Business and Investment sidenote

Small business owners can choose from two basic types of financing- debt and equity.  There are advantages and disadvantages of each type that may be used for different purposes. 

Before you seek start-up capital, organize your records as follows;

Gather you’re financial business records including tax returns Speak with business partners or family members about the sometimes uncomfortable     option of giving up partial control of the business to potential investors Request copies of your personal and any business credit reports  

Entrepreneurs who seek financing face a fundamental choice: Should they borrow funds or take in new investment capital? Since debt and equity are accounted for differently, each has a different impact on earnings, cash flow, and taxes. Each also has a different effect on leverage, dilution, and a host of other metrics by which businesses are measured. The planned use of funds will also affect the choice of financing, with one option more appropriate for certain uses than the other. 

Debt can be a loan, line of credit, bond, or even an IOU — any promise to repay borrowed amounts over a certain time with a specified interest rate and other terms. Debt is accounted for as a liability of the company, and interest payments are deductible business expenses. In the event of bankruptcy or insolvency, debt holders take priority over equity holders. 

For a small business, debt financing has both advantages and disadvantages. On the plus side, debt can be relatively simple to secure through a bank or other financial institution and is available with a broad range of terms, allowing you to customize the debt to meet your specific needs. And since most debt entails regularly scheduled payments of interest and often principal as well, debt is easy to plan around. Perhaps most important, debt, unlike equity, will not dilute your ownership interest in your company. 

On the minus side, however, financing with debt can be more expensive, and you will have to meet scheduled interest and principal payments regardless of your cash flow. Although loan terms can be negotiated to build in flexibility, ultimately the money must be paid back. 

Debt is most often used to fund a specific project or initiative that has an identifiable implementation time frame. It’s also used as a cash flow backup in the form of a revolving line of credit. To attract lenders, you will need to have a good personal and business credit history, sufficient cash flow to repay the loan, and/or sufficient collateral to offer as a second source of loan repayment. 

Equity differs from debt in that it represents a permanent ownership stake in the company. When you finance with equity, you are giving up a portion of your ownership interest in — and control of — the company in exchange for cash. Equity investors may demand dividends or a portion of annual profits. But most investors in small businesses seek long-term capital gains on their investment, meaning that at some point these investors may look to opt out. This can mean the eventual sale of the business or the need to bring in replacement investors in the future. 

The most common sources of equity financing for start-up entrepreneurs are personal savings or contributions from family, friends, and business associates. Many successful entrepreneurs find start-up money, grants and loans using all inclusive support centers such as Ethos Mentor, Business Finance.com or the Small Business Association (SBA).    

Venture or seed capital companies can also be sources of new capital, although they generally deal in larger financings. If your business is incorporated, anyone contributing equity capital would receive shares in the business. If it is a sole proprietorship or a partnership, they would receive an ownership share of the business. 

While equity financing can be used for many different purposes, it is usually used for long-term general funding and not tied to specific projects or time frames. The major disadvantage to equity financing is the dilution of your ownership interest and the possible loss of control. Moreover, equity investors in smaller businesses generally look for high returns over time to compensate for the risk. 

In practice, most businesses use a combination of debt and equity financing. The concern is getting the right balance. If you have too much debt, you may overextend your ability to service the debt and can be vulnerable to business downturns and changes in interest rates. On the other hand, too much equity dilutes your ownership interest and can expose you to outside control.  For more information visit www.EthosMentor.com

Financing a small business can be most time consuming activity for a business owner. It can be the most important part of growing a business, but one must be careful not to allow it to consume the business.  Finance is the relationship between cash, risk and value.  Manage each well and you will have healthy finance mix for your business.

Develop a business plan and loan package that has a well developed strategic plan, which in turn relates to realistic and believable financials.  Before you can finance a business, a project, an expansion or an acquisition, you must develop precisely what your finance needs are.
Finance your business from a position of strength.  As a business owner you show your confidence in the business by investing up to ten percent of your finance needs from your own coffers.  The remaining twenty to thirty percent of your cash needs can come from private investors or venture capital.  Remember, sweat equity is expected, but it is not a replacement for cash.

Depending on the valuation of your business and the risk involved, the private equity component will want on average a thirty to forty percent equity stake in your company for three to five years.  Giving up this equity position in your company, yet maintaining clear majority ownership, will give you leverage in the remaining sixty percent of your finance needs.               
The remaining finance can come in the form of long term debt, short term working capital, equipment finance and inventory finance.  By having a strong cash position in your company, a variety of lenders will be available to you.  It is advisable to hire an experienced commercial loan broker to do the finance “shopping” for you and present you with a variety of options.  It is important at this juncture that you obtain finance that fits your business needs and structures, instead of trying to force your structure into a financial instrument not ideally suited for your operations.     

Having a strong cash position in your company, the additional debt financing will not put an undue strain on your cash flow.  Sixty percent debt is a healthy. Debt finance can come in the form of unsecured finance, such as short-term debt, line of credit financing and long term debt.  Unsecured debt is typically called cash flow finance and requires credit worthiness.  Debt finance can also come in the form of secured or asset based finance, which can include accounts receivable, inventory, equipment, real estate, personal assets, letter of credit, and government guaranteed finance.  A customized mix of unsecured and secured debt, designed specifically around your company’s financial needs, is the advantage of having a strong cash position.
The cash flow statement is an important financial in tracking the effects of certain types of finance.  It is critical to have a firm handle on your monthly cash flow, along with the control and planning structure of a financial budget, to successfully plan and monitor your company’s finance.

