What Is Business Financing?

Unless your business has the balance sheet of Apple, eventually you will
probably need access to capital through business financing. In fact, even
many large-cap companies routinely seek 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.

KEY TAKEAWAYS
 There are a number of ways to find financing for a small business.
 Debt financing is usually offered by a financial institution and is similar
to taking out a mortgage or an automobile loan, requiring regular
monthly payments until the debt is paid off.
 In equity financing either a firm or an individual makes an investment in
your business, meaning you don’t have to pay the money back, but the
investor now owns a percentage of your business, perhaps even a
controlling one.
 Mezzanine capital combines elements of debt and equity financing, with
the lender usually having an option to convert unpaid debt into
ownership in the company.,

What Is Debt Financing?

Debt financing for your business is something you likely understand better
than you think. Do you have a mortgage or an automobile loan? Both of these
are forms of debt financing. It works the same way for your business. Debt
financing comes from a bank or some 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 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 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.
Advantages of Debt Financing
There are several advantages to financing your business through debt.

 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.
 The monthly payment, as well as the breakdown of the payments, is a
known expense that can be accurately included in your forecasting
models.

Disadvantages of Debt Financing

However, debt financing for your business does come with 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.
 Small business lending can be slowed substantially during recessions.
In tougher times for the economy, it can be difficult to receive debt
financing unless you are overwhelmingly qualified.

 
During economic downturns it can be much harder for small businesses to
qualify for debt financing.

The U.S. Small Business Administration (SBA) 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’s website.

What Is Equity Financing?

If you have ever watched ABC’s hit series “Shark Tank,” you may have a
general idea of how equity financing works. It comes from investors, often
called “venture capitalists” or “angel investors.”

A venture capitalist is usually a firm rather than an individual. The firm has
partners, teams of lawyers, accountants, and investment advisors who
perform due diligence on any potential investment. Venture capital firms often
deal in large investments ($3 million or more), and so 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 such as the software developer who
needs a capital infusion to fund the development of their product. Angel
investors move fast and want simple terms.

 
Equity financing uses an investor, not a lender; if you end up in bankruptcy,
you do not owe anything to the investor, who, as a part owner of the business,
simply loses their investment.

Advantages of Equity Financing

Funding your business through investors has several advantages, including
the following:

 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 partial owners in your company and, because of
that, their money is lost along with your company.
 You do not have to make monthly payments, so there is often more
liquid cash on hand for operating expenses.
 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

Similarly, there are a number of disadvantages that come with equity
financing, including the following:

 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 larger 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.
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 an investor
has more than 50% of your company, you have a boss to whom you
have to answer.

What Is 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
success 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.