Raising Capital for Your Small Business
Starting and operating a small business can be a rewarding experience both from an enjoyment standpoint as well as from a fiscal perspective. However, in some cases part of starting up, or operating, your business will require more capital resources than you have on hand. This course is designed to outline how to raise capital resources for your business in the following sections:
- Sources of Small Business Capital
- Types of Small Business Capital
- How to Acquire Small Business Capital
Adding capital to your business can perform a variety of useful functions. You can use an infusion of capital to complete your start-up process and get your small business started. Or, you may use an infusion of capital to expand your current business operation. Regardless of how you will use new money coming into your business, the difficulty can be seeing the other side of the coin.
“In good times and bad, we know that people give because
you meet needs, not because you have needs.”
Kay Grace (author of several books on
fundraising and business consultant)
At the end of the day, people investing their money in your business will likely care very little about what you need to start, maintain or expand your business. Rather, their primary focus will more likely be on whether or not you have something that is in demand, and if they will get a good return on the money they invest in your business. If you can show potential investors the answer to both of those questions is “yes,” you will have no problem generating the capital you need to move forward with your business plan.
Do You Need to Raise Capital?
While you will likely know and understand the needs of your small business best, before you seek out investment capital, be sure to ask yourself if your small business really needs more capital. Take a look at your business plan and ask: Is it necessary to have a particular amount of money on hand in order to start your business? After you have started your business, you should ask: Is it necessary to add investment money in order to expand or grow your business?
There is a saying in business that “there are no free lunches.” That is certainly the case with outside investment in your small business. As we will discuss later in the course, you will have to give up something (either money, in the form of interest, some amount of ownership or control of your business) in exchange for added capital.
One method of starting and operating a small business without adding outside capital is called, “bootstrapping.” Bootstrapping is a method of starting a company with little or no capital infusion, keeping costs and expenses low and using business revenues to grow the business.
Before you make the decision to look for outside sources of capital you should take a look at this method of small business operation to see if it will work for you. Let’s take a deeper look at this small business development philosophy.
Like the cliché “pull yourself up by your bootstraps,” bootstrapping in business means to get the work done with what you have on hand. Many in business look to have “bells and whistles” as their new business gets off the ground. But when using bootstrapping as a business model, having nothing is what you use to your advantage.
When you have nothing, the only thing you can do is sell what you intend to develop. Use the idea of starting small, and having nothing, to your advantage by refining what you will ultimately do with the help of potential customers.
You may be asking, “How can I sell something when I don’t actually make it yet?” Fair question. See how you can get started in the next section of this module.
Bootstrapping – How to Get Started
Like any other small business, before you actually have some tangible product or service to sell, you have an idea on paper (hopefully as part of a comprehensive business plan). In order to move forward with a bootstrapping philosophy, you take that idea out into the marketplace. Let’s use an example to help you see how this concept is put into action.
Let’s assume you are in the process of operating a small business that develops applications for smart phones. You start with an idea for an application, then you take your idea to potential customers. Rather than selling them the actual product, you sell them the concept you created and when it will be ready to hit the market.
You will accomplish two things during this step, and you will have spent only your time:
- You will be able to determine whether there is a market for the product or service you intend to sell; and
- You will learn what enhancements or improvements your product or service may need before you put it on the market.
Bootstrapping – Moving Forward
After a period of selling your idea, you will have a clearer focus on what your finished product or service needs to look like to be attractive to consumers, as well as an understanding of what the ideal target audience is for marketing that product or service. When you decide to move forward, you will first want to adjust your business plan according to what you have learned, then make a commitment to moving forward.
In our example of the smart phone application business, once you have identified a sufficient target market for your product, it is time to begin getting your product to that target market; this is where bootstrapping gets a bit tricky. In order to keep moving forward with this method, you need to generate some revenue to keep the momentum going forward.
Keeping with our full bootstrapping method though, you will do all you can to develop, sell and deliver the smart phone applications on your own. At this early stage, it would be too costly to add employees or technology to help your business grow.
Bootstrapping – When it is Time to Move On?
