Funding A Business: Basics for Beginners

Are you an entrepreneur or a small business owner? Have you had issues financing your business? Well, you’re probably not the only one! However, there are several ways you can solve these financial issues, each with its pros and cons!

After all, a lack of capital can limit your company’s growth and impair your business landscape.

So… in this article, we will go through different ways how you can finance your business…

But more importantly, you will know which type of business financing is more suitable to your business needs and current stage.

Starting from the top with…

What is business funding?

Business owners need money to meet their needs. It’s a fact.

Those needs might include financing business operations, purchasing capital assets for the business, or just expanding the business!

The problem is that most small businesses and start-ups don’t have the money to meet those needs.

So what do they do?

They seek business funding (or financing a business).

It’s a process that involves an institution or organization giving money to those business owners in exchange for… well, it depends! Some demand their money back with interest (Debt financing), others ask for equity in the company (Equity financing) … While others combine both in one deal (Mezzanine capital).

For small businesses, and any business in general, financing a business through a suitable funding model is KEY…

If you take money from the wrong source, you might end up losing a part of your company! Or worse, you might find yourself subjected to repayment terms that hinder your growth for years into the future.

You need to know the different ways of financing a business and understand its upsides and downsides. Then, and only then, make your decision!

Starting with the first type of business financing…

Debt financing

If you want to control 100% of your business but don’t have funds to start or grow your business, consider Debt Financing.

Debt Financing can be the best option for financing a business, especially when it is an early-stage business. But the question is:

What is debt financing?

Debt financing is borrowing money as a loan and having to repay it back with interest.

If you think “it is exactly like mortgage and automobile loans!” you are exactly right. Both are examples of debt financing. It works the same way for your business!

Now, here is how it works…

After you decide you need a loan, you go to the bank, they give you an application, and you fill it.

That’s it for you!

Left would be one of two different scenarios:

First one: you are still a growing business in its early stages, so they check your personal credits before they accept your loan request.

Second, you are a business that has been around for an extended period, so they check sources that include your credit history. This includes Dun & Bradstreet (D&B), the most well-known enterprise for compiling a credit history on businesses!

Along with your business credit history, the bank will likely want to check your books and perform additional due diligence… To confirm the details and data they encountered regarding your business.

To get your loan request approved, make sure that your business records are complete and organized.

If the loan is accepted, the bank will set up payment terms and interests.

Benefits of debt financing

Financing your business through debt has many advantages:

• The lending institution doesn’t take equity in your business. In other words, they have no control or say over how you run your business.
• Your relationship with the lender ends when you pay back the loan. This is valuable when your business starts to have more capital
• You can deduct debt financing interest from your taxes as a business expense.
• The monthly payments of the loan are known expenses, making them an accurate addition to your forecasting models.

Risks of debt financing

Still, debt financing can be a rocky way to finance your business. Here is why:

• For early-stage companies, it is highly unlikely to have consistent capital inflow to cover the debt payments alongside their business expenses.
• During recessions, small businesses’ loans can be significantly slowed.
• In worse recessions, small businesses can hardly receive debt financing… unless they are overwhelmingly competent.

Side Note: During economic declines, small businesses are almost impossible to qualify for debt financing.

Think about it!

During these financial downturns, how can the bank guarantee you’ll pay them their money back?

Plus, they only spend their money on deals that are nearly 99.9% guaranteed.

Now, if you’ve already applied for debt financing and believe that your business won’t qualify for it, there is another way.

If your small business is U.S. based, you can apply for a loan from the Small Business Administration (SBA).

The credit and full faith of the U.S. government are pledged to guarantee a portion of the loan.

These SBA loans provide debt financing to those business owners who might not otherwise be qualified.

Check the SBA website if you want more information and want to know more about the types of loans that it provides.

Now, to the second way you can finance your business.

Equity financing

Imagine this…

Your business qualifies for debt financing, and you go out and take the loan. Then, your business goes bankrupt (Let’s hope this never happens)

The bank or the institution that you take the loan from wants their money back.

They will take it back either as money, or a property that you have.

Your house, your car, or your business office.

Well, one of them doesn’t belong to you anymore.

If you don’t like this scenario… then you probably prefer Equity financing.

