Starting up a business can be a strain on your personal finances. Understanding financal basics, debt vs equity will clarify the process. It can take several months or more before your new business is profitable and can provide financial support for you and your family. This is the Number One reason why you should start on a part time basis, whenever possible.
Debt vs Equity
Before going into business it is always wise to get your finances in order.
Start with a monthly household budget that accounts for your income and your household expenses. Be as conservative as possible, because it is vital to your success that you have the resources to maintain your household expenses while your business is in the growth stage. Any strain on your personal budget will put the financial success of your business at risk.
It is also a good idea to check your personal credit situation. Too often, entrepreneurs think that their business credit and personal credit are separate. A business' credit is built upon the owner's personal credit. Because you have not established a business credit history, lenders and suppliers will use your personal credit history to determine your terms of credit.
Which Should You Choose?
Loans are better for businesses with cash flow that allows for realistic repayment schedules and businesses that can obtain the loan without jeopardizing personal assets. On the other hand, it’s better to seek equity investments to finance a start up venture, because you generally only have to repay investors if the business turns a profit.
Deciding whether to borrow money or take on co-owners can be tricky. If you don't already know a tax advisor who specializes in small business issues, you will be wise to find one. Your personal tax situation, the tax situation of the people who may invest, the terms of the loan and the tax status of the type of business you plan to open are all likely to influence your choice.
Debt vs Equity
There are two types of financing: equity financing and debt financing. When looking for money, you must consider your company's financial strength. The more money owners have invested in their business, the easier it is to attract financing.
If your firm has a high ratio of equity to debt, you should probably seek debt financing. However, if your company has a high proportion of debt to equity, experts advise that you should increase your ownership capital (equity investment) for additional funds. That way you won't be over-leveraged to the point of jeopardizing your company's survival.
Equity equals Ownership (Share Profits and Control)
Most small or growth-stage businesses use limited equity financing. As with debt financing, additional equity often comes from non-professional investors such as friends, relatives, employees, customers, or industry colleagues. However, the most common source of professional equity funding comes from venture capitalists.
Equity financing requires that you sell an ownership interest in the business in exchange for capital. The most basic hurdle to equity financing is finding investors who are willing to buy into your business; however, the amount of equity financing that you undertake may depend more upon your willingness to share management control than upon the investor appeal of the business. By selling equity interests in your business, you sacrifice some of your autonomy and management rights.
The effect of selling a large percentage of the ownership interest in your business may mean that your own investment will be short-term, unless you retain a majority interest in the business and control over future sale of the business. Of course, many small business operators are not necessarily interested in maintaining their business indefinitely, and your personal motives for pursuing a small business will determine the value you place upon business ownership. Sometimes the bottom line is whether you would rather operate a successful business for several years and then sell your interests for a fair profit, or be repeatedly frustrated in attempts at financing a business that cannot achieve its potential because of insufficient capital.
Debt vs Equity
Debt: Money You Owe (Profits and Control are maintained)
There are many sources for debt financing: banks, savings and loans, commercial finance companies, and the U.S. Government are the most common. State and local governments have developed many programs in recent years to encourage the growth of small businesses in recognition of their positive effects on the economy. Family members, friends, and former associates are all potential sources, especially when capital requirements are smaller.
Debt financing refers to what we normally think of as a loan. A creditor agrees to lend money to a debtor in exchange for repayment, with accumulated interest, at some future date. The creditor does not obtain any ownership claim in the debtor's business. Debt financing is attractive because you do not have to sacrifice any ownership interests in your business, interest on the loan is deductible, and the financing cost is a relatively fixed expense.