In some cases, you may develop a small business that you can bootstrap from start to finish, without ever adding capital from outside sources. In our example of the smart phone application business, you may just need a computer and your own good ideas to be successful.
However, many small business ideas that can begin, and operate initially through bootstrapping methods, will ultimately need some outside capital to continue to operate and to grow. Here are some questions a “bootstrapper” needs to ask periodically:
- Is my business working the way I intended it to?
- Do I need more capital to make it work better?
- Is my business growing according to plan?
- Could the business grow faster if I had additional capital?
The goals you have for your small business will play a role in how long you can continue utilizing bootstrapping as a business method. But regardless of the type, structure or size of business you want to develop, bootstrapping is a good way to start and operate your business until additional capital becomes available to you.
Here are a few examples of different businesses that used bootstrapping as a successful business method.
Bootstrapping – Example 1
- Started by Greg Gianforte (Bootstrapping Guru) in 1997
- Developed a customer relationship management software program
- Initially developed software on his own, and began selling software on his own
- Roughly two years in operation before he hired any employees
- Took company public in 2004
- Sold company to Oracle in 2011 for roughly $1.5 billion
Bootstrapping – Example 2
Stacy’s Pita Chip Company
- Started by Mark Andrus and Stacy Madison in1997
- Both Mark and Stacy quit their professional careers to work full-time in the company
- Primary product is pita-type chip that became a hit at family functions and parties
- Both owners had significant personal debt initially, but did most of the work for the company on their own
- Sales revenues reach roughly $60 million in 2006
- Acquired by Pepsico in 2006
Bootstrapping – Example 3
Bar Charts, Inc.
- Started by John and Bobbie Ford in 1991
- Bobbie was a law school student and John was in the real estate industry
- Bobbie created charts and outlines for her law school classes and John thought they would be able to market her outlines to other students
- The initial investment made to the business was $1,000
- John and Bobbie created charts and marketed them to law schools
- Within 10 years, sales were over $10 million
Bootstrapping – Conclusion
If you have the time to commit to your new business full time, and you can survive without your business providing you with significant and regular income, bootstrapping is a great way to start, and build, a small business.
Depending on the goals and daily needs you have for your business, you may not need to raise outside capital. If you don’t NEED outside capital, you should consider these consequences before taking investment money:
- Increased Cost – Borrowed money will have to be paid back with interest
- Heightened Expectations – Capital infusion leads to larger operation and more pressure for greater financial performance
- Loss of Control – Addition of investors can mean your influence over the business is reduced
Whether or not bootstrapping is for you, there will likely come a time when your business will need an infusion of capital to keep operating or to expand. Now we will look at sources of capital for your small business.
If you are looking to infuse capital into your small business, there will be a number of sources to consider, such as:
- Financial Institutions
We will take a look at each of these groups separately and outline the specific sources you can look to within each of these groups for sources of small business capital.
Consider Yourself as a Source of Capital
While it may seem intuitive, some people don’t consider themselves as a source of capital for their own small business. Depending on the amount of capital you need for your small business, and depending on your personal circumstances, you may be able to handle your small business capital needs on your own.
Several potential sources of capital for your small business include:
- Personal savings
- Income from your “regular” job
- Retirement accounts
- Marketable assets
- Life insurance policies
- Credit cards
If your business needs a large amount of capital, or you are not in a position to utilize any of these options listed, family and friends are another potential source of capital.
Family and Friends: The Advantages
While there are varying schools of thought on the wisdom of borrowing capital for a small business from family and friends, it is a viable option that should be considered. The following are some of the advantages of obtaining capital from family or friends:
- You will have easy access to these potential investors without the need for an application or other loan process.
- These loans will typically carry low or no interest rates.
Payment terms will usually be more flexible than you will find with capital acquired through financial institutions or outside investors.
Family and Friends: Consider the Negatives
While there are some advantages of borrowing money from family or friends, these should be weighed against the potential negatives of such an investment:
- There is the possibility your business venture may not succeed and you will have to deal with the reality that your family or your friends have lost their investment, which could lead to some discord.
- When those close to you lend you money for a business concern, there may be more constant pressure and inquisition regarding business decision-making due to familiarity, proximity and access.
