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Types of Financing: Loans or Equity

Before you begin searching for specific sources of funds, consider whether you will be better off with a loan or by offering a part ownership (equity) in your business. Each of these types of financing has advantages, and each has a few strings attached.

A loan, or debt financing, means that you will be paying interest until the money is repaid. This is a commitment that you want to be sure to be able to meet, as there will be penalties if you fail to meet the terms of the loan agreement. The good news is that you retain complete ownership and control of the business. Another positive side to borrowing is that any interest you pay is tax-deductible.

Debt financing can be either short-term (full repayment due in less than 1 year) or long-term (repayment due over more than 1 year).

Equity financing means that the person or business that provides financing will become a partial owner of the company. Unlike a bank, they do not expect to be paid interest nor do they expect to be paid back. On the other hand, they may want to become a decision-maker in the business, often by becoming a member of the board of directors.

What is the tradeoff with equity financing?

If you give a share of ownership in your business in return for funding, your ownership becomes diluted. You may be expected to share in the profits of the business by paying a dividend to all owners, and when the business is sold, the other owner or owners will expect a proportion of the sales proceeds. And you can expect to lose some control to an expanded board of directors.

What about a combination of debt and equity?

Businesses can use both debt and equity financing. In fact, many professionals believe that a proper balance of debt and equity is an ideal combination.

About Debt Financing

The first source for a loan that most people think of is a bank (savings bank or commercial bank). Commercial banks may have tight requirements and traditionally are not willing to take on much risk. They are strictly lenders, so they do not expect to exert the influence and control that a venture capitalist would. If you are not looking for a large amount of money, you may be able to get a loan guaranteed by your personal credit.

A bank loan can be short-term or long-term; the term usually matches the life of the item that is being financed. Like a long-term mortgage on a house, a long-term loan would be given to purchase a building or machinery that will be used for more than 10 years. A short-term loan would finance a seasonal cash flow situation.

You might also need to put up collateral-a specific asset-to guarantee repayment of the loan. This is considered to be secured financing and is most often required for a small business. An unsecured loan is simply a promise to repay under the terms of an agreement. Lenders know that an unsecured loan puts them at the end of the line if a borrower defaults on a loan, and they would require strong credit history to issue such a loan.

When should I consider leasing equipment for my business?

Equipment leasing helps manage cash flow. Many types of equipment are routinely financed with leases-copy machines, computers and vehicles, for example.

What other types of loans are there?

In effect, trade credit is a loan from your suppliers or customers. When a buyer and seller agree that the buyer will pay for the goods at a later-than-normal time, the buyer is financing using trade credit. This is a common form of financing for businesses, in which the supplier knowingly participates. In fact, the supplier may extend additional trade credit as the buyer proves creditworthy.

What about my insurance policies as a source of financing?

Most insurance policies permit borrowing against the cash surrender value. This essentially means taking a personal loan, which you can use to fund the business.

What are some other types of business loans?

In addition to the loans discussed above, business financing can come from one or more of the following sources:

How do I figure out how much to borrow?

The first step to getting a loan is determining how much you need-an important calculation, not to be taken lightly. You want to borrow enough to meet your capital needs, grow the business and increase your profits. But you do not want to borrow so much that you struggle to generate enough profit to pay it back. You also want to expand your business at an appropriate rate. Make sure your ideas work before you bet the farm on them. Building a successful track record with as few missteps as possible will keep your company's finances in top shape and help you get greater amounts of financing later on.

You should estimate all business costs for several months out, which will vary considerably depending on the type of company you have. Identify which costs will be one-time and which will be recurring, which must be paid immediately and which can wait, which are fixed expenses and which will vary over time.

TIP: You can use the startup costs estimate calculator at http://www.bplans.com/contentkit/index.cfm?s=tools&affiliate=sba

I do not have the best personal credit history. Will that be a factor in getting a loan?

Yes, lenders will consider your personal credit history in their decisions to give you a loan. Because new businesses often have no credit history yet, the lender will use your personal credit history instead.