But, what is equity financing?

Defining equity financing

If you have watched “Shark Tank,” or “Dragons’ Den,” then you probably know more about equity financing than you think.

If you haven’t watched it…

Simply put, Equity financing means giving up part (equity) of your company in exchange for capital.

Equity financing comes from two different sources…

• Venture Capitalists
• Angel Investors

Let me tell you the difference…

A venture capitalist is a firm, not an individual, that has teams of lawyers, accountants, partners, and investment advisors.

They perform due diligence to confirm all the facts that you presented about your business.

Facts that include your financial records, past performance of the business, in addition to anything else material-related. All this is just to make an educated decision on whether to invest in your business or not.

Venture capital firms often engage in significant investments ($3 million or more). Making this investment deal process slow and complex.

What about Angel Investors?

Well, from their name…

They are the wealthy individuals that can take you by their wings to more sales, better profits, and publicity.

They are generally more interested in investing a small amount of money, relative to venture capitalists, into a product! Instead of helping build a business.

They are perfect for a software developer or application programmers that want capital infusion for product development or marketing. Or both.

Now, as for anything or anyone… There are pros and cons.

Let’s have a look at them together.

Benefits of equity financing

Financing your business from investors has many advantages:

• The investor, or investors, are not creditors. They are partial owners… meaning that if your business enters bankruptcy, you don’t have to pay back the money.
• You are not subjected to draining monthly payments. You now have more liquid cash for your business expenses.
• Most investors used to be in your shoes. They started a small business that grew to be a multimillion or billion-dollar company. So, they understand that it takes time to build a business. They won’t rush you or ask for impossible deadlines.

Risks of equity financing

Likewise, equity financing has several disadvantages:

• Equity financing, as we’ve discussed, involves giving up a portion of your company to the investors. The riskier the investment, the more equity the investor will want. In some investment deals, the stake can go up to 50% of the company. Unless you buy his portion of the company later ! Your new partner, not just an investor, will have 50% of your profits.
• You can’t make decisions on your own anymore. You will have to consult your investors. If the investor has more than 50%, well… you now have a boss whom you will have to answer to.

Now, to the third type of business financing.

Mezzanine capital

As a small business owner, you want to minimize the amount of equity you give out to investors.

So now you have capital needs for funding your strategic business goals but got rejected when you applied for debt financing.

Still, giving out equity for capital to an investor is not an option.

So mezzanine financing, in return for higher coupons, allows you to reach your strategic business goals…

Especially at times when your capital needs to outstrip its senior debt capacity.

What is mezzanine capital?

Imagine that your company has a specific new project at hand.

Whether it’s running marketing campaigns or renewing their business operations from bottom to top.

You have already taken a loan from the bank, and maybe have a couple of shareholders in your board room. And you have two choices:

1- You give out more ownership in your company to investors for the funds you need.

2- You receive money from the lending institution to achieve your goals, without giving up equity.

What will you choose?

An established competent business owner will go for the second option.

Well, that second option is Mezzanine capital.

However, if you take the money but failed to repay the loan on time or in full…

The lending institution now has the right to convert the loan to an equity interest in your company.

That is why lending institutions are more likely to agree on mezzanine financing than debt financing… the risk is lower.

Benefits of mezzanine capital

Choosing to fund your business using mezzanine capital has several advantages:

• Mezzanine capital is suitable for new companies that are already showing growth. Unfortunately, new companies may not have, at least, three years of financial data, which is a red flag for banks. Banks can’t just give out money based on a pinky promise, they need a safety net if things went south. And having the option to take an ownership stake in the company makes it easier for the bank to give the loan.
• On the balance sheet of the company, mezzanine capital is accounted for as equity. Future lenders are attracted to a company that has equity rather than a debt obligation.
• The mezzanine financing process is often quick with little due diligence.

Risks of mezzanine capital

Mezzanine capital has its fair share of risks too:

• The lender will often view your company as high risk, and the riskier your business the higher the interest or coupon will be. If a company already has debt or equity obligations. Then mezzanine capital provided to that company is frequently subordinate to those obligations. This increases the risk that the lender won’t be paid back. Because of this high risk, the lender will be expecting a 20% to 30% return.
• If you don’t repay the loan on time or in full, you’ll lose the equity of your business to the lenders.