If you choose to obtain capital from yourself, or from family and friends, it is important to understand at the outset what the parameters of the capital infusion are and what the potential risks are overall. Being fully informed at the outset of any such financial transaction will make both positive and negative eventualities much more bearable down the road.
While there are many different financial institutions in existence in modern financial markets, there are two primary financial institutions available to you when seeking after capital for your small business:
- Credit Unions
While each of these types of financial institutions generally have resources they can commit to your small business, both go about the process using different methods, and dealing with each can have a different impact on your small business.
We will take a look at each of these types of financial institutions to help give you a better idea of which would be better to work with when seeking capital for your small business.
Banks: General Overview
Some banks have a large, national base, while others may only have a small regional presence. Regardless of the size, banks typically have a business portfolio not only to service your business accounts, but also to lend money to small businesses. In most instances, the larger the bank is the greater the resources it will have, which, will generally translate to more money to lend to small businesses, and more programs geared toward small business lending.
However, in some cases, dealing with a bank when seeking capital for your small business can lead to frustration. Many banks, especially the larger national based banks, will have a series of protocols to be followed in regard to small business loans. While those protocols are likely implemented to ensure legal compliance and to streamline operations from the banking side, you (as a small business seeking capital) will probably see it as red tape. Cutting through the red tape of banking processes can be time-consuming and frustrating.
Additionally, banks may not be willing to take the risk associated with infusing capital into your small business. Banks will often require a track record of success for your business, or have some guarantee from your personal assets before they will provide you with capital for your small business.
Finally, banks will generally follow a set schedule when it comes to interest rates and repayment terms on small business loans. If you are seeking a small business loan from a bank, you will want to be sure you fully understand the terms and conditions of such a loan, as you will not likely be able to adjust or modify those terms even if you are unable to meet the loan obligations.
Banks: Understanding YOUR Business
Another factor to consider when looking for capital is whether the particular bank you are dealing with has any policies regarding your type of business or industry. Having insight into the specifics a bank is looking for, or seeking to avoid, when considering a small business loan can help you to eliminate frustration as you seek capital for your small business.
Seek out those who have dealt with your bank in the past and those who work at the bank to help you understand the idiosyncrasies of your bank. Catering your request for small business capital to remain consistent with the policies and philosophies of your bank will increase the likelihood of obtaining the capital infusion you are seeking.
Credit Unions: General Overview
Credit Unions, like banks, can be large or small, but generally speaking, most credit unions are located on a more regional or local basis. While there are a few credit unions that have a national presence, organizational guidelines typically require credit unions to be more regional or local rather than national.
Additionally, while there are some large credit unions, the average sized credit union has significantly less assets than the average sized bank. And of course, having less assets overall will generally translate into less assets to lend. To further compound the potential of obtaining small business capital from a credit union is the concept of competition. With a small asset base to lend from, there will be more competition, not just for small business capital, but for all types of lending. This will often cause credit unions to funnel money toward lending vehicles that satisfy their income parameters with less risk than small business lending would.
A final credit union restriction that can make it more difficult for you to obtain small business capital from a credit union is the governmental restrictions on the percentage of assets a credit union can use for small business lending. However, credit unions offer some excellent advantages in this area as well.
Credit Unions: Business Lending Positives
Credit unions are not-for-profit entities, which gives them some tax advantages and saves them significant amounts of money each year. Typically, those savings are passed along to credit union “members” in the form of lower interest rates and more attractive financial products. And, of course, this can only benefit you as you seek capital for your small business.
Also, the community-based nature of some credit unions gives them more of a “community” feel than many other financial institutions. In most instances, you will likely have access, as well as a personal connection to higher level decision-makers. You can then have more of an opportunity to sell your business concept. Additionally, dealing with a smaller lender may help you avoid some of the red tape and stringent policies often seen in larger banks.
Financial Institutions: Summary
Whether the amount of capital you seek to infuse into your business is large or small, whether you are just starting up or have been in business for years, banks and credit unions are a good source for obtaining small business capital. Take the time to outline what you want, how much you will need, and how quickly you will need the capital. The answers to these questions will help you determine which type of financial institution would best suit your needs.
