The Basics of Financing a Business

What Is Business Financing?

Unless your business has the balance sheet of Apple, at some point 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.

What Is Debt Financing?

Debt financing is a concept you may already be familiar with if you have a mortgage or an automobile loan. Both mortgages and automobile loans are forms of debt financing. Debt financing for a business comes from a bank or some other lending institution. Although private investors can offer debt financing to you, this is unusual.

Here is how debt financing works: When you decide you need a loan, you head to the bank and complete an application. If your business is in the early 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 sources of information on the credit history of a business. In addition to the credit history of your business, the bank will likely examine your books and complete other due diligence before agreeing to lend you any funds. Before applying, make sure all your business records are complete and organized.

If the bank approves your loan request, it will set up payment terms—including interest.

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 disadvantages:

• 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, this may not always be true.
• Small business lending can be slowed substantially during recessions. In tougher times for the economy, it can be difficult to receive 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 government. Since SBA loans are 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?

Equity financing comes from investors, who are referred to as venture capitalists or angel investors.

A venture capitalist is usually a firm, rather than a single individual. The firm has partners, teams of lawyers, accountants, and investment advisors who perform due diligence on potential investments. Venture capital firms often deal in significant investments, so the process is slow and the financing 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. An ideal candidate for an angel investor, for example, is a software developer who needs a capital infusion to fund their product development. Typically, angel investors move fast and want simple terms.

Advantages of Equity Financing

Funding your business with funds from investors has several advantages:

• The biggest advantage of equity financing is that you don't have to pay back the money. If your business enters bankruptcy, your investors are not creditors. They are partial owners in your company; their money is lost along with your company.
• You don't 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. With equity financing, you get the money you need—without the pressure of your product or company being required to thrive within a short period of time.

Disadvantages of Equity Financing

Similarly, there are several disadvantages to equity financing:

• 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% of your company. Unless you later construct a deal to buy the investor’s stake, as a partner they will take 50% (or more) of your profits, indefinitely.
• With equity financing, you'll be required to consult with your investors before making any business decisions; if an investor has more than 50% of your company, you have a boss now.

What Is Mezzanine Financing?

A lender is always looking for the best value for its money—with the least amount of risk. The problem with debt financing is that the lender does not share in the business's success. All the lender receives is its initial funding—plus interest—while taking on the risk of default. That interest rate will not provide an impressive return—it will likely only offer single-digit returns.

Mezzanine financing 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.

Mezzanine financing is not as common as debt or equity financing. The deal, as well as the risk-reward profile, is specific to each party.

Advantages of Mezzanine Financing

Choosing to use mezzanine financing 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, which can make it easier to secure this type of loan.
• Mezzanine financing 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 financing is often provided very quickly.

Disadvantages of Mezzanine Financing

There are some disadvantages to securing mezzanine financing:

• The coupon or interest is often higher because the lender views the company as high risk. Mezzanine financing 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 financing, the risk of losing a significant portion of the company is genuine.

Off–Balance Sheet Financing

Off–balance sheet financing (OBSF) is not a type of loan. It is a strategy a company can use to keep large purchases (or debts) off its balance sheet, which can make the business look stronger (and less debt-laden). For example, if a company needed an expensive piece of equipment, it could lease it instead of buying it—or it could create a special purpose vehicle (SPV) to hold the purchase on its balance sheet. The sponsoring company often overcapitalizes the SPV to make it look attractive in the event the SPV needs 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 after they achieve a larger corporate structure.

Funding From Family and Friends

If your funding needs are relatively small, you may want to first pursue a less formal type of financing. Family and friends who support your business can offer advantageous and straightforward repayment terms. And you can set 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

You can borrow from your retirement plan and pay that loan back with interest. However, an alternative—called 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 advisor to conduct these transactions is essential.

The Bottom Line

Every business eventually needs financing. It can be advantageous for your business to avoid financing from a formal source, but not everyone has this option. If you do not have family or friends who are willing to support your company, debt financing is likely the most accessible source of funds for a small business. You can grow the credit profile of your business with on-time, regular payments.

As your business grows—or reaches later stages of product development—equity financing or mezzanine financing may become options.