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Everything You Need to Know About Business Finance

Everything You Need to Know About Business Finance
Lauren Ward
Lauren WardUpdated December 28, 2022
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
There’s more than one way to finance a business. You might use your personal savings, take on debt, offer investors equity, or some combination of all three. Which type of financing is the best choice for your business will depend on multiple factors, including why you need capital, how fast you need it, and your business’s qualifications. Here’s a closer look at how business financing works, the main types of business finance and where to find them, plus the pros and cons of each.

What Is Business Financing?

Broadly defined, business financing is the money business owners require to start, run, or expand a business. More specifically, the term “financing” often specifically refers to ways a company can access capital (which is cash that will be put to work for productive or investment purposes) outside of sales. While many small businesses start by bootstrapping, at some point in a company’s life cycle, it will likely need to seek an outside source of capital. Even large, established corporations run into cash flow issues and routinely seek capital infusions to meet short-term obligations. The use of financing can be vital to any organization — it allows them to purchase products out of their immediate reach and, in turn, expedite growth.Recommended: Fundamentals in Business 

How Does Business Financing Work?

Financing takes advantage of the fact that some individuals and organizations will have a surplus of money they want to put to work to generate returns, while others are seeking money to invest in growth (also with the goal of generating returns), creating a market for money.There are a number of ways to find financing for a small business — including debt, equity, and mezzanine financing. Debt financing is usually offered by a financial institution requiring regular monthly payments until the debt is paid off. In equity financing, either a firm or an individual makes an investment in your business, meaning you don’t have to pay the money back. However, the investor now owns a percentage of your business, perhaps even a controlling one.Mezzanine capital combines elements of debt and equity financing, with the lender usually having an option to convert unpaid debt into ownership in the company.Recommended: Growing Your Landscaping Business or Launching One

3 Types of Business Financing 

Here is a guide to three major sources of funding for small businesses.

1. Equity Financing

Equity financing is a common source of funding for small businesses and startups that has a number of advantages and disadvantages. Here’s a look at how it works.

What Is Equity Financing?

Equity financing is a business financing method where you sell shares of your company in return for upfront capital. The funds can be used for immediate business operations or long-term growth. The cost of shares is based on your company’s valuation (or worth), and investors become part owners of the business.Equity financing for small businesses often comes from venture capitalists or angel investors.A venture capitalist is usually a firm rather than an individual. Venture capital (VC) firms typically have partners, lawyers, accountants, and investment advisors who thoroughly research and evaluate any potential investment. VC firms generally only make significant investments, and the process can be slow and complex.Angel investors, on the other hand, are typically high-net-worth individuals who want to invest a smaller amount of money. They’re often looking to invest in early-stage businesses to help them to get off the ground. Besides being a source of funding, these investors often act as mentors, guiding the entrepreneur on how to run the business, as well as providing connections and other resources. In exchange, angel investors look to earn a significant return from their investment. Angel investors tend to move faster than venture capitalists and want simpler terms.Small businesses and startups can also get equity funding via equity crowdfunding (also called regulation crowdfunding). Using a crowdfunding platform registered with the Securities and Exchange Commission (SEC), you may be able to find both accredited investors and everyday people willing to back your company. In return for cash, investors receive equity ownership in your business.

Pros and Cons of Equity Financing

  • Money does not have to be paid back
  • No monthly payments, leaving more liquid cash available for operating expenses
  • Funding without pressure (investors generally understand that it can take time for a business to thrive)
  • Investors may offer operational expertise and valuable business connections
  • Requires giving up ownership of a portion of your company
  • Typically must share profits indefinitely
  • May need to consult with investors on decisions
  • If an investor purchases more than 50% of your business, you will become a minority owner 

Example of Equity Financing

Let’s say you own company ABC and invested $1,000,000 to start the business. Since the entire investment is your own, you own all the shares in the business.As the business grows, you start looking for additional funding from interested angel investors or venture capitalists. You accept a bid of $500,000 from one of those investors. Combined with your original investment of $1,000,000, the company’s total capital will add up to $1,500,000.When the investor purchases the company’s shares, you no longer own 100% of the business but, rather, 66.67% (investment of $1,000,000 in a total investment of $1,500,000). The investor owns 33.33% of the business.Recommended: Financial Statements for Business

2. Debt Financing

If you’re not interested in giving up any equity in your business, you may want to explore debt financing. Unlike equity, the debt must be paid back. While the money can also come from a wealthy individual, for most borrowers, the money will likely come from a lending institution, which requires applying for a business loan.  

What Is Debt Financing?