Get a copy of your credit report from at least one of the three major credit bureaus-TransUnion, Equifax or Experian. Keep in mind that each credit bureau presents your credit information in a different way on the report. Your credit report lists all the credit you have used in the past, including mortgages, car loans, student loans and credit cards. The report also states your payment history-whether you paid on time and as agreed or you were late in making payments. The report will also reveal if you filed for bankruptcy in the last 10 years.

If your credit history was damaged by a divorce or personal crisis, you should provide a written explanation to the lender and establish that you managed your credit responsibly before and afterward and that you have tried to pay back your debts.

If there are any errors on your report, have them corrected before you apply for a loan. It can take 3 to 4 weeks to get an error fixed.

TIP: You can visit the three major credit bureaus online at:

Equifax: http://www.equifax.com/

TransUnion: http://www.transunion.com/

Experian: http://www.experian.com/consumer/index.html

You also want to get your household finances in order. Your small business might not turn a profit right away, but you still need to pay your living expenses. Create a conservative monthly budget and make sure you have enough money saved to live according to that budget for many months or until you expect to receive an income from your business. Putting away an additional emergency fund is a good idea in case your projections are wrong.

What other factors will lenders consider?

Lenders are very discriminating about whom they lend money to, and they will evaluate many different factors that indicate whether or not you are a good business risk that they could potentially profit from.

First, you must demonstrate your ability to repay the loan. Lenders may look for two sources of repayment, such as cash flow and collateral. Cash flow projections are derived from past financial statements. The longer your company has been operating the more of a financial history it has and the more trustworthy the projections that are based on it. Borrowers must put up some collateral, either personal or business assets, as a backup repayment source.

Second, lenders consider how much equity the business has. Equity usually comes from owners who have put their own money into the company, investors who have provided capital in exchange for interests and retained earnings. Debt should not usually exceed more than four times the amount of equity.

Third, borrowers must show that they have experience in the business and a track record of success in managing a similar company.

How do I determine how much my collateral is worth?

The value of assets put up as collateral is not equal to their market value, but discounted because some value would be lost if the assets were liquidated. For example, according to most lenders, the collateral value of your house is 75 to 80 percent of the market value minus the mortgage balance. The collateral value of heavy equipment is usually 50 percent of the depreciated value. The collateral value of stocks and bonds is 50 to 90 percent of their market value.

If I do not have any collateral, can someone who does have collateral co-sign my loan?

Yes. If you have no collateral, getting someone who has collateral to co-sign the loan may be the only way you can get financing. When someone co-signs your loan, they are risking their assets if you cannot repay the lender.

What is a personal guarantee?

Normally, lenders have no claim to personal assets that you have not put up as collateral in the event that you cannot repay the loan. Your liability is usually limited to the company's assets. But since small businesses are risky ventures, lenders want you take a personal stake in paying back the loan as well as provide them with the added protection of claim to your personal assets if the business fails.

Therefore, many lenders ask you to give them a personal guarantee. Even if your business has been formed with limited liability protection under the law, you are pledging your personal assets to guarantee repayment of the loan.

If you make a personal guarantee and default on the loan, the lender could claim all of your property and half of any property you jointly own. If you are married, the lender may require that your spouse co-sign the loan, in which case, the lender could claim all of your jointly owned property as well as anything your spouse owns separately.

What are the different types of repayment schedules?

Regardless of the type of repayment schedule you choose, make sure you have the right to prepay the loan at any time without penalty.

What kind of interest rate can I expect to pay?

Interest rates for small business loans tend to be relatively high because of the higher risk to the lender to finance a small business venture. However, state laws prohibit lenders from charging unreasonably high interest rates on small business loans. In general, a lender can legally charge interest of up to 10 percent per year, but most charge less than that.

If the business is borrowing money from a shareholder in the company, the interest rate cannot be unreasonably low or the IRS will regard the loan as a capital investment and the loan repayments as dividend payments for tax purposes.

Types of Equity Financing

The equity investor does not expect an immediate payback, but invests with the idea that his or her ownership in the business will grow in value and perhaps pay some cash dividends along the way.

An ownership interest also gives investors the right to participate in certain business decisions, including determining your salary. It is important to remember that the more shares you sell in the company, the more diluted your ownership stake becomes. Equity financing can also take much longer to obtain-months instead of days. But for many companies, especially those with little or no track record, equity financing may be the only option.

