Here are some key things to consider when deciding if debt or equity finance best suits you. Show How much do you need to borrow?The first thing you need to know is how much money you’ll need. You can get an idea of this through a number of different methods:
By comparing this amount to the cash you have available, you can gauge how much money you may need to borrow. To reduce financial stress, if it looks like you need to borrow a larger amount, you may want to consider ideas that can save you more money or, if you can, keep working your existing job for extra income. Another option can be to apply for federal government grants for some new businesses. Debt financeDebt finance is borrowed money that you pay back with interest within an agreed time. The most common types include:
Advantages of debt finance
Considerations for debt finance
Equity financeEquity finance is investing either your own or someone else's money in your business. The key difference between debt finance and equity finance is that the investor becomes a part owner of your business and shares any profit the business makes. The main sources of equity capital are:
Advantages of equity finance
Considerations for equity finance
What next?See which type of debt finance may suit your business or set up a meeting with a CBA Business Banker to discuss your finance options.
Financing is needed to start a business and ramp it up to profitability. There are several sources to consider when looking for start-up financing. But first you need to consider how much money you need and when you will need it.
Debt and equity are the two major sources of financing. Government grants to finance certain aspects of a business may be an option. Also, incentives may be available to locate in certain communities or encourage activities in particular industries. Equity FinancingEquity financing means exchanging a portion of the ownership of the business for a financial investment in the business. The ownership stake resulting from an equity investment allows the investor to share in the company’s profits. Equity involves a permanent investment in a company and is not repaid by the company at a later date. The investment should be properly defined in a formally created business entity. An equity stake in a company can be in the form of membership units, as in the case of a limited liability company or in the form of common or preferred stock as in a corporation. Companies may establish different classes of stock to control voting rights among shareholders. Similarly, companies may use different types of preferred stock. For example, common stockholders can vote while preferred stockholders generally cannot. But common stockholders are last in line for the company’s assets in case of default or bankruptcy. Preferred stockholders receive a predetermined dividend before common stockholders receive a dividend. Personal Savings Life insurance policies - A standard feature of many life insurance policies is the owner’s ability to borrow against the cash value of the policy. This does not include term insurance because it has no cash value. The money can be used for business needs. It takes about two years for a policy to accumulate sufficient cash value for borrowing. You may borrow most of the cash value of the policy. The loan will reduce the face value of the policy and, in the case of death, the loan has to be repaid before the beneficiaries of the policy receive any payment. Home equity loans - A home equity loan is a loan backed by the value of the equity in your home. If your home is paid for, it can be used to generate funds from the entire value of your home. If your home has an existing mortgage, it can provide funds on the difference between the value of the house and the unpaid mortgage amount. For example, if your house is worth $250,000 with an outstanding mortgage of $160,000, you have $90,000 in equity you can use as collateral for a home equity loan or line of credit. Some home equity loans are set up as a revolving credit line from which you can draw the amount needed at any time. The interest on a home equity loan is tax deductible. Friends and Relatives Venture Capital Venture capital investors also prefer businesses that have a competitive advantage or a strong value proposition in the form of a patent, a proven demand for the product, or a very special (and protectable) idea. They often take a hands-on approach to their investments, requiring representation on the board of directors and sometimes the hiring of managers. Venture capital investors can provide valuable guidance and business advice. However, they are looking for substantial returns on their investments and their objectives may be at cross purposes with those of the founders. They are often focused on short-term gain. Venture capital firms are usually focused on creating an investment portfolio of businesses with high-growth potential resulting in high rates of returns. These businesses are often high-risk investments. They may look for annual returns of 25-30% on their overall investment portfolio. Because these are usually high-risk business investments, they want investments with expected returns of 50% or more. Assuming that some business investments will return 50% or more while others will fail, it is hoped that the overall portfolio will return 25-30%. More specifically, many venture capitalists subscribe to the 2-6-2 rule of thumb. This means that typically two investments will yield high returns, six will yield moderate returns (or just return their original investment), and two will fail. Angel Investors Angel investors may be interested in the economic development of a specific geographic area in which they are located. Angel investors may focus on earlier stage financing and smaller financing amounts than venture capitalists. Government Grants Equity Offerings Initial Public Offerings Warrants A warrant is a security that grants the owner of the warrant the right to buy stock in the issuing company at a pre-determined (exercise) price at a future date (before a specified expiration date). Its value is the relationship of the market price of the stock to the purchase price (warrant price) of the stock. If the market price of the stock rises above the warrant price, the holder can exercise the warrant. This involves purchasing the stock at the warrant price. So, in this situation, the warrant provides the opportunity to purchase the stock at a price below current market price. If the current market price of the stock is below the warrant price, the warrant is worthless because exercising the warrant would be the same as buying the stock at a price higher than the current market price. So, the warrant is left to expire. Generally warrants contain a specific date at which they expire if not exercised by that date. Debt FinancingDebt financing involves borrowing funds from creditors with the stipulation of repaying the borrowed funds plus interest at a specified future time. For the creditors (those lending the funds to the business), the reward for providing the debt financing is the interest on the amount lent to the borrower. Debt financing may be secured or unsecured. Secured debt has collateral (a valuable asset which the lender can attach to satisfy the loan in case of default by the borrower). Conversely, unsecured debt does not have collateral and places the lender in a less secure position relative to repayment in case of default. Debt financing (loans) may be short-term or long-term in their repayment schedules. Generally, short-term debt is used to finance current activities such as operations while long-term debt is used to finance assets such as buildings and equipment. Friends and Relatives Banks and Other Commercial Lenders Commercial Finance Companies Government Programs Bonds When a company issues a bond it guarantees to pay back the principal (face value) plus interest. From a financing perspective, issuing a bond offers the company the opportunity to access financing without having to pay it back until it has successfully applied the funds. The risk for the investor is that the company will default or go bankrupt before the maturity date. However, because bonds are a debt instrument, they are ahead of equity holders for company assets. LeaseA lease is a method of obtaining the use of assets for the business without using debt or equity financing. It is a legal agreement between two parties that specifies the terms and conditions for the rental use of a tangible resource, such as a building or equipment. Lease payments are often due annually. The agreement is usually between the company and a leasing or financing organization and not directly between the company and the organization providing the assets. When the lease ends, the asset is returned to the owner, the lease is renewed, or the asset is purchased. A lease may have an advantage because it does not tie up funds from purchasing an asset. It is often compared to purchasing an asset with debt financing where the debt repayment is spread over a period of years. However, lease payments often come at the beginning of the year where debt payments come at the end of the year. So, the business may have more time to generate funds for debt payments, although a down payment is usually required at the beginning of the loan period. For more information on business development, including contracts and agreements, visit the Ag Decision Maker website. Don Hofstrand, retired extension value added agriculture specialist, |