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Financing your small business

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Before starting your own business, you must first figure out how to find the initial investment. Two types of financing are available when starting a business: debt and equity. Each type has a different impact on earnings, cash flow and taxes, so you might want to really think this through. Usually, investments into companies require both debt and equity, and the optimal ratio needs to be determined based on each individual situation.  Here is some useful information in order to help you find the best mix.

First, it is important that you understand some basic differences. Here is a list, derived from an article published in Venture Capital Focus magazine in January 2002, of the principal characteristics of each one:

Finance for small business

Debt

Equity

Must be repaid or refinanced

Can usually be kept permanently

Requires regular interest payments.

Company must generate cash flow to pay

No payment requirements. May receive dividends, but only out of retained earnings

Collateral assets must usually be available

No collateral required

Debt providers are conservative. They cannot share any upside or profits. Therefore, they want to eliminate all possible loss or downside risks

Equity providers are aggressive. They can accept downside risks because they fully share the upside as well

Interest payments are tax deductible

Dividend payments are not tax deductible

Debt has little or no impact on control of the company

Equity requires shared control of the company and may impose restrictions

Debt allows leverage of company profits

Shareholders share the company profits

 

For a small business, debt can be relatively easy to obtain, and it allows you to negotiate in order to customize the debt to meet your needs. Furthermore, debt is requesting regular payments, so your budget is easier to plan around. And the fact that debt, unlike equity, will not dilute your power and ownership in the company should not be ignored.

On the other hand, debt can become a big weight if things are not going so well with the business as personal guarantees are likely to be required as a source of loan payment.

As for equity, it is a permanent investment in exchange of a portion of the ownership and control of the business. Investors accept to share risk with you because they also share the company profits.