The term “investor” has come to be a cliché in many circles today. In this portion of the module we will discuss some different types of investors and how they can help infuse capital into you small business. Here are some specific investors you can look to for small business capital:
- Hedge Funds
- Venture Capitalists
- Angel Investors
Let’s take a look at each of these different investor types and see how they can potentially help your small business with its capital needs.
A hedge fund is a portfolio of investments that uses advanced, and often aggressive, investment strategies in an attempt to generate high returns. Think of a hedge fund as a mutual fund for exceedingly wealthy people. The initial concept behind a hedge fund was to “hedge” or guard against market swings through a series of diversity-based moves that would help the fund earn money regardless of financial market performance. In the last several decades that strategy has evolved somewhat from hedging against risk to taking higher risks. The theory now is essentially based on the notion that while the risks are extremely high, the potential reward is even higher. The new hedge fund philosophy seems to be “take enough risk to ensure a high payout that offsets fund losses.”
The business form of hedge funds will typically be a limited partnership. The hedge fund manager, the individual who makes trading and operational decisions, will generally be the general partner, while the investors who finance the fund act as limited partners. These investors are typically required to be accredited investors.*
While hedge funds can be associated with large national banks, they are more commonly standalone business entities. An Internet search for hedge funds will likely get you on your way to finding a number of hedge funds available for review and potential use. In addition, you may be able to locate a listing of hedge funds willing to invest in small businesses through the Small Business Administration or through your local chamber of commerce or other business support entities.
*”Accredited Investor” is defined by the Security and Exchange Commission in Rule 501 of Regulation D.
Hedge Funds: Small Business Investment Involvement
While hedge funds have not traditionally been involved in small business investment, over the past several years, in an attempt to find new ways to remain profitable, they have been more receptive to both debt and equity financing for small businesses. By and large, hedge funds are large outfits with massive investment capital at their disposal. This, combined with a new focus on the small business industry, makes hedge funds a realistic option when seeking small business capital.
Hedge Funds: Associated Risks
While hedge funds have a ready source of capital this potential capital comes with more strings attached than capital from a more traditional financing source, such as a bank or credit union. Some of the risks associated with hedge fund capital are:
- High interests rates
- Hedge fund volatility
- Loans are typically asset backed
- Lack of certainty
- Riskier risk
Let’s take a little closer look at each of the risks we have listed above.
Hedge Fund: High Interests Rates
Banks and credit unions, like most financial institutions, have several governmental imposed regulations. On the other hand, hedge funds are not subject to many of the federal and state regulations that guide the conduct of more traditional financial institutions. While this trend is changing, and more governmental regulations are being imposed on hedge funds, they are still under regulated.
This lack of governmental oversight creates opportunities for hedge funds to charge exceedingly high interest rates on money loaned to small businesses. In a typical lending scenario, interest rates are set by market forces, risk and fund availability; however, when regulation is limited, desperation can also play a factor in the setting of interest rates. When a business is desperate for capital, and confident that additional capital will aid rather than increase existing problems, the owners are likely to agree to any terms presented to them. In some cases, hedge fund firms will act in a predatory manner in these desperation situations.
Hedge Fund: Volatility
As a small business owner, you generally come to expect some level of volatility within your business. Whether it is fluctuations in sales, production costs or some other factor most small business owners cope with some degree of volatility within their business operation. Hedge funds define volatility at a whole new level.
Hedge funds are backed by investors, which can be individual investors, institutional investors, or a combination of the two. This is where the capital comes from to make trades and loans in an attempt to make the money grow within the fund.
Volatility in hedge funds can come from a couple of different sources. First, as fast as money is contributed to a hedge fund, it can also be taken away. If the money is gone, so too could be capital you thought was coming your way. Second, hedge funds take a great deal of risks in an attempt to grow their investments. In some extreme cases, those risks prove to be catastrophic, and can lead to a loss of nearly all capital. If a hedge fund loses its underlying investments (whether due to poor management, bad luck or another cause), loan or capital infusion will likely be lost as well, regardless of any commitment that may have been made to you.
