Types of Capital for Entrepreneurs

The following is a brief description of the types of capital available for small businesses which will help you understand the options that are most attractive and realistically available for your particular business. In no way is this meant to be a comprehensive listing and is designed to get you acquainted with the most common terms and places where you can obtain financing.

1. Debt Financing

Debt financing means borrowing money that is repaid over a period of time, usually with interest. Debt typically carries the burden of monthly payments, whether or not you have positive cash flow. Interest on the loan is deductible and the financing cost is a relatively fixed expense. Debt financing is usually available to all types of businesses and most business owners go to their banks for such loans. In smaller businesses, personal guarantees are likely to be required. Debt financing includes asset-based financing, leasing, trade credit and various loans that require repayment, with accumulated interest, at some future date. Debt financing does not sacrifice any ownership interests in your business.

2. Equity Financing

Equity Financing is an exchange of money for a share of business ownership. It generally comes from investors who expect little or no return in the early stages, but require much more extensive reporting as to the company's progress. They have invested on the gamble of very high returns and scrutinize how well you have put their money to use. Such investors anticipate that goals and milestones will be met. Equity financing is generally for businesses with fast and high growth potential. The major disadvantage to equity financing is the dilution of your ownership interests and the possible loss of control that may accompany a sharing of ownership.

Typically, financing is categorized into two basic types: debt financing and equity financing, and under these categories, there are various modes of implementation. Debt and equity financing provide different opportunities for raising funds and a commercially acceptable ratio between debt and equity financing should be maintained. From the lender's perspective, the debt-to-equity ratio measures the amount of available assets or cushion available for repayment of a debt in the case of default. Excessive debt financing may impair your credit rating and your ability to raise more money in the future. If you have too much debt, your business may be considered overextended and risky and an unsafe investment. In addition, you may be unable to weather unanticipated business downturns, credit shortages, or an interest rate increase if your loan's interest rate floats. Conversely, too much equity financing can indicate that you are not making the most productive use of your capital; the capital is not being used advantageously as leverage for obtaining cash. Too little equity may suggest the owners are not committed to their own business.

Lenders will consider the debt-to-equity ratio in assessing whether the company is being operated in a sensible, creditworthy manner. Generally speaking, a local bank will consider an acceptable debt-to-equity ration to be between 1:2 and 1:1.

3. Angels

Angels are individual private investors who make up a large portion of informal venture capital. These investors tend to invest small amounts, and they can be difficult to locate because they usually don't belong to networks or trade associations.

Angels are found among friends, family, customers, third party professionals, suppliers, brokers and competitors. There are a few private investor locating services out there. Do your homework, check these people out and negotiate a commission if your request is placed.

The interent is a good place to find out about angels. There is a SBA sponsored website that shows some promise (though not yet realized) for businesses looking for Angels. It is called Access to Capital Electronic Network, better known as ACE-Net. For entrepreneurs, ACE-Net links small companies looking for angel investors to invest between $250,000 to $5 million. The ACE-Net listings use federal securities Regulation D, Rule 504, to raise up to $1 million, or Regulation A to raise up to $5 million, and must meet the corresponding state securities requirements. A majority of the states have adopted new initiatives to permit companies raising less than $1 million on ACE-Net to use a "short-form" listing that significantly reduces the effort. This permits a company to file a simplified single listing along with their business plan.

4. Venture Capital

Venture capital comes from private individuals, investment bankers, or other private financial syndicates, or, on a small loan scale, the SBA. Venture capitalists offer limited financing opportunities for a small population of companies. There just isn't enough venture capital to go around and the $7.4 billion or so the nation's venture capital partnerships started with in 1998 is just a fraction of the estimated $50 to $60 billion America's high-growth companies need each year. These funding sources get thousands of requests each year and only invest in a small number. In general, 80% of a venture capitalist's portfolio is in technology.

5. Joint Ventures/Strategic Partnerships

This is where two or more companies with parallel interests get together based on their mutual needs: They have the money, you have the plan. You have the product, they have the distributors. Do your homework. Seek out companies with parallel interests to your own. This requires much more research than simply asking for a loan. Most of these partners will settle for 20% to 40% equity in your company. Be careful to protect your ideas by having any potential partners sign a non-circumvention document.

6. Small Business Administration (SBA)

A tremendous resource, but the paperwork can be tiring. This is a great place to look. The SBA has many different programs which are implemented through banks. The most common loan program is called the SBA 7(a) loan. This means that the bank will finance the project minus the required injection and the SBA will guarantee up to 75% of the project. The bank sets the rates and the terms of the loan, which can be from 7 years to 25 years. The maximum guarantee is $750,000. There is a SBA guarantee blended fee of 3% on the first $250K, 3.5% on the next $250K and 3.875% on the last $250K of the guarantee. To learn more about the SBA, click here.

