What Is Business Financing?

Most businesses inevitably require access to capital through business financing at some point in their operations. Even many large-cap companies routinely seek capital infusions to meet short-term obligations.

Finding a suitable funding model can be vitally important for small businesses. They may lose part of their companies or find themselves locked into repayment terms that impair their growth for many years into the future if they take money from the wrong source.

Key Takeaways

• Debt financing is usually offered by financial institutions and requires regular monthly payments until the debt is paid off.
• Either a firm or an individual invests in your business and you don’t have to pay the money back if you engage in equity financing.
• The investor owns a percentage of your business and perhaps even a controlling one if you seek equity financing.
• Mezzanine financing combines elements of both debt and equity financing: The lender usually has the option to convert unpaid debt into ownership in the company.

What Is Debt Financing?

Debt financing for a business comes from a bank or other lending institution. Private investors can offer debt financing as well but this is unusual. The bank will check your personal credit when you apply for business financing if your business is in the early stages of development.

They'll check other sources for businesses that have a more complicated corporate structure or have been in existence for an extended period. The Dun & Bradstreet (D&B) file is one of the most important sources of information on the credit history of a business.

The bank will also likely examine your books and complete other due diligence before agreeing to lend you any funds. Make sure all your business records are complete and organized before applying.

The bank will set up payment terms including interest and send the money to the business bank account you specify if it approves your loan request.

Advantages of debt financing

Financing your business through debt has several advantages:

• The lending institution has no control over how you run your company and it has no ownership.
• Your relationship with the lender ends when you pay back the loan. This is especially important as your business becomes more valuable.
• The interest you pay on debt financing is tax deductible as a business expense.
• The monthly payment as well as the breakdown of the payments is a known expense that can be accurately included in your forecasting models.

Disadvantages of debt financing

Debt financing for your business does come with some disadvantages:

• Adding a debt payment to your monthly expenses assumes that you'll always have the capital inflow to meet all business expenses including the debt payment. This may not always be the case for small or early-stage companies.
• Small business lending can be slowed substantially during recessions. It can be difficult to receive debt financing in tough economic times.

The U.S. Small Business Administration (SBA) works with certain banks to offer small business loans. A portion of the loan is guaranteed by the government. SBA loans are designed to decrease the risk to lending institutions so these loans allow otherwise unqualified business owners to receive debt financing.

Tip

You can find more information about these and other SBA loans on the SBA website.

What Is Equity Financing?

Equity financing comes from investors who are referred to as venture capitalists or angel investors.

A venture capitalist is usually a firm rather than a single individual. The firm has partners, teams of lawyers, accountants, and investment advisors who perform due diligence on potential investments. Venture capital firms often deal in significant investments so the process is slow and the financing is often complex.

Angel investors are generally wealthy individuals who want to invest a smaller amount of money into a single product instead of building a business. An ideal candidate for an angel investor would be a software developer who needs a capital infusion to fund product development. Angel investors typically move fast and want simple terms.

Important

You won't owe anything to an investor if your business ends up in bankruptcy. The investor simply loses their investment as a part owner of the business.

Advantages of equity financing

Funding your business with funds from investors has several advantages:

• You don't have to pay back the money. Your investors aren't creditors if your business enters bankruptcy. They're partial owners in your company so their money is lost along with your company.
• You don't have to make monthly payments so there's often more liquid cash on hand for operating expenses.
• Investors understand that it takes time to build a business. You get the money you need with equity financing without the pressure of your product or company being required to thrive within a short period.

Disadvantages of equity financing

There are several disadvantages to equity financing as well:

• It involves giving up ownership of a portion of your company. The more significant and riskier the investment, the more of a stake the investor will want. You might have to give up 50% ownership. They'll take 50% or more of your profits indefinitely as a partner unless you later construct a deal to buy the investor’s stake.
• You'll be required to consult with your investors before making any business decisions. You have a boss now if an investor has more than 50% ownership of your company.

What Is Mezzanine Financing?

Mezzanine financing often combines the best features of equity and debt financing. There's no set structure for this type of business financing but debt capital often gives the lending institution the right to convert the loan to an equity interest in the company if you don't repay it on time or in full.

