By: First Union
What is Debt and Equity Business Financing and Can it Help?
What is business financing? Are there different types of business financing? What is debt financing? What are the pros and cons of debt financing? What is equity financing? Why would I want to obtain equity financing? What is mezzanine financing and how do I get it? Can I get business financing through a family member or friend? What is off-balance sheet financing?
Business finance refers to money and credit employed in your business. Finance is the foundation of business because it is a necessity to purchase assets, goods, raw materials, and other economic activities. Ultimately, business finance is the provision of money at the time when it is needed by your business.
But what kind of business financing is available and what works best for your business? Consider the following options:
Debt financing comes from a bank or other lending institution when your business raises money for working capital or capital expenditures by selling debt instruments. By the lender providing the funds, they become creditors and receive a promise that the principal and interest on the debt will be repaid. If you have a mortgage or car loan, you have personal debt financing.
When you decide your business needs a loan, you fill out an application and they run a check on your business's credit (or if your business is still young, they will run your credit report/). If that goes through, for due diligence, the lender will want to review your financial trackers and official accounting books.
Tip: If you are seeking any type of business financing, take the time to organize your business records and ensure everything has been filed and completed. This will streamline the process of applying for business financing.
When your business is approved for business financing, the lender will set up payment terms with you and let you know of your interest rate. It is similar to obtaining a personal bank loan.
Some of the pros of debt financing include:
- The lender has no ownership of your business, so they have no say in or control of how you run your business.
- Once you pay back your loan (which increases the value of your business/), your relationship with the lender ends.
- Interest paid on a business loan is tax-deductible as a business expense.
- The monthly payments will not fluctuate - they are fixed and you know what to expect month-to-month.
You should also consider the cons of debt financing, which include your monthly payments increasing for a set period and the possibility of not being able to obtain business financing during financial recessions.
At the end of the day, debt financing is most likely the route you will take to expand your business, as it is the most commonly used financing decision made by businesses in the United States.
Equity financing is the process of raising capital through the sale of shares, which means your business decides to raise money because you have a short-term need to pay bills or have a long-term goal that requires funding to invest in your business's growth. When you sell shares of your business, you sell ownership in your company in return for cash, like stock financing. Equity financing does not only come from a bank, but it can also come from entrepreneurs, friends, family members, investors, venture capitalists, or by filing an initial public offering (IPO/) for your business. If you have ever watched ABC's Shark Tank, you are watching the process of obtaining equity financing.
Equity financing is not as simple as obtaining debt financing lending. You need lawyers, accountants, and investment advisors to make sure everything goes smoothly and your books are clean and available to potential investors.
Some of the advantages of equity financing include:
- You do not have to pay back the money. If your business files for bankruptcy, your investor(s/) are not considered creditors, so they lose their money as well.
- Investors tend to understand that businesses are not built overnight. You will get the money you need without the pressure of having to see your product or service up and running in a short period.
- You do not need to make monthly payments, so your financing is liquid for operating expenses.
Of course, with the pros there are cons, which include partnership; you are not the sole decision-maker and your business moves and ideas will always need to be brought to "the board". Also, you only keep the percentage of money that is yours. If your company makes a profit of $100,000 in its first year, and your investor owns 45% of your company, $45,000 goes to them and you take home $55,000.
Mezzanine financing is a combination of debt and equity financing that gives the lender the right to convert to an equity interest in the company in case you default. Mezzanine debt has equity instruments attached (warrants/), which increase the value of the subordinated debt and allow greater flexibility when dealing with bondholders. Mezzanine financing is often associated with acquisitions and buyouts, because it may be used to prioritize new owners ahead of existing owners in case of bankruptcy.
Advantages of mezzanine capital are:
- If you are a new business showing growth but banks hesitate to invest, it is easier to obtain because banks are less liable. This makes it so you do not need the three years of financial reporting to the IRS.
- On the books, mezzanine capital is equity, which makes your business look more attractive to future lenders.
- You can get your capital fast!
However, you tend to pay a higher interest rate since your lender views your business as high risk and you do stand the risk of losing a significant portion of your business.
Personal Relationship Financing
You can obtain lending from friends and family. You may have a friend or family member that believes in your business and can work with you (most of the time in a flexible fashion/) for repayment terms. You also will most likely pay way less interest on this loan, as there is a personal relationship at stake. However, remember that the saying "you shouldn't mix business and family" exists for a reason…
No matter how you obtain business funding, always remember to keep a professional demeanor regarding repayment, representation, and interpersonal interactions. Business financing can launch your business into the next chapter of its offerings and impact on the community (and your wallet/).
Do You Want to Look at Your Financing Options?
If you find yourself needing to find funding for your business, First Union Lending is here to help.
We have nine different business loan types to choose from. This means that we're uniquely qualified to help you find the perfect loan to open your small business.
Applying for a business loan doesn't affect your credit. Better yet, your business loan may be approved as soon as the same day.
To discuss our business loans with one of our lending experts, click here or call 863-825-5626. We'll talk about our various business loans and help you find the right one.
Get started with the process now by learning more about our business loan types.