The Basics of Financing a Business

What Is Business Financing?

Unless your business has the balance sheet of Apple, eventually, you will probably need access to capital through business financing. Even many large-cap companies routinely seek capital infusions to meet short-term obligations. For small businesses, finding a suitable 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.

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Key Takeaways

There are a number of ways to find financing for a small business.
Debt financing is usually offered by a financial institution 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.
However, 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 private investors can 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, banks will check other sources. The Dun & Bradstreet (D&B) file is one of the most important. D&B is the best-known company for compiling a credit history on businesses. The bank will want to examine your books and likely complete other due diligence along with your business credit history.

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 significant investments ($3 million or more), so the process is slow, and the deal is often complex.

Angel investors, by contrast, are generally wealthy individuals who want to invest a smaller amount of money into a single product instead of building a business. They are perfect for the software developer who needs a capital infusion to fund their product development. 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:

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 company thriving within a short amount of time.

Disadvantages of Equity Financing

Similarly, several disadvantages come with 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 more significant 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 share in the business’s success. All it gets is its money back with interest while taking on the risk of default. That interest rate will not 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

Choosing to use mezzanine capital comes with several advantages:

This type of loan is appropriate for a new company that is already showing growth. Banks may be reluctant to lend to a company that does not have at least three years of financial data.

However, 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.
Mezzanine capital is often provided very quickly with little due diligence.

Disadvantages of Mezzanine Capital

Mezzanine capital does have its share of disadvantages:

The coupon or interest is often higher, as 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.
Much like equity capital, the risk of losing a significant portion of the company is genuine.

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 balance financing is good for one-time large purposes, allowing a business to create a special purpose vehicle (SPV) that carries the expense on its balance sheet, making the business seem less in debt.

Off-Balance Sheet Financing

Think about your personal finances for a minute. What if you were applying for a new home mortgage and discovered 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 a company’s balance sheet, making it look stronger and less debt-laden. For example, if the company needed an expensive piece of equipment, it could lease it instead of buying it or create a special purpose vehicle (SPV)—one of those “alternate families” that would hold the purchase on its balance sheet. The sponsoring company often overcapitalizes the SPV to make it look attractive should the SPV need a loan to service the debt.

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

Funding From Family and Friends

If your funding needs are relatively small, you may want to first pursue less formal means of financing. Family and friends who believe in your business can offer advantageous and straightforward 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, in which you make regular payments with interest.

Tapping Into Retirement Accounts

Whereas you may be able to borrow from your retirement plan and pay that loan back with interest, an alternative known as a Rollover for Business Startups (ROBS) has emerged as a practical source of funding for those who are starting a business. When appropriately executed, ROBS allows entrepreneurs to invest their retirement savings into a new business venture without incurring taxes, early withdrawal penalties, or loan costs. However, ROBS transactions are complex, so working with an experienced and competent provider is essential.

How Do You Finance a Business?

There are many ways to finance your new business. You could borrow from a certified lender, raise funds through, family and friends, finance capital through investors, or even tap into your retirement accounts, although the latter isn’t recommended.

What Is Equity Financing?

This form of financing is the process of raising capital by selling shares in your company. If you do this, your investors will essentially own a part of your business.

Can I Borrow From My 401(k) to Start a Business?

You may take out a loan from your 401(k) but how advisable it is to use depends on your situation. Most plans only allow you to withdraw a maximum of $10,000 or 50% of your vested balance (whichever is greater), but there is a $50,000 cap. There are strict rules on repaying your account. If you go this route, make sure you can pay yourself back. It can be risky to take out a loan to fund a start-up because you have to keep your day job with your employer. If you leave with a loan on your plan, you will be required to repay the loan and taxes and penalties for an early withdrawal.

The Bottom Line

When you can avoid financing from a formal source, it 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 most accessible 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. Less is more when it comes to financing and how it will affect your business.