Businesses generally require financing during two phases of the business timeline: during the business start-up phase and when the business is undergoing a significant expansion. Access to funding can be essential, especially in cases where the business owner cannot raise the capital required on its own.
Once the decision is made to pursue business financing, the first challenge is to choose the right financing option. This is not necessarily and easy decision. Emphasis should be put on evaluating the business’s strategic expansion needs and how much capital is required. The capital structure of the business will need to be evaluated to understand if equity can be issued in return for the needed funds. The nature of any collateral will also need to be understood as it might be critical for securing funds or as a backstop for any loan default.
Fortunately, there are options available for business owners in most situations. Here is a list of five main types of business funding.
Debt Finance
Debt funding is typically provided by lending institutions such as banks, based on the business and the business owners’ credit ratings, and the underlying cash flow of the business. Creditors usually look at various entities that are related to the company and how the funds will be utilized in an effort to thoroughly understand the business model.. To be successful, the business owner must provide a viable business plan and loan repayment structure that can win the confidence of the creditors.
Equity Finance
Equity financing is an option where the business owner gets external funds from creditors and financiers in exchange for partial ownership of the business. Equity finance gives the business owner the option of raising capital by bringing on board shareholders who essentially buy shares in the business. In this situation, current cash flow is not as important as the long term viability of the business model and the longer term return potential. The source of funds is basically willing to take greater risks in return for the higher upside related to business ownership.
Mezzanine Finance
Mezzanine finance is sometimes an option for businesses who need financial help but lack the consistent cash flow and assets to warrant straight debt financing. As you might expect, mezzanine financing is more expensive than debt financing. The lender’s claim to any assets in the event of default is secondary to the claim of other lenders typically. That said, the business owner gets financed through loans that come with the option of converting those loans into equity in the event the owner defaults on loan repayment. In most cases, mezzanine finance comes in handy for businesses that do not have sufficient assets that can be utilized as collateral for the loans.
Venture Capital
Venture capital financing gives early stage businesses and startups the option of getting financed by creditors who utilize the investment as an opportunity to build an investment portfolio of several high-growth companies with a long-term focus. The risk to the financing entities is viewed as quite large; hence, the cost of this type of funding is also quite large. The structure of a venture capital investment may vary, but it will typically carry a significant ownership stake. The venture capital investor will always be looking to understand the “exit” strategy or the event where the investment will be monetized. This could be a sale of the company, a public offering or IPO, or another type of M&A transaction that would provide cash to the venture capitalist..
Business Angels and Private Investors
Business angel investors or private investors are another option for startup companies to acquire critical funding. Typically angel investors are family and friends and often the investment is less formal. Less scrutiny is placed on the current cash flow statement or the assets of the company and more emphasis is placed on the credibility of the business managers/entrepreneurs. This type of funding would also include sources of funds such as crowdfunding. Crowdfunding consists of a service where multiple persons can each contribute to raising larger sums of money that are then channeled into the business’s development and expansion.