Hedge Fund: Asset Backed Loans
In the typical lending scenario, there is some type of guarantor for the loaned funds. For example if you obtain a car loan, you are the guarantor, but your car is also used as collateral. If you don’t repay the loan, your car may be taken away and you may still be responsible for the outstanding loan balance.
An asset backed loan is a bit different than simply having a guarantor and/or collateral for a loan. In a typical asset backed loan scenario, a business will be forced to give some measure of security to a lender beyond the business as guarantor of the loan. In fact, many times a hedge fund lender will require an individual to agree to personally guarantee a loan, essentially giving up any liability protection offered by the business structure. While this is a risky proposition for you as a small business owner, if you are seeking to borrow money from a hedge fund, you may have no choice.
Another method hedge funds may use to provide more security for loans to small businesses is to use some asset of the business as collateral for the loan. Generally, this will be in the form of accounts receivable, a share of business ownership, or possibly business assets (either capital assets or intellectual property). The catch for you as a small business owner is a hedge fund lender will typically require more asset value backing than money lent. For example, assume you borrow $500,000 from a hedge fund. You may have to pledge $750,000 worth of accounts receivable as security on the loan in order to get the transaction to move forward.
Hedge Fund: Lack of Certainty
Many times in business, or in movies, the phrase “deal with the devil” is used to mean negotiating for something you want regardless of the terms required, and without consideration of who the other party to the deal may be. Borrowing money from a hedge fund, and the uncertainty such a transaction carries with it, will likely fit into a “deal with the devil” cliché.
As we discussed above, the lack of governmental oversight into hedge funds makes them risky, and potentially dangerous to do business with. Securing financing from a hedge fund is at best a risky proposition, and the lack of certainty regarding what can or will happen as you move forward is certainly a basis to pause before moving forward with any type of capital transaction with a hedge fund.
Hedge Fund: Risk
The accumulation of factors to be considered when dealing with a hedge fund for the purpose of acquiring capital for your small business culminates in the conclusion that this type of deal will incur a great deal of risk for your small business. Hedge fund investors are experienced and savvy in finance-related matters. It is unlikely that you as a small business owner will be as sophisticated in finance matters as a hedge fund manager. This inherent risk makes any type of transaction with a hedge fund a great risk to you and to your small business. Such a risk should only be undertaken after careful consideration of your circumstances as well as all other alternative financing methods.
Hedge Fund: Advantages
While obtaining capital from a hedge fund is risky, there are some advantages to this financing route, such as:
- Will take on more risk. Hedge funds will lend money where traditional financial institutions may not.
- Access to funds. Hedge funds have significant resources to work with, often much more than traditional financial institutions.
- Less red tape. The flip side of having less regulation is the fact that there is usually less “red tape” if you obtain capital from a hedge fund.
- Fast access. If you are able to secure capital from a hedge fund, you will typically have immediate access to the funds.
Hedge Fund: Summary
When seeking to add capital to your small business, you will have to ultimately go to where the money is, as well as to those willing to help you. If that takes you to a hedge fund, be sure you understand the scope of what you are doing. If you are unable to obtain financing through a traditional financial institution, and hedge fund is too much of a risk, there are additional alternatives.
Venture Capital: Overview
Venture Capital Firms are investment firms that specialize in funding start-up companies that have high growth potential. These are generally groups of wealthy investors, investment banks or other financial entities who pool their resources together. They typically seek to invest significant capital amounts into new businesses, especially those in technology related fields, in exchange for an ownership share of that business. The expectation for venture capitalists is that while they will initially bankroll a lot of your small business expenses, when your company hits it big, they will make significantly more money than they initially invested through their ownership share in your business.
Like hedge funds, venture capitalists are willing to take significant risks on start-up business. Their general philosophy is that taking calculated risks will pay off here and there, and the rewards for those payoffs will outweigh losses. So while venture capitalists may experience more misses than hits, the few hits they do get are typically going to be significantly more valuable than the cost of the many misses.
