Business Finance : A much needed fuel for your business

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Business Finance: A much-needed fuel for your business

No matter what stage your business is, business financing is one of the most tiresome tasks that the entrepreneurs face. Today there are several business finance options available in the market. The most popular business finances are venture capital, angel investors, traditional bank loans, IPO (Initial Public Offering), etc. From the plethora of choices, finding the best one suitable for your business is challenging. Yet, bank loans attract most of the business owners. Despite being the grand-dad of business finance, conventional bank loans are one of the most preferred choices. This debt-financing doesn’t involve surrendering the ownership of the business or melting your control on business. Moreover, bank loans carry a lesser interest rate than other business finances.   

Business Finanace

Equity Financing vs. Debt Financing

Equity and debt are the two categories of business finance. Below is the comparison of these two types of financing.

Basis Debt Financing Equity Financing
What is it? Debt financing is an agreement between the borrower and the lender. The entrepreneur borrows a sum from the lender and agrees to re-pay the principle and interest over a period. The various debt financing options are loans, overdraft, asset finance, and ABL (Asset Based Lending). Equity Financing refers to raising a sum through the sale of shares. Unlike debt lenders, equity investors have no right for interest or to have their capital re-paid on a specific date.  Instead, they get dividends and capital appreciation. Various equity financing options are angel investors, VCs, PEs, IPO, and equity crowdfunding.
Suitable for whom? Debt financing is suitable for established businesses. While applying for this type of business finance, you need to produce information about financial performance, collateral, credit report, etc. Equity financing is for businesses that are at the early stages, and have a low credit rating. It’s also suitable for businesses having high growth potential. Businesses that don’t have a robust track record can also go for this category of business finance.
From where to obtain it? Banks 

Loans through SBA (Small Business Administration)

Asset leasing companies

Investment banks

Large corporates

Angel investors

Venture capitalists

Private equity firms

From existing shareholders through a right issue

Advantages
  • In debt financing, there is no risk of losing control. The only obligation that the borrower has to the lender is the repayment of debt on time.
  • You can customize the debt financing according to the necessity of the business.
  • Compared to equity finance, repayment terms are more straightforward. Depending on the conditions, you can make the repayment. 
  • Interest payments fetch tax relief in the way of the borrower.
  • In debt financing like an overdraft, the interest is paid only on the amount used. In invoice finance, the equivalent of interest is payable only to the amount drawn. It gives great flexibility to the borrower.
  • A business can raise finance through equity at any stage of its business.
  • Equity financing is all about the dilution of ownership. Hence, in return, it brings broader expertise with it.
  • While acquiring the shares, equity investors expect a higher return than the debt lenders. An enhancement in the value of their stake can result in the deployment of additional capital in the business. 
  • Equity investors get involved in the business with the owners. Together, they work for the growth and profitability of the business. It results in increasing the value of the business at a faster pace.
  • Fundraising through IPO opens the door of a liquid market. It makes the fundraising for future growth plans easier.
  • The cash generated from the business can reinvest in the business rather than paying off the debt.
  • Equity financing allows the entrepreneurs to focus more on the business than bother about the repayment of debt.
Disadvantage
  • An erratic or seasonal cash-flow from the business can put pressure on the borrower.
  • The borrower needs to pay the penalty for the late repayment and also for exceeding the overdraft limit.
  • For more significant amounts, collateral is necessary.
  • The borrower should take care while setting the repayment terms. Otherwise, they may land in rigid repayment schedules, which can create a lot of stress.
  • Debt financing is a lengthy and time-consuming process. The lenders may ask a lot of information like credit history, the track record of the business, etc.
  • Financing business through equity is costly and demands ample time.
  • The owners of the business lose some control in the business as equity finance involves dilution of ownership. 
  • Depending upon the amount of stakeholding, the investors try to influence the strategic decisions. 
  • The investors may demand regular information and complex reports about the business. It may take away the attention of the management from the business. 
  • Fundraising through IPO requires a plethora of disclosures and governance details. 
  • Dividends are not deductible for tax purposes.

 

Duration of the loan/ investment Usually, for short-term debt financing, the repayment period is less than a year. While for long-term debt financing, it’s more than a year. On average, VCs and angel investors stay in business for 3-7 years. On the other hand, PE firms never stay for more than ten years in any business.

 

Which are the different types of business finances?