Mezzanine financing isn't as common as debt or equity financing. The deal and the risk-reward profile are specific to each party.

Advantages of mezzanine financing

Using mezzanine financing comes with several advantages:

• This type of loan is appropriate for a new company that's already showing growth. Banks may be reluctant to lend to a company that doesn't have at least three years of financial data. A newer business may not have that much data to provide, however. The bank has more of a safety net when it adds an option to take an ownership stake in the company. This can make it easier to secure this type of loan.
• Mezzanine financing is treated as equity on the company’s balance sheet. Showing equity rather than a debt obligation makes the company look more attractive to future lenders.
• Mezzanine financing is often provided very quickly.

Disadvantages of mezzanine financing

There are also some disadvantages to securing mezzanine financing:

• The coupon or interest is often higher because the lender views the company as high risk. Mezzanine financing that's provided to a business that already has debt or equity obligations is often subordinate to those obligations. This increases the risk that the lender won't be repaid. The lender may want to see a return between 20 to 40% because of the high risk.
• There's a real risk of losing a significant portion of the company.

Fast Fact

Off–balance sheet financing is good for one-time large purposes. It allows a business to create a special purpose vehicle (SPV) that carries the expense on its balance sheet, making the business appear to be less in debt.

Off–Balance Sheet Financing

Off–balance sheet financing (OBSF) isn't a type of loan. It's a strategy a company can use to keep large purchases or debts off its balance sheet. This can make the business appear stronger and less debt-laden.

A company could lease it rather than buy it or it could create a special purpose vehicle (SPV) to hold the purchase on its balance sheet if it needed an expensive piece of equipment. The sponsoring company often overcapitalizes the SPV to make it look attractive in the event the SPV requires a loan to service the debt.

Off–balance sheet financing is strictly regulated. Generally accepted accounting principles (GAAP) govern its use. This type of financing isn't appropriate for most businesses but it may be an option for small businesses after they achieve a larger corporate structure.

Funding From Family and Friends

You may want to first pursue a less formal type of financing if your funding needs are relatively small. Family and friends who support your business can offer advantageous and straightforward repayment terms and you can set up a lending model similar to some of the more formal models. You could offer them stock in your company or pay them back just as you would a debt financing deal in which you make regular payments with interest.

Tapping into Retirement Accounts

You can borrow from your retirement plan and pay that loan back with interest.

An alternative known as Rollover for Business Startups (ROBS) has emerged as a practical source of funding for those who are starting a business. ROBS allows entrepreneurs to invest their retirement savings into a new business venture without incurring taxes, early withdrawal penalties, or loan costs. ROBS transactions are complex, however, so working with an experienced and competent advisor to conduct these transactions is essential.

How Do I Finance a Business?

You have many options to finance your new business. You could borrow from a certified lender, raise funds through family and friends, finance capital through investors, or even tap into your retirement accounts. This isn't recommended in most cases, however.

Companies can also use asset financing which involves borrowing funds using balance sheet assets as collateral.

What Is Equity Financing?

Equity financing is the process of raising capital by selling shares in your company. Your investors will own a stake in your business if you raise capital using equity financing.

Can I Borrow From My 401(k) to Start a Business?

You can take out a loan from your 401(k) but this isn't always advisable. Most plans allow you to withdraw a maximum of $10,000 or 50% of your vested balance, whichever is greater, but there's a $50,000 cap.

Strict rules apply to repaying your account. Make sure you can pay yourself back if you go this route. It can be risky to take out a loan to fund a start-up because most people have to keep their traditional day job with their employer during this process. You'll be required to repay the loan plus taxes and penalties for an early withdrawal if you leave with a loan on your plan.

The Bottom Line

Every business eventually needs financing. It can be advantageous to avoid financing from a formal source but not everyone has this option. Debt financing is likely the most accessible source of funds for a small business if you don't have family or friends who are willing to support your company. You can grow the credit profile of your business with on-time, regular payments.

Equity financing or mezzanine financing may become options as your business grows or reaches later stages of product development.

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