While the possibility that you can obtain a loan from a venture capital firm is remote, the more likely scenario is any capital you receive through a venture capital firm will be an equity investment, an exchange of money for an ownership stake in your business. Venture capitalists are looking for two things when considering investment in a small business:
- Business opportunity with potentially above average to high return on investment
- Some stake or control in the business opportunity
If you are considering approaching a venture capital firm regarding investment in your small business, you will first want to consider not only if you meet the criteria above, but also if you meet additional guidelines venture capital firms generally follow.
Venture Capital: Business Profile
Most, if not all, venture capital firms seek out a particular type, or profile, of business to invest in. In some cases many of the investors within the venture capital firm have experience or expertise in a particular area. In other cases, the venture capital firm may have a specific risk/reward profile for certain types of businesses or for specific industries. Whatever the case may be, if you are looking for a venture capital firm to invest in your business, you will want to consider this business profile question carefully.
Once you have found a venture capital firm (or firms) that invests in your type of business or industry, another business profile question that will need to be answered is whether your business plan suits their investment needs. Venture capital firms want to invest in small or start-up business that are in the process or aiming toward taking their business public, or creating a large business entity. While there may be some exceptions to this general philosophy if you are a small business, and intend to maintain private, closely held ownership and are not seeking to grow into a large company you probably will not be an attractive investment candidate for venture capital firms.
If hedge funds are too risky, and your business profile and/or plan do not suit venture capitalists, you may need an angel to help. Angel investors are wealthy individuals who generally have working experience within the fields they seek to invest in. While there are occasionally conglomerations of angel investors, more typically angel investors work one on one with small business owners to help finance and manage their small business toward success.
Angel investors will be more difficult to locate than other investor types because they are everywhere, but they don’t all advertise their desires to invest. In today’s Internet-based society, there are several web sites that can provide angel investor contact information. Additionally, there are annual publications that outline angel investor information so that you can seek them out.
Angels: Business Profile
Like venture capital firms, many angel investors are seeking to invest in businesses that seek to grow into large entities or businesses that intend to go public at some point in the future. This may not be the investment strategy for every angel investor though, so if you are seeking capital from an angel investor be sure to outline your view of the future for your small business. This will help you to find an investor that has a viewpoint consistent with your plan.
Another point to understand is that you may have to unearth your own angel investor. While many angel investors market themselves and actively seek investment opportunity, some potential angels may not be actively seeking investment opportunities.
Angels: Facts and Characteristics
Here are some typical characteristics of an angel investor to help you identify potential angels:
- Angels generally invest close to where they live
- The average angel investor is typically willing to invest $50,000 - $150,000
- Typically have $20,000 - $50,000 discretionary income to invest each year
- Some may have vast wealth but most are well educated, well employed average citizens
- Angels typically seeking between 15 – 30% return on investment
- Most angels want to have some control over the business (stock, equity, board position)
Even if you are not able to locate a self-proclaimed angel investor, you may be able to find your angel on your own. Now that we have looked at several sources of small business capital, it is time to move on to the types of small business capital available.
When seeking capital for your small business, the type of capital you obtain can have a lasting impact on your small business. It is important to ensure you make the correct decision because once you obtain financing, the decision will be final. There are generally two types of financing to seek, they are:
- Debt financing
- Equity financing
Each of these types of financing will infuse capital into your small business but they both do so with different consequences for you and your small business. We will cover each of these financing types in more detail to help you decide which is best for your small business financing needs.
The simple definition of debt financing is borrowing money that will be repaid over a period of time with an interest payment on top of the amount loaned. This type of financing will often require a payment on a regular basis, and may have a balloon type payment at the end of the term. Here are some typical debt financing vehicles:
- Term Loan: Loans are the most common, and most available, form of debt financing.
- Promissory Note: A loan agreement between two entities.
- Bond: A type of loan that operates a bit differently than a traditional loan.
In addition to repayment terms, there may be additional requirements when using debt financing to add capital to your small business. One such requirement is security for the loan amount. This security could come in the form of a personal guarantee, where you as an individual pledge personal assets to guarantee repayment of the business loan. Or, the security may come from some form of an assets guarantee, where the business will pledge specific assets.