 

  • Angel Investors

Angel investors are affluent selves who invest in businesses that have high growth potential and are at an early stage. They even invest in established businesses for their expansions. 

Angel finance is the most suitable equity financings for firms at pre-profit, profitable and growing, and established and growing stages. The most significant advantage of angel financing is that it’s less risky than other business finance options.

Usually, angel investors put money in businesses they understand very well with a long-term perspective. Their skill and experience help the companies, especially those in the early stages, to grow fast. Most angel investors focus on a particular terrestrial area for investments. It helps them to bring the local knowledge and network into the business that aids the business to prosper further.

These days angel investors invest through an angel syndicate or club. Under this, the investors give their money to the syndicate that is managed by professionals. This syndicate management team takes investment decisions.

  • Venture Capitalists (VCs)

Venture capitalists invest in businesses that have competitive advantages and are at the pre-profit stage. IT, pharma, and technology are the favorite sectors of VCs. 

Usually, VCs are companies that are managed by professionals. So with the wealth, they bring a lot of experience also in the business. VCs involves in the everyday affairs of the business and also take part in strategic decision makings. They play an active role in the board of the company as well. VCs look for higher returns from their investments, usually more than 25%. So, they stay in business for an extended period, typically 5-7 years or till the business gets matured. 

  • Private Equity (PE)

Private equity firms invest in mature businesses to improve their profitability through operational improvement. PEs invest in companies that have huge growth potential with a long-term perspective. 

PEs help the companies to generate revenue by foraying into new territories and adding new products as well as services. They even help the firms to organize the value chain, increase the market share, and expand their workforce. In short, PEs provides a platform for the firms to grow by bringing a structure and discipline in the business.

PE firms typically stay 5-8 years in the business. After this period, they sell their investment to either another PE firm or corporates. 

  • Equity Crowdfunding

Equity crowdfunding is a relatively new form of business finance and is an alternative for VC and angel financing. Crowdfunding is done online and gives access to everyone to invest in private companies. It refers to funding a private business by selling the securities to a large number of investors. Equity crowdfunding is suitable for start-ups, early-stage business as well as growth companies. Through equity crowdfunding, companies can raise a maximum of $1.07 million in a year.

There are various funding portals available for equity crowdfunding. Before applying for equity crowdfunding, you need to show that the business is investment-ready. A few crowdfunding sites offer both equity and debt finance. 

  • Public Listing
  • Raising finance through public listing is suitable for profitable businesses that are established and stable. Going for public listing means taking the business to the next level. Public listing or IPO gives liquidity to the shares of the company. The firms can raise funds through public listing for:
  • financing the expansion of the business, 
  • acquisitions, or 
  • expanding the base of shareholders.

The problem with public listing is that it’s a long process. The public listing requires preparations for many months. The companies need to produce an array of documents and records while filing for IPO. 

The public listing process has two parts, i.e., pre-IPO phase and IPO process. The pre-IPO step involves the scrutinization of all documents and records. Assessing the efficiency of the management, tightening the internal control, and improving operational efficiency are part of this phase. 

  • SBA Loans(Small Business Administration Loans)

SBA loans are suitable for those businesses that have limited revenue and have no or fewer assets to guarantee. SBA loans have a unique eligibility criterion. It depends on the nature of ownership, where the business is physically located, and the type of business. The size of the business, ability to repay the loan, and the purpose of the business also matters. 

The benefits of SBA loans are:

  • lower down payments
  • flexible overhead requirements
  • a few SBA loans are available sans collateral
  • interest rates and fees are in line with unsecured loans
  • many SBA loans offer support to start and run business

The amount of SBA loans range from $500 to $5.5 million. They can be used for almost all business purposes while there’re restrictions on some loan programs. 

Various types of SBA loans are:

  1. 7(a) loans for working capital requirements, purchases of fixed assets, and business expansions. 7(a) loans offer a maximum amount of $5 million. You get 7(a) loans through banks, credit unions, and specialized lenders. 
  2. 504 loan programs are also known as real estate and equipment loans. The borrower can use this fund for the purchases of equipment and land. 504 loans also offer a maximum amount of $5 million.
  3. Disaster loans are small-size and low-interest rate loans. These funds are for the repair and replacement of real estate, equipment, and machinery that is impacted by natural disasters. The maximum amount of disaster loans is $2 million.
  4. Microloans fulfill the needs of working capital, purchase of fixed assets, and inventory. They can also be used to meet the demand for starting a business.

