Here at IBC we get a lot of questions about different types of financing and there are many ways to get financed. Here are two of the financing sources and the pros and cons with each.
Equity financing is the process of raising capital through the sale of shares in an enterprise. Equity financing essentially refers to the sale of an ownership interest to raise funds for business purposes. For most new businesses this comes in the form of “partnership” with friends and family in exchange for the money needed to start the business.
A simple way to look at it is this. If your friend “lends” you money with the expectation that you will pay it back, with our without interest, that is debt financing, if your friend gives you money to start the business with the understanding that he now owns a percentage of your business, that is equity financing. There are investors such as angle investors and venture capital funds that will make equity based investments as well. Check out some of the pros and cons.
Pros of Equity Financing
- You can use the money raised from investors for all the start-up costs instead of making large loan payments to banks or other organizations or individuals. You can get underway without the burden of debt payments. This can be a real benefit when you need a longer runway to start generating revenue.
- Depending on who your investors are, they may offer valuable business assistance that you may not have. This can be important, especially in the early days of a new business. A new business often begins with a great idea but the person with the great idea might not have the business experience necessary to run a business. Taking on a equity partner that can also fill your skill gaps should be a consideration.
Cons of Equity Financing
- Remember that your investors will actually own a piece of your business; how large that piece is depends on how much money they invest. You probably will not want to give up control of your business, so you have to be aware of that when you agree to take on investors. Investors do expect a share of the profits so when the business starts making money they will want to get paid.
- Since your investors own a piece of your business, you are expected to act in their best interests as well as your own, or you could open yourself up to a lawsuit. In some cases, if you make your firm’s securities available to just a few investors, you may not have to get into a lot of paperwork, but if you open yourself up to wide public trading, the paperwork may overwhelm you. You will need to check with the Securities and Exchange Commission to see the requirements before you make decisions on how widely you want to open up your business for investment.
This is where most of our clients end up getting the funds they need to start and expand their businesses. If you decide that you do not want to take on investors and want total control of the business yourself, you may want to pursue debt financing in order to start up your business.
The myriad of options in the debt based financing space is vast and can be confusing. Most new business owners start by tapping into the sources that they are familiar with first by using personal loans, home equity loans, and even credit cards, 401k loans etc. Sometimes they reach out to family or friends when other conventional loan options don’t exist.
Pros of Debt Financing
- Debt financing allows you to have control of your own destiny regarding your business. You do not have investors or partners to answer to and you can make all the decisions. You own all the profit you make.
- If you finance your business using debt, the interest you repay on your loan is tax-deductible. This means that it shields part of your business income from taxes and lowers your tax liability every year. Your interest is usually based on the prime interest rate.
- The lender(s) from whom you borrow money do not share in your profits. All you have to do is make your loan payments in a timely manner.
- There are a lot of options and the US government has some great programs to help support new businesses.
Cons of Debt Financing
- The disadvantages of borrowing money for a small business can be significant if you are not careful. Business owners often want something so bad they take a loan that is not right for their business. For example, you may have large loan payment due at precisely the time you need funds for start-up costs. If you don’t make loan payments on time to credit cards or commercial banks, you can ruin your credit rating and make borrowing in the future difficult or impossible. If you don’t make your loan payments on time to family and friends, you can strain those relationships. Being realistic about the debt you take on is critical.
- For a new business, commercial banks may require you to pledge your personal assets before they will give you a loan. If your business goes under, you will lose your personal assets. Understand the terms of your loan and be sure of the repayment strategy. There are literally thousands of options for debt financing with different terms. Know your repayment thresholds and don’t settle for something that puts your personal assets at risk.
- Any time you use debt financing, you are running the risk of bankruptcy. The more debt financing you use, the higher the risk of bankruptcy. Calculate the debt to equity ratio to determine how much debt your business is in compared to its equity is critical.
So the question is, which options are right for you?
It depends on the situation. Your financial capital, potential investors, credit standing, business plan, tax situation, the tax situation of your investors, and the type of business you plan to start all have an impact on that decision. The mix of debt and equity financing that you use will determine your cost of capital for your business. The good news is, there are a lot of options and that bad news is there are a lot of options. Getting the right funding is absolutely critical to the long-term success of your business so make sure you get it right. Do you homework, find the right investors and right lenders, and if you have not been through the process before, find someone that has been through it to help you navigate the options.
There is nothing worse than a great business idea that dies on the table because of a mistake on a loan application. We have seen this many times. The reality is that dreams take money and raising capital often comes down to how you present your idea and present your ability to execute on a plan to deliver it. The good news is that bankers and financial institutions really want to lend you money. That is what they do and how they make a living, but in order to lend they need to have confidence that you will pay them back. If your aim is to expand your business, financial institutions will want to know if the business they are funding is able to repay the loan or can sustain itself in the near future. Below are a few of the biggest mistakes we have seen small business owners make when applying for a business loan.
