The types and sources of capital available to a business depend on where the business is in its lifecycle: true start-up (no sales yet) or “post-revenue” (it has started earning money) or expansion.
The first source of financing for most businesses are the owner(s) personal assets or loans/gifts from friends and family. Your personal resources can include using credit card debt, selling assets for cash, bartering for goods and services needed by your business, cash advances on a life insurance policy, or other sources.
Once a business has grown past its initial stages and cannot fund growth from its revenues, it may need to look for other sources of capital for expansion, to buy inventory, or other needs. The key types of capital are debt and equity.
Debt Financing
If you’ve borrowed money to buy a house or a car, you know what debt financing looks like: you go to a bank or specialty lender and apply for a loan. The lender looks at your earnings history, assets, and general creditworthiness and decides whether you’ll be able and likely to repay the loan. If so, the lender loans you the money.
On a set schedule and at an agreed-upon interest rate, you repay the loan. Once it’s paid, you get your car title or house deed, and you and the bank are done.
In the same way, a business applies to a bank or specialty lender. The lender evaluates the company’s ability to repay the loan. For a new or small business, the lender will check the owner(s) personal credit as well as the business’s creditworthiness. For businesses with few assets to pledge as collateral (assets the lender can seize to repay the loan if the borrower quits paying), a lender will usually require a personal guarantee from the owners on the loan, which means the bank can come after the owner’s house or other personal assets if the business loan isn’t repaid.
With recent government regulations, banks and other lenders must meet tougher guidelines for judging borrowers’ creditworthiness. Most small businesses don’t qualify for loans if they really need the money!
The federal government’s Small Business Administration (SBA) may be an option. The SBA works with banks and guarantees portions of loans made to small businesses. See https://www.sba.gov/loanprograms for information and guidelines.
Equity Financing
Equity financing isn’t a loan that must be repaid. Equity financing means the business gets funds in exchange for part ownership in the company.
Friends or family members, angel investors, venture capital firms, or public stock sales are sources of equity financing.
Angel investors and venture capital sources are discussed in more detailed later Lessons.
These equity investors own part of your company and have a right to be involved in decisions—until you sell the company or buy back the investors’ interest. As discussed later, having investors who are knowledgeable about your business and its market can be a significant asset, but you must weigh the pros and cons.
Mezzanine Financing
Mezzanine means “intermediate” financing. The precise definition varies, depending on who is loaning the money, the stage of the business’s lifecycle, and the terms negotiated.
Typically, a company looks for mezzanine financing at an interim stage of growth, as it moves from one level to the next. Any source (angel, bank, venture capital, insurance company, other lender) can provide mezzanine financing.
One advantage of mezzanine financing is that the lender and borrower can negotiate how to represent it: either as equity (ownership) or as debt (a loan). If the lender agrees to let the borrower show it as equity, the company doesn’t appear to be carrying too much debt. They can also agree to shift a loan to equity shares, giving the lender some control over the business if circumstances change.
If the lender has an equity stake in the business, the involvement in the business can make it easier to get the funding, without quite as much due diligence as a loan might require.
In other words, mezzanine financing is whatever the parties negotiate and can provide some creative interim options for a growing business that already has a track record of success. This is not, however, typically an option for new businesses.
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