Guide To Capital Resources

On the surface, it seems most businesses have only one concern about money: where to get it? But while finding the required funding is obviously important, securing the right type of capital can be just as important. As a business moves through its lifecycle, the type of money it requires changes. Having the wrong type of money at the wrong stage of the business can prove to be a fatal management mistake.

The right type of money your business needs is dependent on the following questions:

How much money do you need? The amount of capital needed will determine if a bank or investor is interested in the deal. Deals that are too small won't interest them.

What will the money be used for? Banks like deals where there are a lot of hard assets to secure as collateral and tend to shy away from pure working capital deals. Investors are the usual option when the money will be used to pay for the day-to-day operating expenses of the business or in the case of more risky activities such as new product launches.

At what stage is your business? Earlier stage businesses including start-ups have to rely upon more personal funds and monies obtained through private investors since they involve more risk than most banks want to assume. Later stage businesses that are in the growth phase are more bankable depending on what the money will be used for?

What is your business' capacity to repay? For larger deals where the time to repayment is longer and more drawn out, investors can offer more flexible repayment terms than banks, but it comes at a steep cost as they also tend to require very high rates of return. Also, the more debt the business has can hinder its ability to raise additional capital.

Once you've answered these basic questions, its time to decide which type of capital is best for your business. In general, there are two basic types of money: debt and equity. Both of these types of capital operate in completely different ways and each can have an entirely different effect on a business. Even the business plan you write needs to be tailored to the appropriate type of capital you are seeking since each is a unique audience. The following discusses the difference between these two forms of money.


Debt Capital:

What is it?
Debt is a liability or obligation owed to another person or institution and required to be paid by a specified date.

What are some forms of debt capital?
Examples of debt capital include bank loans, government guaranteed loans, lines of credit, credit cards, mortgages, notes payable, bonds, accounts payable, trade credit, home equity, leasing contracts, etc. 

Who provides debt capital?(1)
Banks and other financial lending institutions are the chief providers of debt capital. Also, owners or other outside persons may lend money to a business in the form of debt. 

What are the advantages?
Debt can be less costly than equity capital since most interest rates are less than what an investor would require as a rate of return. Also, with debt capital, you don't have to give up any ownership in your business.

What are the disadvantages?
Debt capital can be rough on the cash flow of your business since you are usually required to make constant and periodic principal and interest payments similar to a home mortgage. If your business is cyclical or seasonal or experiences a sudden downturn in sales, the inflexibility of debt repayment can cause a sudden cash crunch.

When should it be used? (2)
Debt capital is best when the money you require will be used mainly for fixed assets. Banks and other debt-based lenders require enough collateral to secure the amount of principal being borrowed so they like loans that involve equipment, real estate, buildings, etc.

If you own a house, a home equity loan is a great source of capital. Home equity loans can be tax-deductible and the interest rates charged are usually much lower than traditional commercial loans.

Also consider debt capital when your business needs a line of credit. A line of credit is similar to a credit card in that it's a short-term money solution. The main advantage of a line of credit is that you only pay interest on the balance of money that you have drawn down. Say, for instance, that you have drawn down $10,000 of a $30,000 line of credit. You only owe interest on the $10,000 not the total amount of credit available. Most lines of credit have a limit of available capital and their interest rates are about the same as most commercial loans.

What do I need to know about debt capital?
For a debt-based loan, you will be required to put up collateral, which is something of value owned by yourself or by your business equal to the amount of the loan. Also, you will be required to put money into the business first before a debt-based lender will participate. The usual amount they like to see varies but is normally around 20% of the total project.

Also, it's important to understand how a bank operates. Most banks are divided into a consumer division and a commercial division. Most debt-based capital such as credit cards and home equity loans originate from the consumer side. The side of the bank may also provide asset-based loans. Depending on the size of the bank, these loans can be made for as much as $30,000 or more.

On the other side of the bank sits the commercial division. It provides commercial mortgages, loans, and lines of credit to businesses. Most commercial lenders are looking for deals of at least $100,000 or more before you'll get their interest, however, they will do smaller loans and lines of credit.

The problem many small businesses have is that they require an amount of money that sits somewhere between what the consumer and commercial sides of the bank are looking for. This leaves the business stuck between a rock and a hard place. A loan request of say $30,000 may be too high to comfortably do on the consumer side while it may be considered too small to even review on the commercial end.

Many entrepreneurs respond to this dilemma by saying, "Well, I could always use more money, so I'll just increase my loan request until I attract the bank's attention." This is not advisable for several reasons. First, you should never over-extend yourself when it comes to debt. This will not only increase the operating expenses of your business but could affect you in the future if you need to borrow more money. Second, it's going to be hard enough trying to secure the actual money you need, let alone an even greater amount. As with any amount, you have to justify exactly what the money will be used for breaking it down into its essential elements. Inflated amounts in a loan request will be quickly spotted and questioned by an experienced lender.

If you run into this problem, try instead to break your business plan into a series of smaller phases until you get it to a level you can afford through personal credit sources. If you can't break your business down into small enough phases that you can afford, then you should consider equity capital instead.

