What Is Business Financing?

Unless your business has the balance sheet of Apple, eventually you will probably need access to capital through business financing. In fact, even many large-cap companies routinely seek capital infusions to meet short-term obligations. For small businesses, finding the right funding model is vitally important. Take money from the wrong source and you may lose part of your company or find yourself locked into repayment terms that impair your growth for many years into the future.

KEY Points

• There are a number of ways to find financing for a small business.
• Debt financing is usually offered by a financial institution and is similar to taking out a mortgage or an automobile loan, 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, but 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.

What Is Debt Financing?

Debt financing for your business is something you likely understand better than you think. Do you have a mortgage or an automobile loan? Both of these are forms of debt financing. It works the same way for your business. Debt financing comes from a bank or some other lending institution. Although it is possible for private investors to offer it to you, this is not the norm.
Here is how it works. When you decide you need a loan, you head to the bank and complete an application. If your business is in the earliest stages of development, the bank will check your personal credit.
For businesses that have a more complicated corporate structure or have been in existence for an extended period time, banks will check other sources. One of the most important is the Dun & Bradstreet (D&B) file. D&B is the best-known company for compiling a credit history on businesses. Along with your business credit history, the bank will want to examine your books and likely complete other due diligence.
Before applying, make sure all business records are complete and organized. If the bank approves your loan request, it will set up payment terms, including interest. If the process sounds a lot like the process you have gone through numerous times to receive a bank loan, you are right.
Advantages of Debt Financing
There are several advantages to financing your business through debt:

• The lending institution has no control over how you run your company, and it has no ownership.
• Once you pay back the loan, your relationship with the lender ends. That is especially important as your business becomes more valuable.
• The interest you pay on debt financing is tax deductible as a business expense.
• The monthly payment, as well as the breakdown of the payments, is a known expense that can be accurately included in your forecasting models.

Equity Financing

uses an investor, not a lender; if you end up in bankruptcy, you do not owe anything to the investor, who, as a part owner of the business, simply loses their investment.
Advantages of Equity Financing
Funding your business through investors has several advantages:
 

• The biggest advantage is that you do not have to pay back the money. If your business enters bankruptcy, your investor or investors are not creditors. They are partial owners in your company and, because of that, their money is lost along with your company.
• You do not have to make monthly payments, so there is often more liquid cash on hand for operating expenses.
• Investors understand that it takes time to build a business. You will get the money you need without the pressure of having to see your product or business thriving within a short amount of time.

What Is Mezzanine Capital?

Put yourself in the position of the lender for a moment. The lender is looking for the best value for its money relative to the least amount of risk. The problem with debt financing is that the lender does not get to share in the success of the business. All it gets is its money back with interest while taking on the risk of default. That interest rate is not going to provide an impressive return by investment standards. It will probably offer single-digit returns.
Mezzanine capital often combines the best features of equity and debt financing. Although there is no set structure for this type of business financing, debt capital often gives the lending institution the right to convert the loan to an equity interest in the company if you do not repay the loan on time or in full.
Advantages of Mezzanine Capital
Choosing to use mezzanine capital comes with several advantages:

• This type of loan is appropriate for a new company that is already showing growth. Banks are reluctant to lend to a company that does not have financial data. According to Dr. Ajay Tyagi’s 2017 book Capital Investment and Financing for Beginners, Forbes has reported that bank lenders are often looking for at least three years of financial data.1 However, a newer business may not have that much data to supply. By adding an option to take an ownership stake in the company, the bank has more of a safety net, making it easier to get the loan.
• Mezzanine capital is treated as equity on the company’s balance sheet. Showing equity rather than a debt obligation makes the company look more attractive to future lenders.
• Mezzanine capital is often provided very quickly with little due diligence.

Please note that mezzanine capital is not as standard as debt or equity financing. The deal, as well as the risk/reward profile, will be specific to each party.