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Guide to Capital Funding

Guide to Capital Funding
Caroline Banton
Caroline BantonUpdated November 17, 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.
Capital funding is the money that lenders and investors provide to a business for daily and long-term needs. The two main types of capital funding are debt financing or equity financing.With debt financing, lenders provide money for operations and growth projects, but expect the loan plus interest to be paid off in a set period of time. With equity financing, investors buy shares of the company and expect that those shares will increase in value. Companies run in-depth analysis on the cost and benefits associated with each type of available funding before deciding to move forward.Read on to learn more about capital funding, from how it works to how to find the right source of funding to grow your business. 

What Is Capital Funding?

Businesses — both large and small — need money to function and grow. With capital funding, a business can fund projects and investments meant to generate even more money over time, such as expansion, purchasing equipment, making capital investments, and developing new products and services.There are many different sources of capital — each with its own requirements and investment goals. However, they generally fall into two main categories: debt financing, which essentially means you borrow money and repay it with interest, and equity financing, where money is invested in your business in exchange for part ownership.

How Does Capital Funding Work?

The way capital funding works will depend on whether a company is raising capital via debt or equity financing. With equity funding, the company gives up a portion of ownership to shareholders in return for cash. The shareholders expect that the value of the shares will go up as the company grows. However, the company doesn’t need to make monthly payments to its investors. With debt financing, a business borrows capital from a bank, online lender, peer-to-peer (P2P) lending platform, or venture capitalist. They must then pay back the loan with interest over a set period of time. However, the company doesn’t give up any ownership or control of the business.

Types of Capital Funding

Companies sell assets and use retained earnings to finance their operations. They also raise capital through equity and debt funding. Here is a closer look at each type of capital funding in more detail.

Equity or Stocks

When a private company wants to raise capital through stock, they hold an initial public offering (IPO). If the company is public vs private, they issue additional shares into the capital markets. Either way, the company can then use that money to fund capital initiatives.  Investors who buy the shares expect a return on their investment (ROI), which is a cost of equity to a business. Returns are usually distributed through dividends (a quarterly or annual payout of the company’s earnings). Typically only mature companies (think the Blue Chip Stocks) pay dividends. Other companies may reinvest the earnings back into the company. In this case, the company provides an ROI by managing the company’s resources in a way that increases the value of the shares held by investors.It’s also possible for a private company to raise equity funding without going public. Startups and young small businesses can get capital funding by bringing in an angel investor or a venture capital firm that is looking to invest in a young company with high growth potential. These investors provide capital in return for an ownership stake in the company. They may also want to have a say in day-to-day decisions and the company’s future direction.

Debt or Bonds

Debt capital can come in the form of traditional loans and debt issues. Debt issues are known as corporate bonds. They allow a wide number of investors to become lenders or creditors to the company. These investors then receive semi-annual coupon payments until the bond matures. The bond coupon rate is the cost of debt to the issuing company. In addition, bond investors can purchase a bond at a discount, and the face value of the bond is repaid when it matures. Companies (large and small) also get debt financing by reaching out to banks and other lenders to access the capital they need. There are many types of business loans. With a traditional business term loan, the company will receive a lump sum of capital upfront. They then start making regular payments (which include a portion of the principal plus interest) that continue for the entire term of the loan. With debt financing, the interest is the cost of the capital. The lender does not share in the profits.Loans are always counted against a business as liabilities, but those liabilities will decrease as those debts are paid down. Loans are also counted as an expense and will generally lower pre-tax profits.Most traditional lenders, such as banks, will lend only to established companies with strong financials. As a result, startups and new businesses may have to look to other sources, such as online lenders. Small businesses can also pursue other types of loans, such as start-up loans, equipment loans (where the equipment purchased serves as collateral), a business line of credit, or vendor financing (which allows a company to procure goods or services from a vendor without making immediate payment).Recommended: Applying for and Getting a Small Business Loan 

Equity Vs. Debt Funding 

Whether a company should choose equity funding, debt funding or a hybrid, depends on many factors, including how much debt the company already has on its books, the predictability of the company's cash flow, and how comfortable the owner is in working with partners.Debt capital may be easier to obtain than equity financing — and there may be more available. This type of working capital can result in strong short-term growth and increased profitability. On the other hand, a company is contractually obligated to pay off the loan by a specific deadline. If the business suffers unexpected setbacks before paying it off, then debt capital could become a severe challenge to the company’s financial viability.With equity funding, a company does not need to make regular payments according to a set schedule. However, bringing in investors or issuing additional funds in the markets dilutes the holdings of existing shareholders, since their proportional ownership and voting influence within the company will be reduced.Here’s a closer look at the pros and cons of equity vs. debt funding.

Pros of Equity Funding

  • No fixed monthly payments, which means less risk compared to debt funding 
  • Allows companies with poor credit histories to raise capital
  • Doesn’t take funds out of the business
  • May lead to valuable partnerships

Cons of Equity Funding

  • May cost more than debt funding (since the amount of money paid to the partners could be higher than the interest rates on debt financing)
  • Owners have to give up some control of the company
  • Potential for conflict, since all the partners will not always agree when making decisions
  • No tax benefits like the ones offered by debt financing

Pros of Debt Funding

  • Owners retain control of the company
  • Loan interest is typically tax deductible (whereas dividends paid to shareholders are not)
  • Cost of capital is known and predictable 
  • Lender doesn’t have claim on future profits

Cons of Debt Funding

  • Companies need a good credit rating to qualify for financing with low interest rates
  • Higher debt-equity ratios increase the financial risk of the company and can make it harder to attract capital
  • A lender may require collateral, which puts assets at risk
  • Owners may be required to personally guarantee the debt

Explore Small Business Loans 

If you’re interested in raising capital for your small business without diluting equity, Lantern by SoFi can help. With our online financing marketplace, you can compare small business loan rates without scouring the web and checking multiple sites. With one short application, you’ll be matched with loan offers that meet your company’s needs and qualifications.Let Lantern by SoFi connect you with the right lender for your capital funding needs.
Photo credit: iStock/Prostock-Studio
This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice. LCSB0622013

Frequently Asked Questions

What are the sources of capital funding?
Is capital funding typically a loan?
Is capital funding only for long-term needs?

About the Author

Caroline Banton

Caroline Banton

Caroline Banton is a finance and business writer whose work has appeared on sites such as The Huffington Post, Investopedia, The Motley Fool, LendingTree, MSN, and Time. With an MBA from Johns Hopkins University, Caroline has written for fintech companies, acted as a career coach, and ghost-written for prominent thought leaders in the financial industry.
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