In the vast majority of cases when considering how to finance a business, the owners and management team can only provide a small fraction of the funds required and outside help is usually required.
A business plan financial projection will answer the question of how much funding a business will need to launch and operate successfully. It will identify the peak funding and the period for which your business needs this funding for. The next question is how and from where your business can be best financed.
There are many different types and sources of finance but generally they fall into one of two categories, Equity or Debt.
How to Finance a Business Using Equity
Equity includes capital injected by the owners or outside investors in the business, such as angel investors, venture capital investors, or the stock markets. Any retained profits of the business are also classified as equity.
Investors want to know they will get a return on their investment:
- What are the losses likely to be?
- What is the business break even point?
- What is the net present value and internal rate of return of the investment?
- What the Return on Investment and Return on Equity are?
- That there is a clear exit strategy.
- Will the business pay dividends?
Investors take the highest risk of all the providers of finance as they can only take a share of the profits after interest and other liabilities have been paid. Accordingly, they normally seek a higher return on their investment than debt finance providers.
Using Debt to Finance a Business
Debt includes loans from family and friends, bank loans and overdrafts, government loans, mortgages, and leasing.
Providers of loan finance for financing a new business usually require security for the debt, such as a mortgage on a property or personal guarantees. In addition they will impose performance related criteria, called covenants to continue to provide the loan.
The cost of debt finance is the interest and fees payable to the lender based on the amount of money borrowed and the duration of the loan. The interest payments are normally an expense of the business and therefore reduce its tax liabilities.
Lenders want to know that they will get their money back, the projections need to show:
- How much money does the business need and how will it be used?
- When is it needed and how long for?
- That the loan and interest can be repaid from cash-flow
- That security is available if it all goes wrong?
- How much the owners have invested?
- Is management information useful and up to date?
Different Finance in a Business for Different Stages
Different types of finance are suitable at different stages in the development of the business. The following chart summarizes the use of the major sources of finance.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.