How should I write the business plan?
Since most business plans written to obtain debt capital are focused toward a bank as the intended audience you should try to think like a banker. Bankers are conservative. They need to see collateral to secure the loan and the financial projections you provide need to be very conservative. Make sure you break down your loan request into its essential elements. In other words, you should list out how much you need for equipment, inventory, supplies, signage, prepaid expenses, working capital, etc. 

The most important thing the banker is looking for is the cash flow of the business. They want to see that your business has enough capacity to repay the loan amount. Your business plan should include these assumptions into the financial projections showing very clearly both the principal and interest payments being made. A complete loan package should be put together including tax returns of the business (if you have them), personal tax returns of the owners, a personal financial statement, a loan application, and a comprehensive business plan.



Equity Capital:

What is it?
Equity capital is money raised from the owners of a business.

What are some forms of equity capital?
Examples of equity capital include common stock, partnership interests, and other ownership-based interests.

Who provides equity capital?
The owners of the business who may include partners, private investors, customers, suppliers, angels, investment bankers, and venture capitalists provide equity capital.

What are the advantages?
Equity capital can be much more flexible than debt. There are no collateral requirements for equity capital and repayment terms and conditions can be tailored to the needs of the business. Usually, payments to investors can be put off until the business exceeds breakeven or reaches a certain level of profitability. Needless to say, this can really help the cash flow of an emerging business. Also, equity capital can be a great way of raising large amounts of money for your business.

What are the disadvantages?
Equity can come at a very steep price. While a debt-based bank loan might run you say 10%, an investor or venture capitalist seeks much higher rates of return say around 20% to 40%. Also, equity investors generally want a share of the business so you will have to give up some ownership. While these investors don't want to run the day-to-day operations of your business, they usually want a seat on the board of directors where they can influence the decisions of the management team.

When should it be used?
Equity capital is well suited for start-up businesses that require large amounts of working capital or involve a new product launch. Also, established businesses that are about to enter a new growth phase of their business cycle can benefit from equity capital. Banks are not fond of lending cash and working capital to a business, especially if they are in the start-up phase. This is true because these monies cannot be secured by collateral. Once a dollar is spent on payroll or advertising, it is gone forever and cannot be liquidated by the bank. This becomes the domain of the equity investor. The investor is willing to take on more risk for more reward. They fund high-risk start-ups, new product launches, new marketing initiatives, and major growth and expansion phases of a business.

What should I know about equity capital?
Obtaining equity capital is far from easy. A venture capital firm, for instance, may get 1,000 or more business plans in a single year. From these 1,000 they will read maybe 100 of them based upon what they see in the plan's executive summary. From those 100 business plans that they read, they may fund just 10 of them.

Angel investors, which are generally individual private investors, look for deals around $50,000 to $1,000,000. Most venture capital firms will do some seed funding around $200,000 to $300,000 but the size of their average deal ranges from about $1 to $2 million.

Equity investors are usually seeking large ownership deals in a venture. While an angel investor may seek small ownership positions, many large venture capital firms will want 30% to 70% of the venture just for getting in on the early stages of the business.

Be sure to do your homework on an investor or venture capital firm. Most angels and venture firms target certain industries. You obviously stand a much better chance of making a match if your business fits into their category of interest. Also, talk to some of their portfolio companies to see how much control the firm wanted and how supportive they were when the business experienced any problems.

Keep in mind, most equity deals are highly regulated and need to conform to all Securities and Exchange Commission rules. Be sure to consult an attorney who is well versed in these laws before making any decisions about considering equity.

How should I write the business plan?
If you are trying to secure equity, you cannot spend enough time on the executive summary of your business plan. This is the first thing, if not the only thing, that gets read by an equity investor. The executive summary is your business plan in miniature. It should contain the scope of the opportunity and the essence of the plan in less than a page.

After reading the executive summary and making the decision to read on, equity investors look to one section of the plan more than the rest: the management team. Savvy investors know that an experienced and well-rounded management team can make all the difference when it comes to success of the business. Your management team section should be very comprehensive citing the background, education, experience, skill-sets, and responsibilities for every member of the team. Also, you should include all of the outside professionals that you will utilize such as your attorney, accountant, management consultants, etc.

If an investor likes what they see in the management team section, they will usually proceed to the financial projections. Obviously, one of the most important things an investor wants to see is what potential return there might be. For this they turn to the projected profits of the business. While your business plan need not discuss the amount of ownership you are willing to give up (that will be negotiated later) it should give the investor some idea of what returns they might receive from their investment in your business.

Finally, your business plan should indicate some exit strategy for the investor. An exit strategy is how the investor will get their original capital back and convert their ownership back to the business. Investors don't want to be an owner in your business forever. They want in, they want to get their return on investment when your business is growing the fastest, and then they want to take their money and move on to other opportunities. An exit strategy might include converting equity to debt by getting a bank loan to pay off the investor. It can also include selling the business, bringing in other investors to take their place, or even taking the business public.

Remember with equity investing you usually have to give up a substantial share of ownership of your business, but keep in mind, it's better to have a piece of something rather than all of nothing.


1. All loans and lines of credit are subject to credit approval.

2. Consult a tax advisor about possible tax benefits. A mortgage would be taken on your home. You could lose your home if you do not meet the obligations in your agreement with the lender.