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 maximum or peak funding and for how long the funding is needed. The next question is how and from where the 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.
Equity investors do not normally require security, and share the risks and rewards of ownership of the business.
The cost of equity finance arises because part of the ownership of your business is sold in return for the funds and a percentage of the profits will now belong to another party.
The share of profits is paid out as a dividend to the shareholders. As dividends are not treated as an expense, they do not normally reduce the tax liabilities of the business.
Investors want to know they will get a return on their investment:
- How much money could be lost?
- 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.
- What dividends will be paid?
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, and will impose performance related criteria, called covenants, for the loan to be maintained.
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 can normally be charged as an expense and therefore reduce the tax liabilities of the business.
Lenders want to know that they will get their money back, the projections need to show:
- How much money is needed and what is it going to be used for?
- 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?
- Management information is up to date and being used.
Different Finance in a Business for Different Stages
Different types of finance are suitable at different stages in the development of the business, these are summarized in the chart below.
|Family and Friends loans|
|Bank loans & overdrafts|