Your finance plan is a result and part of your strategic planning process.  You need to be careful in matching your cash needs with your cash goals.  Using short term capital for long term growth and vice versa is a no-no.  Violating the matching rule can bring about high risk levels in the interest rate, re-finance possibilities and operational independence. Some deviation from this age old rule is permissible. For instance, if you have a long term need for working capital, then a permanent capital need may be warranted.  Another good finance strategy is having contingency capital on hand for freeing up your working capital needs and providing maximum flexibility.  For example, you can use a line of credit to get  into an opportunity that quickly arises and then arrange for cheaper, better suited, long term finance subsequently, planning all of this upfront with a lender.

Unfortunately finance is not typically addressed until a company is in crisis.  Plan ahead with an effective business plan and loan package.  Equity finance does not stress cash flow as debt can and gives lenders confidence to do business with your company.  Good financial structuring reduces the costs of capital and the finance risks. Consider using a business consultant, finance professional or loan broker to help you with your finance plan.

Investors and Equity

Practically every economy is built upon the backs of small businesses and entrepreneurs. Every day someone comes up with an idea that will make a great business. Every day, these same people wonder how they will come up with the cash to get the business off the ground. The classic answer is to look for investors, and this is where things can go bad.

If you’re seeking investors for your business, you are going to need to form a business entity. Corporations and limited liability companies are the most popular, and give you the ability to trade ownership interest in exchange for cash contributions. With a corporation, investors will buy shares in the corporation. With limited liability companies, the investors will buy membership interests. Regardless, this traditional exchange gives rise to a problem common among small business owners, to wit, giving away too much equity.

From Joy to Misery

A common mistake made by new business owners is to give away too much equity when getting initial cash contributions. This occurs because you let insecurities impact you evaluation of the business. Instead of giving away two percent of equity in exchange for $50,000, you give away ten percent. Let’s look at an example.

I start a business selling digital gadgets. I prepare my business plan and realize I need $250,000 to get everything up and running. I have $50,000, but need to find the rest somewhere. I form a corporation with 1,000 shares and start approaching potential investors. I offer 100 shares for $25,000. I find five investors that give me $125,000 in exchange for 500 total shares. In summary, I now have $175,000, but have given away half the equity in the business. While I am not happy about this, I am still so enthused about the business idea that I shrug it off.

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One of the most important decisions facing managers in need of capital to fund their business operations is debt versus equity financing.  Debt and equity are the two predominant sources of capital available to businesses, and each offers both benefits and drawbacks.  The way that money is raised can have a tremendous impact on the success of a business.

Debt financing involves taking out loans that must be paid back over time, generally with interest.  Businesses can borrow money over the short term (under one year) or long term (more than one year).  Principal sources of debt financing are banks and government agencies, such as the Small Business Administration (SBA).  Debt financing offers businesses a tax advantage—the interest paid on loans is typically deductible.  It also limits businesses’ future repayment obligations for the loans, since the lender does not receive a share of ownership in the businesses.

However, there are some drawbacks.  New businesses sometimes experience difficulty making regular loan payments when they have irregular cash flow.  Debt financing can therefore leave these businesses susceptible to economic downturns or rising interest rates.  Businesses that carry too much debt are more likely to be perceived as risky, and therefore less attractive to investors and less able to raise additional capital in the future.

Equity financing, by contrast, involves obtaining money from investors in exchange for an ownership share in the business.  These funds may come from family members and friends of the business owner, wealthy investors, or venture capital furms.  The principal benefit of equity financing is that the business is not obligated to repay the funds.  Instead, the investors hope to realize a positive return on their investment in the form of future profits.  The association with high-profile investors may also enhance a new business’ credibility.

The chief disadvantage to equity financing is that the investors become partial owners of the business and therefore gain some control over business decisions.  As ownership interests are weakened, managers face the possibility that they could lose autonomy in operating the business.  Also, businesses that rely excessively on equity financing are likely not making the most productive use of their capital.

Debt and equity financing are both important ways for businesses to obtain capital for their operations.  Determining which to use or emphasize depends on the goals of the business and the extent of control managers would like to maintain.  Experts recommend that businesses use both kinds of financing in a commercially appropriate ratio.  This ratio, the debt-to-equity ratio, is a critical factor used by analysis to determine whether managers are running a business in a sound manner.  While debt-to-equity ratios vary widely by industry and company, a reasonable ratio should generally fall between 1:1 and 1:2.

According to some experts, businesses should rely more on equity financing during the early stages of their development, since such companies may experience difficulty repaying debt until they achieve a consistent cash flow.  On the other hand, many start-ups may have trouble attracting sufficient venture capital until they demonstrate strong profit potential.

In short, all businesses require sufficient investment capital in order to succeed.  The most sensible strategy is to obtain capital from a variety if sources, using both debt and equity financing, and hire professional accountants and attorneys to facilitate financial decisions and transactions.