. Small Business Administration works with certain banks to offer small business loans. A portion of the loan is guaranteed by the credit and full faith of the government of the United States. Designed to decrease the risk to lending institutions, these loans allow business owners, who might not otherwise be qualified, to receive debt financing. You can find more information about these and other SBA loans on the SBA website.

Equity Financing
If you have ever watched ABC's hit series, "Shark Tank," you may have a general idea of how equity financing works. Equity financing comes from investors, often called venture capitalists or angel investors. A venture capitalist is often a firm, rather than an individual.

The firm has partners and teams of lawyers, accountants and investment advisers who perform due diligence on any potential investment. Venture capital firms often deal in large investments ($3 million or more), and thus the process is slow and the deal is often complex.

Angel investors, by contrast, are normally wealthy individuals who want to invest a smaller amount of money into a single product instead of building a business. They are perfect for somebody like the software developer who needs a capital infusion to fund the development of his or her product. Angel investors move fast and want simple terms.

Advantages of Equity Financing
The biggest advantage is that you do not have to pay back the money. If your business enters bankruptcy, your investor or investors are not creditors. They are part-owners in your company, and because of that, their money is lost along with your company. Second, you do not have to make monthly payments, so there is often more liquid cash on hand for operating expenses. Finally, investors understand that it takes time to build a business. You will get the money you need without the pressure of having to see your product or business thriving within a short amount of time.

Disadvantages of Equity Financing
How do you feel about having a new partner? When you raise equity financing, it involves giving up ownership of a portion of your company. The smaller and riskier the investment, the more of a stake the investor will want. You might have to give up 50% or more of your company, and unless you later construct a deal to buy the investor's stake, that partner will take 50% of your profits indefinitely.

You will also have to consult with your investors before making decisions. Your company is no longer solely yours, and if the investor has more than 50% of your company, you have a boss to whom you have to answer.

Mezzanine Capital
Put yourself in the position of the lender for a moment. The lender is looking for the best value for its money relative to the least amount of risk. The problem with debt financing is that the lender does not get to share in the successes of the business. All it gets is its money back with interest while taking on the risk of default. That interest rate is not going to provide an impressive return by investment standards. It will probably offer single-digit returns.

Mezzanine capital often combines the best features of equity and debt financing. Although there is no set structure for this type of business financing, debt capital often gives the lending institution the right to convert the loan to an equity interest in the company if you do not repay the loan on time or in full.

Advantages of Mezzanine Capital
This type of loan is appropriate for a new company that is already showing growth. Banks are reluctant to lend to a company that does not have financial data. Forbes reports that bank lenders are often looking for at least three years of financial data, but a newer business may not have that much data to supply. By adding an option to take an ownership stake in the company, the bank has more of a safety net, making it easier to get the loan.

Mezzanine capital is treated as equity on the company's balance sheet. Showing equity rather than a debt obligation makes the company look more attractive to future lenders. Finally, mezzanine capital is often provided very quickly with little due diligence.

Disadvantages of Mezzanine Capital
First, the coupon or interest is often higher, since the lender views the company as high risk. Mezzanine capital provided to a business that already has debt or equity obligations is often subordinate to those obligations, increasing the risk that the lender will not be repaid. Because of the high risk, the lender may want to see a 20 to 30% return. Finally, much like equity capital, the risk of losing a significant portion of the company is very real.

Please note that mezzanine capital is not as standard as debt or equity financing. The deal as well as the risk/reward profile will be specific to each party.

Off-Balance Sheet
Think about your personal finances for a minute. What if you were applying for a new home mortgage and you discover a way to create a legal entity that takes your student loan, credit card and automobile debt off your credit report? Businesses can do that.

Off-balance sheet financing is not a loan. It is primarily a way to keep large purchases (debts) off of a company's balance sheet, making the company look stronger and less debt-laden. For example, if the company needed an expensive piece of equipment, it could lease it instead of buy it or create a special purpose entity (SPE) - one of those "alternate families" that would hold the purchase on its balance sheet. The sponsoring company often overcapitalizes the SPE in order to make it look attractive, should the SPE need a loan to service the debt.