An example of this type of security would be your small business pledging $150,000 worth of accounts receivable as security for a $250,000 term loan through a bank. If your small business defaults on the loan, the bank will then have access to those accounts, and any money received on those accounts would divert directly to the bank, rather than through your small business.
Debt Financing: Advantages
While debt financing creates financial obligations and adds costs to your annual budget, it also has some significant advantages over equity financing. One primary benefit of this type of financing is your ability to maintain control of your business. Small business owners often put their heart and soul into starting and building their businesses. In addition to this emotional investment, those who build successful businesses often understand their industry and customer base well. Giving up control to equity investors who may care more about their bottom line than the success of the business is a circumstance many small business owners want to avoid. Taking on debt financing is one way to accomplish that goal.
Another advantage of debt financing is you (and any others who share an ownership interest in your small business) maintain the same level of ownership. While equity financing will essentially sell ownership shares, which will diminish the ownership share of current owners, debt financing will not impact the ownership structure of your small business.
Finally, a fiscal advantage for the business operations of debt financing is that interest payments on debt financing will generally provide a tax benefit for the business. While these advantages are attractive, you will also want to consider the disadvantages to debt financing as well before you ultimately decide if this is right for your small business.
Debt Financing: Disadvantages
When you secure debt financing for your small business it will typically require some periodic payments. Whether those are monthly principal and interests payments on a bank loan, or semiannual bond coupon payments, the obligation to make payments will continue for the life of the loan, note or bond regardless of the financial condition of your small business.
Another potential disadvantage to debt financing is that it often reacts to market changes. If you have debt obligations attached to variable interest rates, the cost of borrowing that money could increase based on interest rate changes. Although this could potentially become a positive event, be sure to consider the possibility for a change in interest rates to your detriment prior to agreeing to any debt financing and be sure your business will be able to absorb any potential additional costs.
Finally, when considering the use of debt financing for your small business you should consider future decisions your small business may want to make. While infusing capital into your small business may be necessary and important now, always be sure to consider what the debt to equity ratio of your small business looks like. Taking on large amounts of debt can hinder the financial flexibility of your business in the future.
Types of Small Business Capital – Debt Financing: Conclusion
In the Internet, instant gratification, world we live in today many believe everything right now is a way of life. Often in business while everything may be around the corner it will take time, and a lot of work, to obtain it.
“I like thinking big. If you’re going to be thinking anything, you might as well think big.”
Most who start a small business will not have sufficient resources initially to implement those “think big” ideas. Using debt financing as part of a business plan to help expand and move big ideas along, can be a path to finding great success in business.
Equity financing is fundamentally different from debt financing in that when you infuse capital into your small business through equity financing you are essentially selling ownership in your small business. Therefore, when you obtain equity financing there is no need to consider how you will repay the money, or plan for monthly payments on the financing. Instead, you will have to adjust to more cooks in the kitchen so to speak, as selling ownership in your small business will add additional voices who have a stake in the performance of your small business.
Now let’s take a look at some different ways you can obtain equity financing and some of the advantages and disadvantages of this financing method.
Equity Financing: Methods
There are a variety of methods you can use to obtain equity financing. Here the two primary methods you can use to generate equity capital for your small business:
- Contribute personal capital
- Obtain outside capital through stock sale
Each of these methods has several different factors and distinctions to consider, so let’s take a look at each in more detail.
Equity Financing: Personal Capital
Any contribution you make into your small business is an equity contribution. If you initially contribute $50,000 to capitalize your small business, that is your equity stake, or share in the business. Any additional capital contributions you make will add to that initial amount.
Where this can get a bit tricky is if you share in the ownership of a small business with others. When capital contributions are made after the initial capitalization those contributions can change the ownership character of the business. Let’s take a look at an example to illustrate this point.
Equity Financing: Personal Capital Example
In this example we will assume that two individuals started a general partnership. At the outset both John and Terry contributed $50,000 to capitalize the business. Accordingly, each general partner acquired a 50% ownership share in the partnership.
