Financing a Small Business
December 15, 2015
An important question for any small business owner – whether a start-up venture or an ongoing business – is, "How do I finance my business?" Of course, an owner can finance the entire business from personal savings or, absent the capital needed, must seek funding from investors or lenders. Funding for a small business can come from several sources.
Debt financing is when a business borrows money. It creates a debt and must repay the debt with interest. The repayment terms and interest will be specified in the debt instrument. The interest paid is a business expense and, therefore, tax deductible.
Equity financing, sometimes referred to as equity capital, is an investment from the owner or outside investors. At times, it is even referred to as "risk capital" since the investment is at risk of being lost if the business fails and the investment becomes worthless. When owners seek funds from outside investors, they must give up a percentage of ownership in return for the invested funds. The investors will be seeking a return on investment (ROI) thru dividend distributions and an increase in value of their investment.
Implications for the Future
It is important to understand that whatever choice made today for funding will have implications in the future. Some considerations in deciding whether to choose debt financing or equity financing will be based on various factors. Two important factors are:
• Does the owner want complete ownership of the business with no interference from outside investors?
• Are the funds needed for short-term or long-term requirements of the business?
Debt has to be repaid based on the terms of the debt instrument. Loans might be difficult to obtain based on the current economic climate, the business' ability to repay, type and value of collateral to secure the loan, amount of the owner's investment in the company, and even the owner's personal credit rating can affect both the ability of the business to secure a loan as well as the interest rate and repayment terms of a loan.
Differing from debt financing, equity stays in business and has tax implications if cash dividends are paid or when the stock is redeemed.
Amount of Risk
Regardless of the choice, investors or lenders will scrutinize the business to determine the amount of risk. No individual or lending institution wants to lose money in a failed business.
Posted by Richard Weinberger, PhD, CPA
Chief Executive Officer
Association of Accredited Small Business Consultants