You may have some cash you want to put into the business yourself, that will be your initial base. Maybe you also have family or friends who are interested in your business idea and they would like to invest in your business. That may sound good, but even if this is the best arrangement for you, there are factors you must consider before you jump in. If you decide to accept investments from family and friends, you will be using a form of financing called equity financing.
One thing that you want to be clear about is whether your family and friends want to invest in your business or loan you some money for your business. That is a crucial distinction! If they want to invest, then they are offering you equity financing. If they want to loan you money for your business, then that is quite different and is actually considered debt financing.
For a new business, commercial banks may require you to pledge your personal assets before they will give you a loan. If your business goes under, you will lose your personal assets.
Any time you use debt financing, you are running the risk of bankruptcy. The more debt financing you use, the higher the risk of bankruptcy. Calculate the debt to equity ratio to determine how much debt your firm is in compared to its equity.
Some will tell you that if you incorporate your business, your personal assets are safe. Don’t be so sure of this. Even if you incorporate, most financial institutions will still require a new business to pledge business or personal assets as collateral for your business loans. You can still lose your personal assets.
Which is best; debt or equity financing? It depends on the situation. Your financial capital, potential investors, credit standing, business plan, tax situation, the tax situation of your investors, and the type of business you plan to start all have an impact on that decision. The mix of debt and equity financing that you use will determine your cost of capital for your business.
Besides debt and equity financing, there are two other traditional sources of capital for your business. Operating revenue and the sale of assets can also generate money for your firm.
Make your financing decisions wisely!