There are two main types of business finance, debt finance and equity finance. Broadly speaking, debt financing is funds borrowed from a lender and repaid with interest and equity financing is capital exchanged for part-ownership / shares in a company.
Debt or equity?
All businesses, big or small need finance at some point. Whether they’re just starting out, looking to expand, purchase equipment or just smooth out bumps in cash flow. In this article, we’ll explore the main types of business finance available and the benefits of each.
Running a business is tough. Over 250,000 businesses failed in FY17/18. That’s up 12.7% from the year before!
Lack of capital is one of the main reasons. That could result in insufficient investment in equipment, operations or marketing. However, the main reason is more day to day - cash flow management. Cash flow problems are a headache for almost 50% of Australian companies.
This means choosing the right type of finance is critical to the success or failure of your business.
There are an enormous range of options available. Let’s explore them! To start with there are two main sources of finance available for businesses:
- Debt finance - funds borrowed from a lender that must be repaid with interest.
- Equity finance - money exchanged for part ownership of your business. This could be your own funds or from investors.
Debt financing - traditional business loans, credit lines and receivables finance
It’s a broad term, which encompasses many types of finance options. What they share in common is that they do not give away part ownership, but the funds must be paid back with interest.
Loans can be short term (from 30 days to a year). Or long term (from 1 to 5 years) - often for larger expenses, such as starting a business or for equipment or fixed assets.
There is also usually some sort of credit check. In order to determine if you’re credit-worthy, finance companies may want to look at:
- Your credit rating
- Your business track record and financials
- Your past bank history
- Whether you’ve invested your own money
- Your ability to repay the loan
Debt financing can be secured or unsecured, with secured loans attached to a fixed asset, such as property. If you can’t meet the payments, the lender could seize the asset. Unsecured loans tend to be smaller and attract higher interest rates.
Equity financing - investors, bootstrapping and crowdfunding
This is the world of venture capitalists and angel investors. It’s a risky business for the investor, but with risk comes reward. As we said at the start of this article, many businesses fail. And investors (the business owner included) only see a repayment or a return if the business makes money.
There are lots of things to consider when giving up equity. They’re beyond scope of this article, but they include decision making and voting rights, dilution, valuation and exit methods.
Let’s consider the advantages and disadvantages of both types of finance:
|You get to keep control of your business and the decisions that drive it||Most types of loan must be repaid in full with interest over a fixed term|
|The interest on the loans is generally tax-deductible||Repayments begin straight away|
|You have the option of either long or short loan terms||It must often be secured against collateral, which you can lose if you don’t keep up with repayments|
|Funds can be available quickly and when they are needed||Constant cash drain from the business, as the loan is repaid every month|
|Generally, there is less risk involved as the loan doesn’t have to be paid back immediately||Investors take some ownership of your business - meaning you lose some|
|You’re not paying it back, so there is more cash on hand||They get a say in the direction of the company / business plan, as well as day-to-day decisions|
|The investors could bring credibility & skills to your operation||There is a lot of time and effort involved in finding people to invest|
Sources of debt & equity finance
There’s a wide range of funding opportunities for business owners, choosing the right one will depend upon how established your business is, what the funding is required for and the assets the business has.
Sources of debt finance
- Financial institutions - a traditional lender; a bank, a building society or credit union
- Finance companies - non-bank financial institutions and online lenders
- Retailers - purchasing goods through credit, which must be paid back at a later date with interest
- Suppliers - trade credit on materials and services needed to run your business
- Receivables finance (or invoice financing) - using your unpaid invoices as an asset to secure a loan or line of credit (we’ll explore different kinds of receivables finance, such as factoring and discounting in much more detail in other articles)
- Peer to peer loans - a way to match businesses looking for a loan with people looking to invest
- Family & friends - a loan taken from people you know. It’s important to get a formal written agreement / terms and conditions here to avoid any misunderstanding
- Equipment finance / asset finance - a loan secured against assets on a company's balance sheet or a form of funding used to lease essential equipment
- Trade finance - a type of finance used to facilitate imports and exports
- Supply chain finance - a form of funding initiated by large buyers to smooth the supply chain with sellers
Sources of equity finance
- Personal finances / bootstrapping - most small business begins this way
- Venture capital - businesses who specialise in making investments in companies in whom they see potential
- Private investors / angel investors - like VC, but individuals rather than firms
- Family & friends - taking cash from people you know in exchange for part ownership
- Crowdfunding or equity crowdfunding - a recent method of fundraising which gives the public early or exclusive access to a product or service in exchange for up-front funds. Equity crowdfunding involves offering shares for funds at an early stage
- Government - in certain circumstances a government grant may be available for small businesses
- IPO (or initial public offering) - to float your company on a stock exchange and sell shares to the public