Financing and capital management are critical components of business. There are many roles that capital plays within a business, including how it can unlock new opportunities for growth by helping companies find and hire the right talent or help a company invest in the infrastructure or assets required to deploy products or services.
There are many different sources of capital – each with its own requirements and investment goals. They fall into two main categories: debt financing, which essentially means you borrow money and repay it with interest, and equity financing, where money is invested in your business in exchange for part ownership.
Common Sources of Capital: Debt Financing
Depending on the market conditions and the bank’s policies and preferences, some companies may find a more attentive audience with a commercial loan officer after emerging from the startup phase. In determining whether to “extend debt financing” (essentially, make a loan), bankers may look first at general credit rating, collateral and your ability to repay. Bankers also can closely examine the nature of your business, your management team, competition, industry trends, and the way you plan to use the proceeds. A well-drafted loan proposal can go a long way in demonstrating your company’s creditworthiness to the prospective lender and ability to service the loan.
Commercial Finance Companies
Some companies that get turned down for a loan from a bank turn to a commercial finance company. These companies usually charge considerably higher rates than institutional lenders but might provide lower rates if you sign up for the other services they offer for fees, such as payroll and accounts receivable management. Because of fewer federal and state regulations, commercial finance companies generally have more flexible lending policies and more of a stomach for risk than traditional commercial banks. However, the commercial finance companies are just as likely to mitigate their risk – with higher interest rates and more stringent collateral requirements for loans to undeveloped companies.
If you need money to purchase assets for your business, leasing offers an alternative to traditional debt financing. Rather than borrow money to purchase equipment, you rent the assets instead. Leasing typically takes one of two forms: Operating leases usually provide you with both the asset you would be borrowing money to purchase and a service contract over a period of time, which is usually significantly less than the actual useful life of the asset, resulting in potentially lower monthly payments. If negotiated properly, the operating lease will contain a clause that gives you the right to cancel the lease with little or no penalty. The cancellation clause can provide you with flexibility if sales decline or the equipment leased becomes obsolete. Capital leases differ from operating leases in that they usually don’t include any maintenance services, and they involve your use of the equipment over the asset’s full useful life.
State and Local Government Lending Programs
Many state and local governments provide direct capital or related assistance through support services or even loan guarantees to small and growing companies. The amount and terms of the financing will usually be regulated by the statutes authorizing the creation of the state or local development agency.
Trade Credit and Peer to Peer (P2P) Lending
Some companies overlook an different source of capital or credit: suppliers and customers. Suppliers have a vested interest in the long-term growth of their customer base and may be willing to extend favorable trade-credit terms or even provide direct financing to help fuel a good customer’s growth. The same principles apply to customers who rely on the company as a key supplier of resources. You may also consider exploring one of the online P2P lending platforms.
Common Sources of Capital: Equity Capital
Private Investors (Angel Investors)
Many early-stage companies receive initial equity capital from private investors, either individually or as a small group. These investors are called “angels” or “bands of angels” – and are a rapidly growing sector of the private equity market.
Institutional Venture Capital Firms
Perhaps the best-known source of equity capital for entrepreneurs in recent years is the traditional venture capital firm. These formally organized pools of venture capital helped create Silicon Valley and the fast-growing high-tech industry over the past two decades. These funds, however, tend to do fewer deals that required to meet the total demand for growth capital, meaning the pools of financing can be more limited than others.
If you need money to purchase assets for your business, leasing offers an alternative to traditional debt financing. Rather than borrow money to purchase equipment, you rent the assets instead.
Strategic Investors and Corporate Venture Capitalists
Many large corporations have established venture capital firms as operating subsidiaries that look for investment opportunities (typically within their core industries) to achieve not only financial returns but also strategic objectives, such as access to the technology your company may have developed or unique talents on your team.
A wide variety of overseas investors, foreign stock exchanges, banks and leasing companies seem quite interested in financing transactions with U.S.-based companies. Be sure to carefully consider cultural and management-style differences as well as governance and contractual laws before you engage in any international financing transaction.
Many growing companies begin their search for capital with the assistance of an intermediary, such as an investment banker, broker, merchant banker, or financial consultant. These companies and individuals aren’t direct suppliers of equity capital, but they will often assist the growing company by arranging financing through commercial lenders, insurance companies, personal funds, or other institutional sources. Investment bankers will also arrange for equity investment by private investors, usually in anticipation of a public offering of the company’s securities.
FAQs on Sources of Capital
1. What are the major sources of capital for any business?
The three main sources of capital for a business are equity capital, debt capital, and retained earnings.
- Equity capital is where a company raises money by selling off a percentage of the business in the form of shares which are purchased and owned by shareholders.
- Debt capital is where the company can raise funds by borrowing money in the form of loans or bonds.
- Retained earnings are simply the money that is left over after expenses and other obligations.
2. What are some examples of equity capital?
Shareholder equity is the most common form of equity capital. This is the money sourced from shareholders through the selling of shares in a publicly listed company on a stock exchange.
Another form of equity capital is private equity. This is money sourced from private investors such as venture capitalists and institutions such as pension funds through the issuance of shares in a company.
3. What are some examples of debt financing?
When a company needs to raise capital, it can do so by selling debt instruments to investors. These are loans where the principal sum and interest are repaid to the investors. These loans can take the form of bonds, notes, and bills and may also include mortgages, bank loans, and equipment loans.
The information contained herein is for generalized informational and educational purposes only and does not constitute investment, financial, tax, legal or other professional advice on any subject matter. THIS IS NOT A SUBSTITUTE FOR PROFESSIONAL BUSINESS ADVICE. Therefore, seek such advice in connection with any specific situation, as necessary. The views and opinions of third parties expressed herein represent the opinion of the author, speaker or participant (as the case may be) and do not necessarily represent the views, opinions and/or judgments of American Express Company or any of its affiliates, subsidiaries or divisions. American Express makes no representation as to, and is not responsible for, the accuracy, timeliness, completeness or reliability of any such opinion, advice or statement made herein.
A version of this article was originally published on June 08, 2015.