Now off to the fourth type of business financing…

Off-balance sheet financing (OBSF)

Off-balance sheet financing is an accounting practice where liabilities and assets are not reported on balance sheets.

Why?

To sustain low debt-to-equity (D/E) and leverage ratios. This results in less expensive borrowing and preventing covenant breaches.

To put it in simpler terms! Imagine there is a legal entity that takes your student loan, credit card, mortgage, or automobile debt off your credit report.

This is OBSF for businesses.

OBSF is not a loan. It is primarily a way to keep large debts away from the business balance sheets, which makes it look strong and less debt-laden.

Here are two examples:

Let’s say that a company needs an expensive piece of land for business operations. Instead of buying the land, it is better to lease it. (1)

Or, it can also create a special purpose vehicle (SPV), and then buy the land. (2)

This purchase will be added to the SPV balance sheet, not the balance sheet of the mother company.

SPV can be, and already has been, used in scandalous illegal actions like in the Enron Scandal in 2001. To prevent these types of scandals from happening…General Accepted Accounting Principles (GAAP) strictly regulate the use of off-balance sheet financing.

Most businesses cannot benefit from this kind of financing, but smaller companies that expand to become much larger corporate structures may be able to use it.

Financing my business through friends & relatives

The more distant you are from formal means of financing your business, the better off you are.

It is REALLY stressful when you try to repay the money or else the bank takes your home or car in debt financing…

Or equity of the business you have sweat and bled for (Equity and Mezzanine financing).

When you need funds for your business, your family and friends can contribute to your finances. Of course! If they believe in your business.

They can set up a lending model. Something like formal banking models, that are accustomed to their financial status as well as to your funding needs.

In exchange, you could offer them a stock company or a debt financing deal.

I realize this might look like the formal models of financing a business, but there is a huge difference between taking money from encouraging relatives…And taking money from firms that won’t hesitate to take ownership of your business the first chance they get.

Financing my business through my retirement

You can easily borrow money from your retirement plan and have to pay it back with interest…

But, there is an alternative known as a Rollover for Business Startups (ROBS).

This is a practical source of funding for those starting a business, or individuals running very early-stage businesses.

It allows entrepreneurs to invest their retirement funds into a new business venture…Without paying taxes, early withdrawal fees, or loan fees.

Still, ROBS financial transactions are complicated. So it’s highly recommended that you work with an experienced and qualified provider.

How to finance my business?

There are many ways you can finance your business. You can borrow money from a certified lender… evade those underground lenders with ridiculously high interests.

Additionally, you can raise capital through your family or friends, investors, and even use your retirement funds to finance your business. However, the latter is risky and not favored.

GOLDEN TIP!

The journey of starting and running a business is filled with uncertainties. Anything can happen…

You can take a loan, the business doesn’t go well, and you lose property of yours to the bank.

You can apply for mezzanine financing, but can’t keep up with the monthly payments. Then the lender then will take equity in your company. Meaning that at least 20% of the business profits will go to the lender. As a result, it hinders your business growth and expansion for years into the future.

Therefore, you should be as prepared as you can be When life happens. Here are some of our golden tips. Feel free to use any, or all, of them:

• Make sure you have more than one source of income. It helps you fund your business without applying for debt, equity, or mezzanine financing… even when your business is not generating enough income initially.
• You can build a side hustle that generates income, and help you fund your business operations more effectively.
• Do You want to reach your business goals fast? Motivate and inspire your employees. The more motivated and inspired your employees, the better and the faster results.

Final thoughts

Finally, we’re here!

We have discussed most of the ways you can finance a business.

And yes, there are more ways you can finance a business… feel free to check them out.

If you are a small business owner and don’t have family or friends to help you find the business…

Then debt financing is probably the best accessible option for you. But as you grow and develop the product, operations, and the corporate structure in total…Equity financing or mezzanine capital can now become viable options.

However, if there is one thing we want you to remember from this article is this sentence…

“In the world of financing a business, less is always more and better to how it will affect your business.”

Remember that, always plan ahead, and you will do fine.