SBA loans require a lot of paper works and take ample time for approval. They’ve stricter eligibility criteria, and the borrower needs to pay more fees than conventional loans.

  • Conventional Bank Loans

Low-interest rates, faster approval, shorter repayment times, and flexible repayment conditions are a few characteristics of bank loans. At the same time, it’s difficult to get bank loans, as most of them require a guaranty or personal collateral. 

The interest rate of bank loans can be either fixed or variable. It’s better to go for a fixed-rate when the interest rates are low. At the same time, the variable rates will be adjusted based on the interest rate index. 

  • Overdrafts

Overdrafts are used to meet short-term fund requirements and working capital needs. The availability of overdraft largely depends upon the market conditions. To get an overdraft, the owners need to show how the business will generate future revenue to repay the debt. 

  • Peer-to-peer lending (P2P)

Peer-to-peer lending is the substitute for bank loans. It’s cheaper and quicker than bank loans. The amount of P2P loans ranges from a few thousand to several million. The upper cap of P2P loans varies with the industry. 

P2P loans usually come under individual loans or personal loans. So to get this loan, the borrower needs a good credit score.

  • Asset-based Finance

Invoice financing (IF) and Asset Based Lending (ABL) are together called asset-based finance. 

ABLs are short-term loans used for working capital purposes. These loans are secured, and their amounts depend on the value of the collateral.

Invoice financing refers to borrowing money against the unpaid invoices. Invoice financing is one of the best ways to raise funds for working capital. Usually, it’s available to products and service-based businesses.

Typically customers take 15 to 90 days to pay the invoice. Invoice financing solves the problems that the businesses face due to the longer payment time takes by the customers. 

While raising funds in this way, the businesses pay a part of the invoice amount to the lenders as fees. Invoice factoring, invoice discounting, and single invoice finance are various types of IF.

  • Asset Finance

Many times financial constraints keep the firms away from machinery, equipment, and other fixed assets that are necessary for business. Asset finance helps the firms to acquire a plethora of assets- ranging from office equipment to machinery and vehicles. Equipment leasing, hire purchases, finance leases, operating leases, and asset refinancing are various asset finances.

In asset finance, the need for additional collateral is less as the asset financed acts as the security. Asset finance gives more flexibility to the borrowers as the lender can’t recall the finance during the agreement period. 

What are the prerequisites of business loans?

You need to check a few facts before applying for a business loan. As business loans involve a lot of risks compared to other loans, your application needs to go through a strict screening. It makes the application process a more extended event. Usually, you need to submit several documents and produce many business details along with the application. 

The following are the widely asked information:

  • At what stage is your business? 

The business must have a track record of at least two years to get the loan. New businesses and start-ups may find it challenging to get funding through loans as they have a negligible track record.

  • The age and qualification of the business owner

It’s one of the primary criteria. The lenders always check whether the owner has an understanding of the business. If the age of the business owner is beyond 65, then the loan processing may face roadblocks.

  • The financial details of the business

While applying for business loans, the owners need to produce the following financial information of the company:

  1. Audited income statement and balance sheet of the company
  2. Details of the accounts receivable and payable
  3. Details of the past and current loans, if any.
  4. Documents related to investments, debts, credit card accounts, etc.
  5. Tax details 
  • The credit report of the business
  • A credit score plays a vital role in the loan approval. The lenders verify the credit score of the company as well as the owner. If the business is at an early stage, then the lenders consider the credit score of the business owner. If the score is below 650, then getting a business loan may be difficult.
  • The collateral

Almost all business loans require collateral or guaranty. It can be land, equipment, machinery, etc. 

  • The outlook of the business
  • Making a robust business plan is very crucial in business finance. A specific and solid business plan helps you to get funding promptly. It helps the lenders or investors to understand the nature of the business, its outlook, and the risks. A well-written business plan also implies the management’s ability to understand the business.

Final thoughts

Before finalizing the type of business finance, it’s necessary to compare various options and their interest rates/fees. The business owners should make a repayment plan in advance to keep the repayment pain at bay. For early-stage businesses, equity options look more attractive and comfortable. While mature enterprises have the luxury to select either debt or equity financing option.

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