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Financing is the activity, process, or instance of raising or providing funds for an enterprise (or the funds thus provided). Financing transactions take place between a business and its investors (equity financing) or between a business and its creditors (debt financing). Individuals also use debt financing for certain large purchases such as residential real estate and motor vehicles.
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Equity FinancingRaising capital through equity differs from debt financing in that debt must be paid back with interest while equity involves giving away a portion of the company. Equity can take on various forms depending on the structure of the business, but always has a positive impact on the company's balance sheet and allows the business to retain cash flow. However, one of the biggest disadvantages of equity financing is that the founder's percentage of ownership is decreased with every fraction of ownership that is sold.
Corporations commonly issue common stock or preferred stock which may be retained until the investor decides to sell them or the corporation decides to buy them back. C corporations often issue common stock to founders, officers, directors, and initial investors, and may pay out dividends on these shares. Dividends are paid out of earnings and profits, and cannot be paid out unless the company is generating income. Common stock allows the holder the right to one vote per share on all matters decided by the shareholders. Preferred stock allow the holder to receive dividends before holders of common stock, but they must give up their voting rights in exchange for preferential treatment.
Limited liability companies (LLCs) issue membership units and allow their profits and losses to flow through to the equity holders (membership partners). Although there is often a manager, every membership partner of an LLC can fully participate in the management of the company, and must report any income or loss on their individual tax returns. Unlike a corporation, an LLC can issue an infinite number of membership units, but will usually choose to define a maximum amount to make the investment opportunity more attractive.
General or limited partnerships issue limited partnership interest to passive investors who do not wish to make decisions for the company. As with an LLC, limited partnerships do not have to limit the amount of investors, but often choose to do so. The general partner is not under any obligation to put out personal capital, and as such, the limited partners initially receive more of the net income for their investment.
Deciding how to raise capital can be a daunting task which requires much research and often the help of a lawyer or experienced financial planner in order to structure the right equity financing for the needs of your business.
Debt FinancingMany businesspeople use debt financing for their businesses for a variety of reasons. Debt takes less time to secure than equity, the cost of the principle and interest is readily measurable, and the equity of the company is not diluted by new ownership. However, there are some drawbacks to this type of financing, including the fact that the company is required to pay back the debt and it must carry the debt as a liability on its balance sheet. Introducing debt can also place an extra financial burden on the business, and small business owners may be required to pledge personal collateral.
One of the most common types of debt financing is through a bank loan. This can be obtained by presenting the appropriate paperwork to show that the business is creditworthy, including a business plan or loan proposal with detailed financial projections. Banks will usually require the owners of a start-up business to personally guarantee the loan. Interest that the bank charges will vary according to the type of loan and perceived credit risk of the borrower but should be deductible as a business expense.
The Small Business Administration (SBA) is another avenue through which to apply for a business loan. There are several loan options through the SBA, including the 7(a) loan guarantee program, the 504 program, the microloan 7(m) program, and other specialized programs for women, veterans, and minorities. The 7(a) program provides loans through commercial banks but guarantees them, providing financing to small businesses that would otherwise not be able to obtain it. The 504 program provides fixed-rate, long-term financing for small businesses to acquire land, buildings, or equipment through private, nonprofit corporations called certified development companies. The microloan 7(m) program provides small businesses with a short term loan of $35,000 or less for working capital, inventory, furniture, and other supplies.
Revenue participation or royalty financing is when an investor buys a portion of the future revenue stream of the company. It is considered a form of debt financing because these investors must be paid first before any of the company's other expenses. Revenue participation can be structured through preferred stock or LLC membership units.
Other common means of debt financing often utilized by small business owners include credit cards, home equity lines, retirement funds, and life insurance borrowing. Each of these options comes with varying degrees of benefit and risk and must always be treated as a loan and repaid within a timely manner.
With the wide variety of choices available, business owners seeking debt financing must do their homework, and if necessary, consult with legal and accounting professionals to ensure they make the best decision for their needs.
Financing Organizations and LinksFinancing-related organizations include the Securities Industry and Financial Markets Association, the Small Business Administration, the Commercial Finance Association, and the American Financial Services Association, as well as other, more specialized or localized, organizations.
The following links include page titles and summaries for reference articles, directory pages, and captioned images about financing and finance-related topics.
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