When starting a new business, there’s a lot to be excited about, but there are also many tasks to take care of. If you need financing, then one of the first things you’ll do is consider how to finance a new business. We will cover standard options, compare debt financing, equity, and mezzanine financing, and will answer some of the most frequently asked questions people have about financing a new business.
Debt Financing Vs. Equity Vs. Mezzanine Financing
It’s essential to understand three basic categories of financing: debt financing, equity, and mezzanine financing. None are necessarily better than another in all circumstances, but one can be significantly better for your new business enterprise in some cases.
Debt Financing 101
Debt financing involves raising capital by selling debt to investors. In return for giving you the money, they become creditors and receive payments for principal and interest. There are several advantages to this option:
- You can potentially leverage a small part of overall capital to grow or start a business
- Most debt payments are tax-deductible
- You retain 100% ownership control
- It can be more affordable than other options, including equity financing
Of course, there are disadvantages, too:
- You must pay interest on the loan
- You are required to make payments regardless of your new company’s revenue
- It is a risky choice with the inconsistent income a new company generally experiences
Equity Financing 101
The process of equity financing involves raising funds by selling shares of the company. This essentially means that you would be selling part of your business in exchange for start-up capital. The main advantage of this option is that you do not have to repay the money and therefore do not start your new company out in debt.
On the other hand, you will be starting your company without having 100% ownership of it. This requires that you share your future profits with investors for as long as you own the company. Depending on the equity financing agreement, you might also be required to get approval from investors to make decisions about your company’s future.
Mezzanine Financing 101
Essentially a cross between the two options above, debt financing and equity financing, mezzanine financing gives creditors the option to convert the money they are owed to equity in the company. It is generally used by established companies rather than to gain funds to start a new business. Some companies use this option to fund specific projects, and these types of loans are most common in expanding a company or during the merger of a company.
Funding a New Business Often Involves Pulling from Several Sources
While some new business owners will pull funds from a single place, it is much more common to pull funding from several places. The good news is that there are many common ways to fund a new business and the suitable options for any particular business depend on:
- The industry they are entering
- Their credit score
- Their business expertise
- The amount they need to borrow
It is wise to explore all potential ways to fund your business to ensure you have not overlooked a potentially lucrative option.
Personal Savings
For most start-up businesses, the best possible option is to use your personal savings. Known among financial circuits as “bootstrapping,” this option means that you do not owe any debt when you start up, and your company is 100% yours. That said, it is a very risky situation when your entire personal wealth is tied up in the new company.
Credit Cards
Starting a business using credit cards can be a great way to earn exceptional perks with the right cards, but it can also be a great way to get into significant debt with high-interest rates. Generally speaking, this is an option to consider only if you expect to be able to pay the credit cards off monthly. If you can, you could earn miles, reward points, or cash back to further the growth of your business.
SBA Microloans
The Small Business Administration offers several small business financing programs, but microloans are the best option for many start-up companies. They can provide up to $50,000 in capital to start or grow a company. They can be a good option for those who do not need more than this amount to start a company, and they generally come with competitive interest rates.
Crowdfunding
If your business is something you think is new to the market and people will be excited to support it, you can consider crowdfunding. This allows you to get small investments from potentially millions of people. It’s also a great way to increase awareness of your brand and your product.
You start by providing a business plan that details what you need money for and how it will be used. Potential investors can review the proposal to decide if they are interested in investing. Most of these platforms are rewards-based, meaning that you would offer various rewards for different levels of investment. The rewards typically involve the product or service your new company will offer.
Business Loans & Lines of Credit
The more traditional ways to financing a new business are taking out business loans and lines of credit. There are many options within these categories, from short-term loans you pay off in a manner of months to loans that can be paid off over the next ten years, to development loans and even loans designed explicitly to finance the acquisition of new equipment.
It can be difficult for a company to qualify for a business loan when they are just starting, but business lines of credit are often a little easier. While a business loan involves one lump payment, lines of credit are similar to a credit card in that you have a certain amount of credit you can draw on for your business, and as you make monthly payments to pay down money you have already used, you can take out further credit for future expenses.
Lines of credit can be a great flexible option for companies just starting out, with the added advantage of interest only being charged on the credit line actually in use.
Frequently Asked Questions About How To Finance a New Business
Are there additional questions you have about ways to finance a new business? The answers are likely below.
Q: What is the best way to finance a new business?
A: As you can see from the above-described options, no single option works for everyone. Each type of financing has its unique advantages and potential drawbacks.
Q: Are there different types of equity financing?
A: Yes. Selling equity in your business to private investors or venture capital firms is the most common option for a new business, but public stock offerings are another form of equity financing a company might use to increase its available capital.
Q: How much funding should I get for my new business?
A: One of the biggest mistakes new companies often make is assuming that they should take advantage of the maximum amount of capital offered to them. This is not always the case. It is crucial to draw up a business plan and have a realistic idea of how much it will cost to get your business started. You will also need to consider additional funds you might need before your business becomes profitable.
If you take out more funding than necessary, you will end up with higher payments or financial obligations. Getting into unnecessary debt is a common way for a new business to fail.
Q: What do I need to provide to apply for start-up funding?
A: That depends on where you are applying for funding and their requirements. With new companies that have not established business credit, it is common for loans to require personal credit guarantees.
Q: What is an angel investor?
A: This is another term for equity financing. In exchange for offering you start-up capital, an angel investor will receive a percentage of equity in your company. Depending on how the agreement is written, you might be able to repurchase your equity at a pre-agreed upon rate after a certain period of time has elapsed.
Q: How hard is it to get a new business funded?
If you have never run a business before and are attempting to start a company with an unproven concept, you will likely find it challenging to get funding. If you are an experienced business person with a solid business plan and are starting a company based on a proven concept, then you will likely have a much easier time.