Methods of Financing Your Business
Once you've completed your financial calculations, statements, and projections, you will have a clearer idea of how much money you need to raise in order to finance your business. The two main ways of financing a business, equity financing and debt financing, will be discussed.
Equity capital is the amount of money that you and/or your partners put into the business or raise from other investors. Equity is not debt. While investors share in the profits (or losses) of the business, their investment is not a loan.
Remember that to attract investors (shareholders) or partners, you must be able to demonstrate both the profitability and the reasonable risk of your business venture. The best way of doing this is through solid financial planning..
Consult your lawyer and your accountant before you enter into any equity agreement for your small business.
Personal Investment from Self, Friends, and Relatives
Personal savings, securities, real estate, and other personal assets are the most obvious source of cash for equity financing. Friends and relatives may provide additional sources of funds. In most cases, the small business owner must assume the largest share of the risk- this means making the largest investment in the business.
Personal investment in the business by you, your family, and your friends demonstrates a faith in, and a commitment to, your business. This is important to other potential investors and lenders. In fact, banks and other lending institutions have established guidelines for the amount of investment that is required before they will lend money to a business. This is sometimes called the debt-to-equity ratio, and it varies depending on the type and nature of your business.
If you cannot supply all the equity capital needed to finance your small business, you may have to find one or more partners willing to put money into the venture. Obtaining a partner means that ownership of the business, including its profits and liabilities, is normally shared.
In most cases, partners want a say about how the business is run. Limited partners, sometimes called silent partners, can contribute financially to your business without participating in its management. Limited partners are normally only responsible to the business or its creditors in proportion to the amount they have invested in the partnership; however, parties considering a partnership agreement should seek legal advice on this and related issues.
A business may be incorporated as a private or public corporation. A private corporation can have up to 50 shareholders, but it cannot sell shares to the general public. The vast majority of new small business corporations are private.
Ownership is shared in a private corporation, generally in proportion to the amount investment of each shareholder (which may be translated into the number of voting shares each person owns). You must be able to demonstrate the viability and profitability of your business venture to attract potential shareholders.
Because public corporations can sell their shares to anyone, they provide the greatest opportunity for raising equity capital. However, offering shares to the public can be a long, complicated and expensive procedure. A detailed prospectus of the business' operations must be filed with the Alberta Securities Commission.
Nevertheless, when your business becomes sufficiently large and prosperous, a public share offering can be an attractive method of obtaining financing.
Another way of raising funds is to ask employees to invest in the business. You might consider making your most talented and dedicated employees a partnership offer, or, if your business is incorporated, you could sell stock to employees to provide a form profit sharing.
Employees may be willing to invest in your business because they understand its products or services, trust the management, and are able to closely monitor their investment. Having a stake in the business can positively influence employees' working habits since they will benefit from its success. On the other hand, when employees have a share in the business, it could prove difficult to remove, retire, or replace them if they become unproductive or uncooperative.
In Canada, a number of venture capital firms provide equity financing, usually for high risk enterprises with potential. Most venture capital investment is directed to the expansion of existing businesses. As a general rule, venture capitalists plan to liquidate all or part of their investment in your business at a substantial profit within five to ten years.
Venture capitalists are in a high-stakes, high-risk business. In negotiations, they will aggressively try to make the best deal they possibly can with you. Besides fast-growth prospects, they look for sound management and a high degree of financial commitment on the part of the small business owner/operator.
While most venture capitalists do not wish to become involved in your day-to-day operations, they will require representation on your board of directors. Some venture capital sources may consider equity participation if your venture meets their criteria.
With your equity capital in place, you are now in a position to approach lenders for a business loan. Debt capital is the money your business borrows. It must be fully repaid with interest, over a specific time period. While lenders do not share in business profits as investors do, they must be repaid with interest whether the business is showing a profit or not.
Potential lenders include the following:
- Banks and Trust Companies
- Alberta Treasury Branches
- Credit Unions
- Private Investors
- Commercial Finance Companies
- AFSC Commercial
- Business Development Bank of Canada
As a small business owner/operator, you should familiarize yourself with the lenders requirements before determining the type and the source of your debt financing.
When determining the type of debt financing that is right for your business, remember this basic rule:
- Finance day-to-day operations (working capital) with short-term operating loans;
- Finance long-term fixed assets with longer-term loans or mortgages
Business Term Loans (Financing Fixed Assets)
Major purchases require foresight and careful planning. The fixed assets of a business, such as land, buildings, and equipment, are usually financed through a combination of equity capital contributed by the owner(s) and business term loans.
A business term loan has a maturity of not less than one year and usually not more than 15 years. The security offered for repayment is usually the assets being financed. The repayment schedule is generally based on the useful life of the asset. This type of debt financing is frequently referred to as fixed-asset financing.
Lenders will finance only a percentage of the value of the asset being purchased. For example, a bank may lend up to 75% of the value of a truck, to be repaid within five years, and up to 80% for a building, to be repaid within 12 years.
The benefits of a business term loan are the following:
- The loan agreement is based on the borrower's ability to repay the loan out of earnings
- As long as the borrower meets the terms of the loan agreement, no payments other than the regular installments will be required before the due date of the loan
- A long-term working relationship is established between lender and borrower
When lending on a medium to long-term basis, credit institutions tend to focus on the 'earning power' of your business over a period of years. Therefore, to obtain long-term loans, your business plan must convince lenders of the viability and profitability of your business venture over time. If the loan is given to a limited business (corporation), the lender may require your personal guarantee - if the business cannot repay the loan, you will be personally liable.
Canada Small Business Financing (CSBF) Program
This federal government program supports term debt financing to small businesses. The program is administered by many lending institutions to which you can apply. Talk to your lending institution to see if you qualify for a business loan under the terms and conditions of this program.
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