Business financing generally comes in two flavors: equity and debt. For small businesses, equity financing often takes the form of contributions by family members, friends, business associates, and investors. For business owners, the biggest drawback to equity financing is loss of control. If Uncle John pumps his savings into your newly formed company, he may want a substantial voice in its day-to-day operations, whether or not he understands your industry or business model. On the plus side, equity contributions may be easier to procure than bank loans or other forms of financing.
Without an established track record, businesses may struggle to obtain debt financing. To extend a loan, a lender must be willing to risk the institution’s funds on your business. Loan terms generally compensate for this risk by stipulating an interest rate that reflects the lender’s estimate of your credit worthiness. If the lender thinks your firm may struggle making the loan payments, expect a higher rate.
From a business owner’s perspective, the signing of loan agreements also carries risk. That’s why it’s wise to proceed slowly. Take time to develop a formal business plan, cash flow projections, and a realistic picture of the firm’s needs. Determine whether alternate forms of financing may be available. Remember that failure to make timely loan payments may adversely affect your company’s ability to obtain future financing.
In general, a company should use debt financing for capital items such as plant and equipment, computers, and fixtures that will be used for several years. By incurring debt for such items, especially when interest rates are low, a firm can release operating cash flows for day-to-day operations or new opportunities. For short-term needs, consider establishing a line of credit.
Regardless of the form of financing chosen, all businesses must produce a product or service that others want to buy. Debt should be viewed as a tool – one of many – to help your company thrive.