This article is an extract from LegalVision’s Online Business Manual. Download the full Manual here.
How to Finance a Growing Business
There are two common ways to finance a growing business: debt finance and equity finance. Whether you choose debt or equity depends on your business’ cash flow and the amount of capital you need to grow your business.
Debt Finance vs Equity Finance
Debt financing is where you borrow an amount from a lender, such as a bank or credit union, and repay the amount plus interest over a period of time. The ‘price’ to access the capital is the interest payments.
Equity financing is where you trade shares in your company for cash. The ‘price’ to access the capital is some number of shares in your company. Providers of equity finance include angel investors, venture capital funds and private equity funds.
Which Should I Choose For My Business?
Equity finance is advantageous because you share the risk of your business with your investors — if your business is unsuccessful, you don’t need to pay your investors back.
In exchange for accepting this risk, investors share in the company’s profits. Also, equity finance does not put a strain on your cash flow, because there’s no need to make interest payments. But equity capital can be hard to come by because there are far fewer equity investors than debt financiers.
Debt financing is easier to access for most businesses, and you retain ownership of your business. Some lenders require you to provide security for their loan — you give the lender the right to seize certain assets if you default on the loan. Take care when providing a security — although it will reduce your interest payments, it also puts your assets at risk.
There are different debt finance options, depending on your growth goals. If a small business aims to conduct business in overseas markets, trade products (such as letters of credit and open account terms) work well as they help to manage fluctuating exchange rates and credit risk. If a business needs to buy inventory and equipment or wants to expand its team, a simple term loan is the most flexible and the best option for small businesses. Typically, you can choose a fixed or variable interest rate. The choice depends on your risk appetite.
Most businesses will finance their business through a combination of debt and equity to balance the pros and cons of each option.
Practical Tips When Assessing Debt Financing Options
Understand your business’ accounts
Cash flow issues can arise when businesses take on excessive amounts of debt. Limiting your business’ debt will also help with your credit rating, and your ability to apply for further funding.
Plan for the future
Work with your lender to achieve the cash flow requirements of your business. For example, if your business experiences fluctuations in sales during the holiday season, ensure your debt financing solution will help you manage any seasonal cash constraints.
Keep the lines of communication open with your lender
If you expect that adverse business conditions will affect your ability to make loan repayments, communicate with your lender early to avoid defaulting on your loan. Lenders can often relax repayment conditions for short periods, but only with prior warning.
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