Investors assume more risk than lenders. If the business fails, investors have no claim to corporate or personal assets to recoup their investment. When assets are liquidated, all creditors must be paid in full first. Only what is left over is distributed to owners. Essentially, they can lose their entire investment. Investors expect a much higher return than lenders in exchange for taking on so much risk. In order to get equity financing, you must demonstrate that your business has the high-growth potential to generate the kind of returns investors are looking for.

It can take years for a company to mature to a point where equity investors realize gains. They usually only profit once their shares become publicly traded through an initial public offering (IPO), the business is acquired by another company or through some other exit strategy.

Who provides equity financing?

If I want to attract investors, how should I structure my company?

Investors will be most interested in corporate structures that limit their risk. They may be willing to lose their investment, but they probably will not be willing to risk their personal assets.

What if I have a group of investors lined up?

If you are looking at gathering funds from a number of investors, you should be aware of regulations supervised by the Securities and Exchange Commission. There are rules limiting the number of investors and amount of money raised before a business must comply with regulations that apply to a public company.

Are the interests I am selling in my company considered securities?

Shares of a corporation and interests in a limited partnership and limited liability company are, by law, considered to be securities. Therefore, as a business owner, you need to comply with federal and state securities laws if you sell equity in your company in exchange for capital investments. Most small businesses can sell ownership interests in the company to a limited number of investors with minimal paperwork required to comply with securities laws. As a rule of thumb, you should be completely forthcoming with any details that are pertinent to investors making a fully informed decision about the company. If your company grows considerably larger, you may have to meet more complex disclosure requirements and eventually register the securities with the SEC.

How do I go about asking investors for money?

Companies seeking equity funding usually make a presentation to a group of potential investors. Entrepreneurs should put a great deal of time and effort into preparing these presentations, as they could be the most important sales pitch in the life of your company. Explain in detail the idea for your business, your plan for executing it and how the company will profit from it. Put technical or insider jargon in plain language investors can understand. Also, sell yourself as a proven, experienced manager who has the skills to make your company succeed. Honestly address the challenges the company faces and how you plan to overcome them. Investors are more focused on the downside of risk than the upside of a great idea.

What are private placements?

A private placement, or private stock offering, is the sale of securities to a limited number of qualified private investors. While a public stock offering is the sale of shares to the general public, a private placement is the offering of shares to only institutional investors and accredited high-net-worth individuals.

When does a private placement make sense?

Companies usually make private stock offerings after they have already received several rounds of private equity funding and now need greater amounts of capital, but they are not ready to go public.

Private placements enable companies to raise capital more quickly and less expensively than a public offering. Companies also have more control over private placements than they do over public offerings. Owners can decide how much to sell, at what price and to whom. Private placements do not need to be registered with the SEC, but they do have to comply with state and federal securities laws. While companies do not have to make public disclosures of financials, they do have to disclose all relevant information to potential investors in the private placement.

As with all private equity investments, companies must demonstrate that they have a strong future growth rate and a potential exit strategy for investors.

How do private placements work?

A company making a private stock offering issues a Private Placement Memorandum, or PPM. The PPM includes the company's financials and business plan as well as any other relevant information. Preparing a PPM involves hiring attorneys who specialize in private placements to oversee the paperwork and make sure the process complies with SEC and state laws. The issuing company and potential investors usually work with an investment bank as a go-between. Investors who decide to invest complete a subscription agreement.

How are profits distributed to investors?

What is a public stock offering?

A public stock offering is the sale of equity in a company, in the form of shares of common stock, through an investment-banking firm to the general public. A private company "goes public" by selling its stock on the open market for the first time through an IPO.

Why do companies go public?

Companies become publicly traded in order to raise greater amounts of capital to expand the business, fund research and development, make acquisitions and pay down debt. Once public, a company can raise more capital by issuing additional stock in a secondary offering. Public companies can also more easily raise private funds and get better rates when issuing debt.

Investors who purchase equity interests in a private company need an exit strategy to unlock the value of their shares. Going public provides them with an opportunity to sell their holdings for potentially much more than they paid for them, or at least see them increase in value. And, as a founding owner and large shareholder, you personally would also stand to make a great deal of money.

