Financing Basics

There are two types of financing: equity and debt financing.  When looking for money, you must consider your company's debt-to-equity ratio - the relation between dollars you've borrowed and dollars you've invested in your business.  The more money owners have invested in their business, the easier it is to attract financing.

Debt Financing 

There are many sources for debt financing: banks, savings and loans, commercial finance companies, and the U.S. Small Business Administration (SBA) are the most common.  State and local governments have developed many programs in recent years to encourage the growth of small businesses in recognition of their positive effects on the economy.  Family members, friends, and former associates are all potential sources, especially when capital requirements are smaller.

Traditionally, banks have been the major source of small business funding.  Their principal role has been as a short-term lender offering demand loans, seasonal lines of credit, and single-purpose loans for machinery and equipment.  Banks generally have been reluctant to offer long-term loans to small firms.  Loan guarantee programs encourage banks and non-bank lenders to make long-term loans to small firms by reducing their risk and leveraging the funds they have available.

In addition to equity considerations, lenders commonly require the borrower's personal guarantees in case of default.  This ensures that the borrower has a sufficient personal interest at stake to give paramount attention to the business. For most borrowers this is a burden, but also a necessity

Equity Financing

Most small or growth-stage businesses use limited equity financing.  As with debt financing, additional equity often comes from non-professional investors such as friends, relatives, employees, customers, or industry colleagues.  However, the most common source of professional equity funding comes from venture capitalists. These are institutional risk takers and may be groups of wealthy individuals, government-assisted sources, or major financial institutions.  Most specialize in one or a few closely related industries.

Venture capitalists are often seen as deep-pocketed financial gurus looking for start-ups in which to invest their money, but they most often prefer three-to-five-year old companies with the potential to become major regional or national concerns and return higher-than-average profits to their shareholders.  Venture capitalists may scrutinize thousands of potential investments annually, but only invest in a handful.  The possibility of a public stock offering is critical to venture capitalists. Quality management, a competitive or innovative advantage, and industry growth are also major concerns.

Different venture capitalists have different approaches to management of the business in which they invest.  They generally prefer to influence a business passively, but will react when a business does not perform as expected and may insist on changes in management or strategy.  Relinquishing some of the decision-making and some of the potential for profits are the main disadvantages of equity financing.