Also, your local bank should have an SBA loan officer who can explain them to you. SBA loans require a personal guarantee. This program is also used for restructuring existing debt. This is a guarantee from the SBA and not an actual loan.

7. Small Business Investment Corporation (SBIC)

Hi-bred is a close description. These firms leverage their private capital into government money to form a sort of venture capital fund. Most SBICs are part of commercial banks. They offer both long term loans and equity participation. They are generally conservative in the placements, investing only in established companies for management buyouts, funds to go public, strategic partnerships and bridge financing.

8. Commercial Paper

This is a short term debt instrument typically issued from 2 to 270 days. An issue is normally a promissory note that is unsecured and may either pay interest or be sold at a discount off the face value that is paid at maturity. Commercial paper is considered safe by big investors even though the loans are usually not backed by any specific collateral. They are normally issued only by very solid firms and may also be backed by bank lines of credit, letters of credit or some other from of credit guarantee. The company may pledge assets to obtain a credit guarantee which is then leveraged into an issue of commercial paper. Usually, only very large banks, corporations, and mutual funds are involved in such transactions.

9. Letters of Credit

A financial instrument used in international trade but can be used for domestic transactions as well. A letter of credit is essentially a set of instruments from a seller's bank to the buyer's bank. The instructions stipulate the conditions that both parities must meet in order for payment and delivery to take place. There are various types of letters of credit. The bank might issue the L/C based on your pledge of a receivable or other hard asset.

10. Receivable Factoring

Factoring is an arrangement in which you raise cash against the value of your receivables for a hefty interest charge. This can be a costly means to raise short-term capital. But since it's undeniably an option, especially for those companies that can't raise funds from banks, it makes sense to explore this option. Basically, funds are advanced against goods sold, accepted and not yet paid for. Normal advances on accounts receivable are 80% to 90%. The lenders are looking for ninety (90) days or less to be paid. Funding is available for older accounts receivable, but the rates take a dramatic turn upwards.

11. Purchase Order Advances

Leveraging your future. If you have purchase orders with your customer base, you may be able to get advances towards their completion. The typical advance is less than 50%, and the rates are very high.

12. Equipment Leasing

You can think of this as renting assets. You gain the capital equipment you need and agree to pay rent for a specific period of time. There is no interest rate here, but the rates tend to be higher than commercial loans. Some of that is offsetby being able to expense 100% the payments (pretax). Check with your tax accountant to be sure.

13. Asset Sale Lease-Backs

If you are cash poor and asset heavy, this may work for you. Here you are selling your asset for cash to a funding source who leases it back to you (typically with a lease end purchase option). This is most commonly used in commercial real estate transaction but can also apply to various other assets.

The benefits of a leaseback are: it frees up capital; the rent or payment you make can be deducted as a business expense; if you sell and lease back, you maintain an interest in the property; and it may allow you to buy back the property at the end of the lease period.

14. Private Placements

Private placement is the general term for several kinds of stocks or bonds that are sold directly to investors; cannot be resold on the public market; and are not required to be registered with the SEC. Even though private placements need not be SEC registered, they are subject to state securities regulations and to US fraud statutes. A Private placement is a way to raise capital with a small number of investors (typically less than 35). These are now available in a boilerplate format in most states. Contact your state's Department of Corporations for information on what is required to stay out of trouble.

15. Initial Public Offerings (IPO's)

Forms of stock offerings that let you raise more money if you are willing to negotiate the perils of the capital markets. In order to go public, a company must register the IPO with the SEC and become subject to the SEC regulations for a publicly held company. In 1998, there were about 700 initial public offerings compared to about 800,000 new businesses that were formed. The cost for an IPO is quite high and is, thus, not the way most businesses raise money. However, for certain businesses it is often the only way to generate the huge influx of money needed.

16. Limited Partnerships

In a limited partnership, one or more general partners are responsible for the actual management of the business. One or more limited partners provide investment dollars but normally have no management input. Limited partners have no responsibility for debts or litigation losses the company might incur and the general partners bear all those risks. Limited partnerships usually exist for the purpose of investing. The general partner has all the exposure and management duties, while the limited partners have put up all the money.

There are numerous Limited Partnerships out there that have been formed to invest in businesses. You can search them out or inquire with your State as to the requirements for forming your own.

17. Convertible Debt

Convertibles are typically corporate bonds or preferred stocks that are issued with provisions allowing the holder to exchange them for (convert them to) a fixed number of shares of common stock at a specified price. These are most common with seed or start-up funding where the lender would like a piece of the rock in the event you become a tremendous success.

18. Lines of Credit

A revolving account that is continuous in its nature. The funds are available as draw downs against the total line. These types of accounts are most commonly secured with accounts receivable and inventory as collateral.

There are numerous creative ways to finance your business. If one of those comes your way take a moment to investigate it. You can never know too much about how to capitalize your business.