Most entrepreneurs draw on savings and other forms of personal resources as the primary source of capital to launch and initially build their operations. This investment is often supported by funds from family and friends.
When seeking external financing to launch or build your business, the two key categories are debt (loans) and equity (sale of ownership).
Debt financing is a promise or obligation to pay back the financing over a period of time with an associated interest charge. Most small business bank loans and personal loans are debt financing arrangements.
Equity Financing – Equity financing is the selling of ownership shares in a company, whether through the transfer of partnership rights (partnership, limited partnership), shares of stock (corporation), or shares of membership (limited liability company) in return for capital. There is no obligation or promise to pay back funds in an equity arrangement, which makes this type of investment an “at risk” investment.
Debt Financing comes in two forms: term loans and lines of credit. Term loans are issued by the financial institution as a one-time lump-sum payment to finance capital expenditures (eg. machinery), real estate or permanent working capital. In exchange, the business owner makes regular installment payments (covering both principal and interest) over a set period of time. Oftentimes the term loan is also secured against an asset (eg. the equipment purchased, or a personal asset such as a home or car). A firm in the construction industry for example might pursue a term loan to purchase equipment/machinery not tied to a specific job, but rather enable them to expand services and/or realize long-term savings.
While term loans are most effective for these longer term financing requirements, a business line of credit on the other hand is most effective to meet a small business’ short-term working capital needs, such as inventory and payroll expenses. Additionally, lines of credit provide important short-term access to cash to enable firms to mobilize for executing contracting opportunities, as well as cover the gap in time between work completion and payment for services rendered.
Through a line of credit, banks and other financial institutions extend borrowers access to a specified maximum dollar amount, as they would with a credit card, with interest accumulating only when the small business draws down on the line of credit. Further, no interest accrues until the small business draws down on the line of credit, and the small business owner can borrow against the line of credit again once repayment is made. Keep in mind, however, that not all lenders offer this product.
To secure financing small business owners can connect with banks as well as credit unions and other community-based lenders, who are often mission-driven and have more flexible underwriting criteria. This enables these lenders to provide financing to many small businesses that can’t qualify for a conventional bank loan. Firms such as these, including start-ups and those with poor or limited credit history and, limited equity to invest and/or collateral, utilize these loans to build a repayment track record and ultimately position themselves for higher levels of financing from larger banks to further grow their business.