Financing is financing, right? A loan for a business is just like a loan for a home, right? Unfortunately, this simply isn’t the case. Commercial financing is an entirely different game compared to personal financing.
Sooner or later, you are going to need financing as a business. It might be to get up and started. It might be to finance materials needed to fulfill a large order. Whatever the reason, it is vital to understand that there are two basic forms of commercial finance for businesses – debt financing and equity financing.
Equity financing is the most common choice of newer businesses. Why? Well, the statistics are fairly ugly. Something between 70 and 90 percent of all new business fail within two calendar years from the date of launch. As a result, traditional commercial banks are loath to invest in newer companies. The risk is just to big that a default will occur.
So, what exactly is financing and who does it? Well, equity financing is not really financing at all. It is the sale of pieces of ownership in the business to drum up money. For most small businesses, this means tapping into the bank of Mom & Dad as well as lightly twisting the arms of friends. For businesses with bigger ideas, angel investors or venture capitalists can also be sources of funding. The primary issue to keep in mind, however, is once that equity is sold off, the business is no longer “yours”. It is owned by a group and a group that wants to make a profit.
Debt financing for a business is much more like personal financing. You are usually dealing with a bank. Assuming your company has been around for a bit, the bank will be receptive to chatting with you about your financing needs. That being said, it is not going to give you a general loan. Commercial debt financing usually is tailored to a specific need. If my business needs to buy a piece of equipment, the lender will give me a loan for that specific piece of equipment.
There is one area where commercial banks will provide more general financing to small businesses. This is in the form of a line of credit. These lines can be a blessing and a course. First, they are expensive. Second, they tend to be watched closely by the bank. You might have a million dollar credit line, but you will rarely get to use it all. If the bank sees your balance going up towards the limit, it will often call the line. This means it will essentially demand payment within a specified time. If you do not make it, the bank will come after your assets since it required you to personally guarantee the line. This is something you see happen with service companies, such as law firms, all of the time.
So, which form of financing is better for your business? If you can swing it, debt financing is by far the best. Giving up ownership interests in your company should be avoided, which makes equity financing a Faustian bargain.