After a year in operation, the partnership is having cash flow problems and is in need of an infusion of capital. However, only John is in a position to make an additional financial contribution to the partnership. John makes an additional $10,000 contribution to the partnership. The tricky part is how this additional contribution will be characterized. While before John’s additional contribution the ownership shares were clearly 50-50, after his additional contribution those numbers are no longer as clear.
The most straightforward determination of the resulting ownership situation could be made by looking to the partnership agreement. However, if the partnership agreement is silent on the issue the partners will have to make a determination of how to characterize the additional contribution. If it is characterized as an additional equity contribution John and Terry have two choices moving forward.
Choice one is to value John’s $60,000 contribution the same as Terry’s $50,000 contribution. This would leave the ownership shares unchanged, but will reduce the value of John’s contribution, because he paid $60,000 for the same share that Terry paid $50,000 for.
Choice two is to revalue the ownership shares based on the total contribution of $110,000. That evaluation would give John a 55% share and Terry a 45% share.
Equity Financing: Stock Sale
If seeking additional capital from yourself (in the case of a single person small business) or the other current business owners (in the case of a partnership), corporation or limited liability company with multiple owners, is out of the question, equity capital will have to come from outside investors. This type of transaction will typically be completed through the sale of stock.
The word “stock” typically conjures up images of a prestigious operation like the New York Stock Exchange with traders covering the floor, paper everywhere and stock quotes ticking across an electronic board. The reality of “stock” is that in can take many shapes and forms. In the most rudimentary sense stock means an ownership share.
If you and one other individual start a business, and each contribute 50% of the startup capital, you could have two shares of stock, one for each owner. Should you chose to add a third owner at a later date, you could sell that third individual one third of the business, or one share of stock. On the other end of the spectrum, when you and a second individual capitalize your business, you could create one share of stock for each dollar of startup capital contributed. If this was the case, adding a third owner later you could use the same system, dollar for dollar stock, or each share could cost less, or more, than one dollar.
Equity Financing: Types of Selling Stock
Typically when selling stock in a small business, the two options you will have are:
- Private placement
- Public placement
A private placement is a sale of your stock either directly to investors, or to one investor, who later sells the stock directly to their customers rather than in a public forum like a stock exchange. A public placement is when the stock is offered to the public at large, can be sold on a public stock exchange and may be advertised.
Equity Financing: Summary
Equity financing, regardless of the type you choose, is a method for infusing capital into your business. While there are technical requirements that must be satisfied, and the cost may initially be higher than other financing methods, this method will open financing avenues that cannot be accessed through other financing methods.
However, such opportunity comes with a price. That price is investors looking over your shoulder and ceding some level of control over your small business. This increased involvement in the leadership of your small business may have an impact on the flexibility of your business operations.
Before you travel down this type of equity financing road be sure to consult with a seasoned professional to ensure you understand the full scope of such a decision.
Whether you need a little or a lot, starting and maintaining your small business will require some capital. Having a good plan in place is the key to being able to generate capital for your small business when you need it. Outlining within your business plan when you will need capital, how much you will need, and what you will use the capital for is important. Having those details well covered in your business plan will help you when meeting with potential lenders and investors.
Depending on the age of your small business, the business plan may be the only document you will have to share with potential lenders and investors. Therefore, having a comprehensive, well thought out and well put together plan in place may be one of the most important aspects of raising capital for your small business.
Regardless of how long your small business has been in operation, being in a position to show potential lenders and investors that you not only have the professional skill and ability to put a quality business plan together, but that you also have the management ability to follow through with that plan can give you a leg up when seeking to acquire capital for your small business.
When your small business is appealing to a lender for a loan, or to investors for an investment, and you are able to show how the timing for your request fits into your business plan you will appear organized and operationally sound. In contrast if you do not have a solid business plan, or are seeking capital because your small business is in dire straits rather than seeking capital as part of a predetermined plan, you may come across as unorganized or desperate. Being in the latter category will likely exclude you from acquiring capital from the best sources, leaving your small business looking to higher risk lenders and investors. Such a scenario will likely cost more in terms of interest rates or amount of control of your business ceded to investors.