When it comes to securing money to start your business, there are two types of financing to consider: equity and debt financing. But before you approach any potential sources, you need to understand your company’s debt-to-equity ratio. This is the relation between the money you’ve borrowed and money you’ve invested in your business. Obviously, the more money you have invested in the business as opposed to borrowed, the easier it will be to obtain financing.
Conventional wisdom says that if your ratio of equity to debt is high, you should probably seek debt financing. If, on the other hand, your business has a high proportion of debt to equity, it may be wise to increase your ownership capital (equity investment) for additional funds. That will prevent you from becoming over-leveraged to the point of jeopardizing your company’s survival.
You can apply to many sources for debt financing, including banks, savings and loans, commercial finance companies, and the U.S. Small Business Administration (SBA). State and local governments also offer programs to assist in the growth of small businesses. Many entrepreneurs also borrow debt financing from family members, friends, and associates.
Banks are the primary funding source for small business owners, who may apply for demand loans, seasonal lines of credit, and single-purpose loans for machinery and equipment. Although most banks are reluctant to offer long-term loans to small businesses, the SBA guaranteed lending program encourages banks and other lenders to make long-term loans to small firms by reducing their risk and leveraging the funds they have available.
In addition to equity, lenders generally require the borrower’s personal guarantees in case of default. This ensures that the borrower has a sufficient personal interest at stake to make repayment of the loan a priority.
Most small businesses use limited equity financing, since this is generally more applicable to larger companies. As with debt financing, additional equity often comes from personal investors such as friends, relatives, employees, customers, or colleagues.
The most common source of equity funding, however, comes from venture capitalists, institutional risk takers comprised of wealthy individuals, government-assisted sources, or major financial institutions.
It’s a common misconception that venture capitalists look for start-ups as investments for their seemingly limitless funds. In actuality, they tend to prefer investing in young companies (three to five years old) with the expansion potential to grow into major businesses with high profits for shareholders. For this reason, then, this option is usually a limited one for small business start-ups.
Should this be an option for you, however, you should be aware that different venture capitalists take different approaches to management of their investments. Most prefer to maintain a passive influence, but will react strongly if the business does not perform as expected and may insist on changes in management or strategy. This need to relinquish some of the decision-making and some of the potential for profits are the main disadvantages of equity financing.
So, figure out your company’s debt-to-equity ratio, and research the available funding sources to determine which is best for you. Remember that the impression you make on the financiers you approach is all-important. If you already have a good relationship with your banker, that might be your best option. If you will be approaching a new source for the first time, be sure that you make a professional impression. Although your financial application is the bottom line, making a positive impression might help to tip the scales in your favor.