Off-balance sheet financing is strictly regulated and GAAP accounting rules govern its use. This type of financing is not appropriate for most businesses but may become an option for small businesses that grow into much larger corporate structures.

Family and Friends
If your funding needs are relatively small, first pursue less formal means of financing. Family and friends who believe in your business can offer simple and advantageous repayment terms in exchange for setting up a lending model similar to some of the more formal models. For example, you could offer them stock in your company or pay them back just as you would a debt financing deal, where you make regular payments with interest.

The Bottom Line
When you can avoid financing from a formal source that will usually be more advantageous for your business. If you do not have family or friends with the means to help, debt financing is likely the easiest source of funds for small businesses. As your business grows or reaches later stages of product development, equity financing or mezzanine capital may become options. When it comes to financing and how it will affect your business, less is more.

Related Articles
  1. Entrepreneurship

    Top 5 Startups that Emerged in Toronto

    Learn how Toronto has built a fertile climate for startups, and identify some of the top companies to emerge from the city's hot startup market.
  2. Entrepreneurship

    Top 5 Startups that Emerged in London

    Learn why London's startup scene is so prolific, and identify some of the hottest companies emerging from this scene as of mid-2015.
  3. Active Trading Fundamentals

    The 4 Biggest Private Equity Firms in London

    Discover information about the largest private equity firms that are headquartered in London, ranked by total assets under management.
  4. Retirement

    Retirement Planning for Entrepreneurs and Small Businesses

    If your business has receiveables, here's a smart way to leverage them to build up your retirement fund fast.
  5. Investing

    The 8 Best Business and Finance T.V. Shows

    With so many talking heads to choose from, which is the right show for your business and money matter needs? We review the best shows on now.
  6. Active Trading Fundamentals

    The Biggest Private Equity Firms in San Francisco

    Learn about some of the larger private equity firms with a presence in San Francisco, including KKR, the Blackstone Group and Warburg Pincus.
  7. Active Trading Fundamentals

    The Companies of Peter Theil's Founders Fund

    Learn about the major public companies that Peter Thiel has invested in and companies that are on the verge of going public at multibillion-dollar valuations.
  8. Active Trading Fundamentals

    The Biggest Private Equity Firms in Los Angeles

    Learn why Los Angeles is a thriving market for private equity, and identify the five largest private equity firms operating in the city.
  9. Entrepreneurship

    What Does Bootstrap Mean?

    The term bootstrap refers to launching and building a business with little capital and no funding from outside sources.
  10. Professionals

    Small RIAs: How to Level the Playing Field

    In order to compete with larger firms, small RIAs have to get a little creative. Here are a few ways to kickstart growth.
RELATED TERMS
  1. Operating Cost

    Expenses associated with the maintenance and administration of ...
  2. Internal Rate Of Return - IRR

    A metric used in capital budgeting measuring the profitability ...
  3. Venture Capitalist

    An investor who either provides capital to startup ventures or ...
  4. Net Present Value - NPV

    The difference between the present values of cash inflows and ...
  5. Cost Test

    A standard test applied to a process to determine if the net ...
  6. Enterprise Investment Scheme (EIS)

    A UK program that helps smaller, riskier companies to raise capital ...
RELATED FAQS
  1. What are the primary advantages of using mezzanine financing?

    Small and mid-sized businesses that have an established track record with profitable operations have several options when ... Read Full Answer >>
  2. What are the primary disadvantages of using mezzanine financing?

    For small established businesses, the ability to acquire affordable capital to fund rapid growth and expansion is an ongoing ... Read Full Answer >>
  3. Why do companies issue preferred stock?

    There are a number of ways companies can raise funds to finance upcoming projects, expansion and other high costs associated ... Read Full Answer >>
  4. What is the formula for calculating weighted average cost of capital (WACC) in Excel?

    When analyzing different financing options, companies need to look at how much it will cost to fund operations. There are ... Read Full Answer >>
  5. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  6. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!