When businesses are looking to acquire new assets and equipment to increase their income or productivity, they often look to banks and investors to provide the capital necessary to do so. Those providing
When businesses are looking to acquire new assets and equipment to increase their income or productivity, they often look to banks and investors to provide the capital necessary to do so. Those providing the capital do so under the expectation that they will be reimbursed with interest at some later date, as a result of the increased value brought to the business by the investment.
Types of business financing
There are two main types of business finance:
Debt finance: which is money borrowed from external lenders, predominantly banks
Equity finance: which is money invested by individuals or companies in exchange for a share in the ownership of the business
Many businesses use both types of financing to acquire the capital they need, though there are positives and negatives for each.
Debt financing allows business owners to retain full control of their business and the interest paid on the loan is a tax deductible expense. Banks also offer many different types of loans for different term lengths, allowing business owners to shop around for the arrangement that best suits them. At the same time, these loans typically have to be paid back in a fixed time period and loan repayments often start immediately. In addition, these loans are usually secured against the assets of the business or the owner, which means putting valuable property at risk. Finally, when it comes to large loans, the interest and repayments can become a burden which makes it more difficult to grow the business.
Equity financing is less risky than debt financing, as it does not need to be paid back immediately and it does not come with a fixed term. This allows businesses to have more cash on hand and better cashflow, as they do not have use profits to make repayments. At the same time, the investors may bring valuable skills to the table and may be more than just silent partners, offering additional expertise or enhancing credibility. This comes at the cost of business autonomy, as the new stakeholders will have some say in how the business is managed and in the decisions the business makes. The biggest difficulty with equity financing is the significant time, effort and difficulty involved in finding the right person and negotiating the terms of the investment.
Sources of business financing
Debt financing can come from a number of organisations, though it is most often financial institutions. Other options include:
Family or friends
Equity financing is more variable and the type that best suits a business will depend on the type of business, how long it has been operating, its revenue and its value. Options include:
Using owner’s personal finances
Family or friends
Selling stocks (done through an IPO)
Businesses rely on the advice of their financial planners, their business coaches and their accountants to determine which type of financing and which source is most advantageous for them. In most cases, capital is raised from multiple sources using both types of financing, especially in the early stages of startups or in periods of rapid growth.