The fundamentals of business finance for small entrepreneurs include keeping personal and business finances separate, maintaining accurate financial records, and creating a budget. Entrepreneurs must also understand cash flow management, monitor critical financial statements such as the income statement and balance sheet, and plan for taxes and other financial obligations. 

There are several ways entrepreneurs can learn about business finance management. This article explains the basics of business finance for small entrepreneurs, providing a comprehensive overview of financing options. We recommend reading to get the most benefit from the information provided. 

Business Financing Defined 

Businesses often need capital through business financing at some point in their operations. Many large organizations seek capital infusions to meet short-term needs. For small businesses, choosing the right funding model is critical. Picking the wrong source could mean losing part of the company or facing long-term debt. 

Key Takeaways 

• Financial institutions usually offer debt financing that requires standard monthly repayments until the debt is paid. 

• Either a firm or an individual invests in personal finances in your business, which doesn’t require repayment when you engage in equity financing. 

• The investor owns a percentage of your business, or even a controlling interest, if you seek equity financing for your business & start-up finance. 

• Mezzanine financing combines features of debt and equity financing, with the lender having the option to transform any unpaid debt into ownership in the company. 

Debt Financing Explained 

Banks or lending institutions offer debt financing to businesses. While it is unusual, private investors also offer debt financing. Banks will check your personal credit when you apply for business financing if you seek start-up funding. 

Banks will check other sources for businesses with a complex corporate structure or that have been in operation for an extended period. The Dun & Bradstreet (D&B) file is an important source of information on businesses’ credit histories. 

Banks will also examine your books of accounts and complete due diligence before approving your proposal to lend any funds. Therefore, it’s helpful if you ensure your business records, such as accounting, are in order and organized before you forward your application. 

Banks will set up repayment terms, including interest rates, and send the funds to the business bank account you specify after the funds are approved.  

Benefits of Debt Financing 

Debt financing has several benefits. 

• The lending institution does not control how you manage your company and has no ownership. 

• Your relationship with the lender ends when you repay the loan. This clause is especially important if your business becomes valuable. 

• The interest you pay on the loan is tax-deductible as a business expense. 

• The monthly repayment and its breakdown are fixed expenses that can be accurately included in your forecasting models. 

Downsides of Debt Financing 

Debt financing also has downsides. 

• Adding debt repayments to your monthly expenses indicates you have the capital inflows to meet all business expenses, including debt repayments. It may not be the case for start-ups still wondering how to manage business finances. 

• During recessions, small businesses can slow down considerably. It can become challenging for them to receive debt financing in tough economic times. 

The US Small Business Administration (SBA) works with many banks to offer small business loans. A part of the loan is guaranteed by the government. SBA loans help reduce lending institutions’ lending risk and ensure unqualified business owners can access debt financing. 

Equity Financing Explained 

Equity financing is provided by investors known as venture capitalists or angel investors. 

Venture capitalists belong to a firm rather than an individual. The firm includes partners, accountants, a team of lawyers, and investment advisors performing their duties in relation to potential investments. Venture capitalists often make significant investments to slow down the process and complicate the financing. 

Angel investors are generally wealthy individuals who invest in a single product rather than building businesses. Ideal candidates for injured investors would be software developers seeking capital to fund product development. Angel investors request simple terms and generally move fast. 

Important: if your business enters bankruptcy, you won’t owe the investor anything. The investor loses their investment as they are considered part owners of the business. 

Benefits of Equity Financing 

When you receive funds from investors to finance your business, it has several benefits. 

• As your investors are not creditors, you are not required to repay the money. As partial owners of the company, the investor loses their money if your company goes bankrupt. 

• You are not saddled with monthly repayments, leaving you with more liquid cash for operating expenses. 

• As investors understand that businesses cannot be built overnight, you receive the money you need with equity financing without the pressure of your company or product thriving within a short time. 

Equity Financing Downsides 

Equity financing also has downsides. So 

• Equity financing requires you to give up a portion of your company. The more significant and risky the investment, the higher stake the investor will demand. You may have to forgo 50% of the ownership. In addition, they may demand 50% or more of the profits as partners of your business unless you construct a deal to buy their stake. 

• Before making any business decisions, you must consult with your investors, as they are like a boss, especially if they have acquired 50% ownership of the company. 

Mezzanine Financing Explained.  

The best features of equity and debt financing are combined in mezzanine financing. While no structure for this type of business financing is established, the debt capital gives the lender the right to convert the finances into an equity interest in the company if you fail to repay on time or in full. Mezzanine financing isn’t as common as debt or equity financing. The financing and risk-reward profile are specific to every party. 

Benefits 

• Mezzanine financing is appropriate for new companies already showing growth. Banks are usually reluctant to lend to companies that have not been established for at least 3 years. New businesses often have little data to provide. However, the bank has a stronger safety net when it includes an option to take an ownership stake in the company, making it easier to secure such loans. 

• Mezzanine financing is treated as equity on a company’s balance sheet. This can make the company more attractive to lenders because it does not appear as debt. 

Downsides 

• Lenders view such companies as a risk and charge them higher interest rates. Companies already in debt or with equity obligations can receive mezzanine financing, making them subordinate to those obligations and increasing the risk of non-repayment. In such cases, lenders may want to see a return on investment of between 20 to 40% due to the higher risk. 

• The risk of losing a significant portion of the company also exists. 

Off-Balance Sheet Financing 

Off-balance sheet financing isn’t a type of financing, but a strategy companies use to keep significant debt purchases off their balance sheets, making their businesses appear stronger and less debt-ridden. 

Companies lease, buy, or create special-purpose vehicles (SPVs) to hold their purchases on their balance sheets when they require expensive equipment. The sponsoring company often overcapitalizes the special-purpose vehicle, making it appear attractive in the event the SPV needs loans to service its debt. 

Off-balance sheet financing is highly regulated. Its use is governed by the generally accepted accounting principles (GAAP). While this type of business financing is not appropriate for most businesses, it is an option for small businesses after they have grown into a larger corporate structure. 

Funding from Family and Friends 

If your funding requirements are relatively small, you can initially pursue less formal funding options by tapping family and friends who may want to support your business. You may receive straightforward repayment terms and other benefits, allowing you to set up a lending model comparable to some of the more formal models. You can offer them stock in your company or repay them as you would a debt financing deal. 

Tapping into Retirement Accounts 

Of late, a practical source of funding for business start-ups has emerged in the form of rollover for business start-ups (ROBS). Entrepreneurs can use a ROBS to invest their retirement savings in new business ventures without incurring taxes, early withdrawal penalties, or loan costs. However, ROBS transactions are complex, making it essential to work with an experienced, competent advisor to conduct them. 

How to Finance a Business 

As a new business owner, you have several options to finance your business, so long as you understand the business loan basics. You can borrow from certified lenders, raise finance from investors, family and friends, or even your retirement accounts, although it is not recommended. 

Companies can also use asset financing by borrowing funds collateralized by balance-sheet assets. 

Conclusion 

Most businesses eventually require financing. While avoiding financing from a formal source can be beneficial, not everyone has that option. Debt financing is the most accessible source of funds for small businesses. If you don’t have family or friends willing to support you or your company, you can establish your company’s credit profile with on-time and regular repayments. 

Equity or mezzanine financing can become an option as your business expands or reaches later stages of product development. However, it is essential that you understand business finance management to acquire the funds you need, regardless of which type of finance you choose for your business.