What does the IPO process involve?

In order to go public, companies should be able to demonstrate they have the potential to generate minimum annual earnings growth of 20 percent. They must also have the ability to achieve a valuation-that is, shares outstanding times stock price-of around $100 million.

The IPO process is a long and involved one. Before going public, the company hires an investment bank to handle the offering, registers with the SEC, issues a preliminary prospectus and markets the IPO to institutional investors in a "road show." After the SEC approves the offering, an "effective date" is set-that is, the day the stock will be offered. The investment bank and the company then decide on the opening stock price, which is largely determined by market conditions and institutional investor interest. Most of the IPO shares are allocated to large institutions, but individual investors can sometimes get shares.

On the day of the initial public offering, the company's stock trades on the open market for the first time. From that moment forward, market demand dictates the stock price. Stock prices frequently spike on the first day of trading and settle back down in the days following. After 180 days, people who held shares before the IPO are allowed to sell them.

What are the drawbacks to going public?

Going public is expensive-more expensive than other means of business financing. A company must give up at least 25 percent of its equity in the offering, perhaps much more. Taking a company public is complex and requires the hiring of many experts to help with the process. Tackling the mountain of paperwork involved costs a great deal of money. Fees and expenses can add up to as much as 20 percent of the deal. Once public, companies are required to follow strict rules and disclose financial information regularly, which are costly and time-consuming endeavors.

When going public, the original owners relinquish some of their ability to make independent decisions. The company is now largely owned by public shareholders. Even though they might not have a majority stake in the company, their holdings are significant enough that companies must hold shareholder meetings, notify shareholders of company developments and allow them to vote on certain business decisions. Finally, if shareholders do not like how you are running the company, they can vote with their feet and sell their shares, hurting both the company and your personal fortune.

SBA Programs

The Small Business Administration is a valuable resource for more than just financing. It offers a range of programs-several large ones and others for special circumstances-that may be just what you need to start a business or grow to the next level. (Your state and local community are also potential resources.)

Although sponsored and funded by the SBA, these programs are administered by banks.

TIP: To find an SBA microloan intermediary in your area, visit: http://www.sba.gov/financing/microparticipants.html

The SBA also provides special areas of funding for Small Business Development, Women's Business Centers, veterans and Native Americans programs. It also provides assistance after some disasters. Further, the SBA has resources for businesses that want to export goods to other countries.

My business generates plenty of money to repay a loan, but I have very few personal or corporate assets to put up as collateral. What can I do to get financing?

The SBA, an independent federal agency, offers programs to help small-business owners get financing. The SBA has federal funds to provide guarantees on loans to small-business owners that are structured according to the SBA's requirements.

Most banks and many commercial finance companies offer SBA-guaranteed loans. About 850 lenders qualify as SBA-Certified Lenders, which means they meet certain SBA criteria and have experience in making SBA-guaranteed loans. The agency can process a loan with one of these lenders in about 3 business days. About 500 lenders qualify as SBA Preferred Lenders and handle about 30 percent of all SBA-guaranteed loans. They have full authority to process SBA loans and can complete applications in 1 business day.

TIP: To find SBA lenders, go to http://www.sba.gov/financing/basics/lenders.html.

While the SBA sets the guidelines for the loans, the lenders provide the actual funds to the borrowers. The SBA guarantees as much as 80 percent of the principal of the loan with the full faith and credit banking of the federal government, significantly reducing the risk to the lenders.

Many small businesses are fully capable of repaying a loan, but do not have enough collateral to get one. SBA programs make it possible for those types of companies to get financing. It is also hard for small-business owners to get long-term loans because they involve increased risk to the lender, but long-term loans mean lower, more manageable payments. SBA-guaranteed loans mitigate the risk and encourage lenders to make loans with terms of up to 10 years.

SBA loans are also relatively inexpensive. The maximum allowed interest rates range from the prime rate plus 2.75 percent to the prime rate plus 4.75 percent. Lenders of SBA loans also cannot charge repayment fees. Applying for an SBA loan may be a more involved and lengthy process than applying for a traditional loan.