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 the 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. And there are an enormous range of options available. Let’s explore them!
So to start with there are two main broad categories 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) – these are usually available to more established companies. 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, lenders 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 will seize the asset. Unsecured loans tend to be smaller and attract higher interest rates.
Equity financing “I’m looking for $100,000 for a 10% stake in my business”
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 pretty well beyond scope of this article, but they include decision making and voting rights, dilution, valuation and exit methods.