1. Cooking-the-Books – A common mistake that business owners make when seeking a loan, is exaggerating the numbers. Any financial information regarding your business should be clear and tangible. Here at IBC we see a lot of application turndowns in which a small business owner has exaggerated figures. Often this is an honest mistake that occurs when the owner is guessing at the numbers and not really sure of the actuals or simply “rounding up” in order to please the bank forgetting that a bank can still verify the information on your application. All this does is affect confidence and lead to loan denials if the verification process shows different figures from what you submitted. It is good to be accurate with the information that you fill in the loan application forms even if their willingness to loan is at a lower amount. If you want to increase chances for loan approval, present accurate balance sheets, cash flow statements and any other relevant documents requested.
2. Clear Intent – Lenders want to know exactly what you plan to spend the money on. If you are not sure or it is unclear, that is a recipe for rejection. Any banker worth his salt will want to know how any loan applicant intends to use the funds to improve their business. Unfortunately, one of the most common thing we see from business owners is failure to clearly describe how they plan to spend the money they are requesting. This leads to loan denials by most lenders since a lender wants to lend you money so that you can increase the revenues of the business and be able to repay back the loan with interest. Banks want you to spend money on the right things that will improve your current business’ position. The lender wants to see the needs of your business and evaluate whether the money to be borrowed is enough to meet those needs. You will also want to be brief and to the point when describing your needs and how these funds are going to help you start your idea or expand your business.
3. Run Your Credit Before They Do – The mistake of not knowing your personal credit ratings before applying for a loan may lead to a loan denial. The credit reports clearly outline how dependable are you when it comes to payment of bills and any debts. The figure can tell whether someone can trust you with their money or not. The good news is that the higher the credit rating you have, the higher the chances for your loan to be approved. Knowing what blemishes you have on your credit will allow you to start cleaning them up in preparation for funding, and in some cases allow you the time to preemptively develop a explanation for the negative marks. It is never good to be confronted by a lender with a credit problem that you are unaware of.
4. Have a Business Plan – Remember, your banker will need to get approval from a board or a supervisor to make your loan happen. So you need to arm him with a solid understanding of your business. A business plan is a great way to do this. You should have a road map that clearly shows how you want to operate your business for growth purposes. The business plan should then be submitted along with your applications.
In short, you have to show the lender how injecting money into your business will be able to generate more revenue. Understanding your market, your costs, your breakeven points etc. will build confidence in the lender and increase the likelihood of the loan approval. A proper business plan should include the target market and the goals of the business, as well as expected future growth.
In Summary, lenders are looking for consistency and thoughtfulness on the part of the borrower. Of course the underwriters are going to review the numbers to make sure the loan meets the institutions risk profile but don’t let these four simple things stall the process before you even have a chance. Know your numbers, have clean intent and state your needs clearly. If you do that, you will be on your way to achieving your dreams!
Bankers want to lend but just like stock fund managers, banks are filling a portfolio and like a stock portfolio investor looks to fill his portfolio with certain types of stocks, commercial lenders are doing the same thing. Some focus on manufacturing or medical while others are looking for commercial real estate the list goes on. Lending institutions are investors and they look to round out their holdings. Like any good business, lending institutions also specialize in order to do a great job delivering a product. For banks, loans are their product. There are many different types of loans with different risk profiles and each lender has a formula for maximizing their investments. For example, some financial institutions have specialized on SBA lending (government back lending) others in asset or merchant based lending. Some banks are very aggressive while others maintain a conservative position. Understanding this dynamic is important because it can be the difference between success and failure. If you fail to take this into consideration you might end up with a loan but it might not be the best funding option for your business.
How does this happen? Let’s analyze it. When you approach a bank that, let’s say, focuses on SBA lending it is highly likely you will end up in a SBA loan. If you fill out a form on a Merchant Lending site you will most likely get a merchant back loan. We work with a lot of great banks and fantastic bankers they are all going to do their very best to get you the funding you need. It’s not nefarious, it is optimistic. Bankers are optimistic and are going to figure out a way to get you the money you need – to find you the best possible product that they (with emphasis on THEY) can offer you, but it is your responsibility to look at the options in the industry and to figure out what is the best option is for your business.
Borrowing money is a big decision and should not be done on a whim or without significant consideration. I talk to business owners every day that shop three, four, even five different suppliers to save a few bucks on cleaning supplies but walk into the first bank they come across and sign up for a loan. It does not make sense to put the due diligence into your cleaning service and not into your funding sources. Yes, it is time consuming and at times confusing, but perseverance is crucial. Getting the right loan can be the difference between barely surviving and financially thriving.