Debt vs. Equity Financing
Before you start pursuing financing options, you need to establish an approach. What type of funding do you want? What will you do if your first choices don’t work out? There are many financing options available, depending on your needs and strategy. Make sure you’ve done all your research and business planning so you know how much financing you’ll need.
Find a Balance Between Debt and Equity Financing
Ideally you should have a balance of equity and debt financing:
- Equity financing: securing investments from yourself and others in exchange for partial ownership and/or a share in the business’ profits and losses.
- Debt financing: borrowing money from lenders that must be repaid with interest no matter what.
Types of Equity Financing
Equity capital is the amount of money that you and your partners put into the business or raise from other investors. Equity is not debt. While investors share in the profits (and losses), their investment is not a loan. Make sure you consult your lawyer and your accountant before you enter into any kind of equity agreement—they will have a major impact on the future of your business.
Personal Investment: From Yourself, Friends, or Relatives
Personal savings, securities, real estate, and other personal assets are your most obvious sources of cash. Friends and relatives can provide additional funding. In most cases, the small business owner must assume the largest share of the risk by making the largest investment.
Personal investment in the business demonstrates a faith in and commitment to your business. This is important to other potential investors and lenders. Banks and other lenders have rules about how much investment they require before they will lend money to your business. This is sometimes called the debt-to-equity ratio, and it varies depending on the type of business.
Partner Investment: Full Partners and Silent Partners
If you cannot supply all the equity capital you need, you can also find partners who are willing to invest money into your business. You will usually share ownership with your partners, including profits and liabilities. In most cases, your partners will also want a say in how the business is run.
If you don’t want to share decision-making authority, you can take on limited partners, sometimes called silent partners. They contribute financially to your business without participating in management or controlling the partnership. Limited partners are normally only responsible to the business or its creditors in proportion to the amount they have invested, and liable only to the extent of the amount of capital they’ve contributed.
If you are considering a partnership agreement, make sure you seek legal advice.
Shareholder Investment: Public Corporations and Private Corporations
If you have incorporated your business as either a private or public corporation, you can take on shareholders to finance your business. Shareholder investment is complex—make sure you seek qualified legal advice from an experienced lawyer and have a shareholder agreement in place.
A private corporation can have up to 50 shareholders, but it cannot sell shares to the general public. The vast majority of new small business corporations are private. Company ownership is shared by all the shareholders, usually in proportion to their investment. Make sure you talk to a lawyer about who to approach for investment, and how best to start.
You must be able to demonstrate the viability and profitability of your business to attract potential shareholders. It can be difficult to attract shareholder investment before a new business launches.
Public corporations can sell their shares to anyone, providing the best opportunity for raising equity capital. But offering shares to the public can be a long, complicated, and expensive procedure. You must file a detailed business operations prospectus with the Alberta Securities Commission.
When your business gets larger and more successful, a public share offering can be a great way to raise funds.
You can also raise funds by asking your employees to invest in your business. Your options include:
- Making a partnership offer to your best employees
- Selling stock to your employees as a form of profit-sharing (if your business is incorporated)
Employees can be a great way to raise equity: they understand your business, trust the management, and can keep a close eye on their investment. Investing can improve your employees’ working habits too—they will benefit from your shared success.
The disadvantage is that it can be difficult to remove or replace employees that have invested in your business if they become unproductive or uncooperative.
Venture capital firms provide equity financing for businesses, usually for high-risk enterprises with great potential. Most venture capitalists plan to liquidate all or part of their investment at a substantial profit within five to ten years—they are not lifetime investors.
Venture capitalists are looking for:
- Fast growth potential
- Great management
- Substantial financial commitment from the business owner
Most venture capitalists will not want to become involved in your day-to-day operations, but they will often want representation on your board of directors.
Types of Debt Financing
Debt financing is money you borrow for your business. It must be repaid with interest. Lenders do not share in your business profits (as investors do), but they must be repaid no matter what—even if you have no profits.
Once you have secured all the equity capital you can, you can talk to lenders about a business loan. Different lenders have different requirements for awarding loans—make sure you understand them before you start.
To decide what type of debt financing is right for your business, remember these basic rules:
- Finance day-to-day operations (working capital) with short-term operating loans
- Finance long-term fixed assets with longer-term loans or mortgages
Potential lenders in Alberta include:
Small Business Services Canada has a detailed description of the debt financing options available.
Business Term Loans: Longer-term Loans for Financing Fixed Assets
Major purchases like land, buildings, and equipment are usually financed through a combination of equity capital and business term loans, sometimes called fixed-asset financing.
Business term loans can last anywhere from one to 15 years, depending on the useful life of the asset you’re purchasing. If you cannot repay the loan, the asset you’re purchasing will be repossessed by your lender.
Lenders will only finance a percentage of the asset’s value—75% of a truck’s value, or 80% of a building’s value, for example.
The benefits of a business term loan are:
- Your loan agreement is based on your ability to repay the loan out of your earnings—it’s less likely you’ll end up with a loan payment you can’t make.
- As long as you meet the terms of your loan agreement, there are no other payments to make—no profit-sharing or salaries, for example.
- You can build a long-term working relationship with your lender, in case you need more financing in the future.
To secure a long-term loan, you must convince lenders that your business is viable and will be profitable over time. Some lenders may require your personal guarantee—if the business cannot repay the loan, you will be personally responsible for it.