Debt financing is when you borrow money to finance your business. You agree to pay back the creditor the funds borrowed, plus interest, by a future date. Unlike equity financing, the funder doesn’t own any part of your business or have any say in decisions. Once you repay the debt, your relationship with the funder ends.Debt financing can be structured in different ways. Here are three of the most common types of business loans:
  • Installment loans With this setup, you receive funding from a lender upfront and repay it (plus interest) over time according to a fixed schedule. Also referred to as term loans, these loans may be secured (which means they require collateral) or unsecured (no collateral required).
  • Revolving loans This gives you access to a set line of credit that you can draw from as needed. You only pay interest on the funds you use, and once you’ve repaid what you’ve borrowed, you have access to the line of credit again. Business credit cards and lines of credit are two common examples of a revolving loan.
  • Cash flow loans A cash flow loan is a type of unsecured borrowing that is used for the day-to-day operations of a small business. With this type of loan, you borrow against your future revenue and repay the loan with incoming cash flows of the business. Offered by alternative lenders, this type of loan can be easier to qualify for than a conventional term loan. However, interest rates tend to be higher. Merchant cash advances and invoice financing are examples of cash flow loans.
Debt financing can also be broken down into: 
  • Short-term debt financing (which generally has a repayment period of 12 months or less) 
  • Long-term debt financing (which has a repayment term up to 10 years, and in some cases, as long as 25 years).
Rates for small business loans will vary depending on the lender and the type of loan, as well as your business’s credit history, revenues, years in business, and available collateral. 

Pros and Cons of Debt Financing

  • Maintain ownership and full control of the company
  • Interest is typically tax deductible as a business expense
  • When the loan is paid off, the lender is no longer in the picture
  • Responsibly paying off a loan can help build business credit
  • Can be difficult to qualify for loans with the best rates and terms
  • Involves making monthly payments (even when business is slow)
  • May not be an option for startups
  • May require collateral or a personal guarantee, which puts business or personal assets at risk

Examples of Debt Financing

Debt financing includes:

3. Mezzanine Capital

Mezzanine capital typically combines features of equity and debt financing on one product. It may be preferable to debt in some situations because the company owners don’t have to relinquish equity right away.

What is Mezzanine Capital?

Mezzanine financing typically starts out as a business loan but, should the business default on payments, the lender can turn the loan into an equity ownership in the business.Mezzanine financing might be used by companies when they are unable to access the amount of funding they need for a large capital investment through traditional debt products. There are a variety of arrangements available for mezzanine financing. In some cases, a lender/investor might get immediate equity in a business. More commonly, though, the lender/investor will acquire warrants for purchasing equity at a later date. In this case, equity in the business is used as security. A key benefit of mezzanine financing for businesses is that the loan is usually treated as equity on the balance sheet. As a result, it does not count as debt in the calculation of the company’s debt-to-equity ratio. This can improve the firm’s leverage position and make it possible for them to borrow in other ways, such as through standard bank loans.Mezzanine funding generally isn’t available to startups or young companies. To receive mezzanine financing, a business must typically have an established reputation, solid product offering, history of profitability, and realistic growth plans.Mezzanine financing is typically structured as subordinated debt, which means it falls below senior debt. It is also typically unsecured, meaning it is not backed up by a lien or any type of business asset. Should the borrowing company go bankrupt, senior debt holders get first dibs on any of a company’s assets. The subordinated debt lender would be next in priority.Since the odds of getting repaid in the event of liquidation are lower, lenders generally see subordinated debt as riskier than senior debt. To compensate for this, they usually charge higher interest rates than senior debt lenders.

Pros and Cons of Mezzanine Capital

  • Typically doesn’t require putting up any collateral
  • May be able to make interest-only payments in the beginning
  • Usually involves giving up less equity than equity financing
  • Interest on the mezzanine debt is typically tax-deductible
  • Higher interest rate than conventional business loans
  • Usually not available to startups or young companies
  • May include multiple warrants
  • Potential for dilution of equity and loss of company control

Example of Mezzanine Capital

Since mezzanine financing tends to be costlier than regular debt financing, why would a business use it? One example is in a leveraged buyout. Let’s say company ABC wants to buy company XYZ for $100 million. They first look to debt financing. The lender, however, only wants to put up 80% of the value and offers company ABC a loan of $80 million. Company ABC doesn’t have all of the remaining $20 million, so it looks for a mezzanine lender to finance $15 million. By doing this, company ABC only has to invest $5 million of its own capital to buy company XYZ. The lender, on the other hand, will be able to convert the debt to equity if certain requirements are met.Using this method of financing leverages company ABC’s potential return while minimizing the amount of capital it has to put up to make the acquisition.Recommended: What Does Leverage Mean in Business? 

The Takeaway

Funds are the lifeblood of any business. A business would not function unless there is adequate money accessible for use.There are two main ways that businesses can acquire outside funding — debt financing and equity financing. Debt is a loan that must be paid back often with interest, but comes with some tax advantages. Equity does not need to be paid back, but it relinquishes ownership stakes to the shareholder. Both debt and equity have their advantages and disadvantages. For companies in later stages, mezzanine financing, which combines features of both debt and equity financing, may be an option.

 3 Small Business Loan Tips

  1. Generally, it can be easier for entrepreneurs starting out to qualify for a loan from an online lender than from a traditional lender. Lantern by SoFi’s single application makes it easy to find and compare small business loan offers from multiple lenders.
  2. If you are launching a new business or your business is young, lenders will consider your personal credit score. Eventually, though, you’ll want to establish your business credit.
  3. SBA loans are guaranteed by the U.S. Small Business Administration and typically offer favorable terms. They can also have more complicated applications and requirements than non-SBA business loans.

Frequently Asked Questions

What are some examples of business finance?
What are the most common ways to finance a business?
How can you get financing for your business?

About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
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