Small business start up costs are often financed with personal funds including savings, loans from family members, and even credit card advances. If a business is to grow, it is usually necessary to obtain larger amounts of financing than these methods can provide. Businesses are financed in a variety of ways including:
Public and private securities offerings
Venture capital financing
Various types of bank financing
Each of these methods of financing has advantages and disadvantages.
Bank Financing
Bank financing is the most common type of financing for businesses, especially small businesses. Bank financing can take several forms. In most instances a lender making a conventional loan will require the borrower to pledge collateral to secure the loan. Collateral may consist of a pledge of accounts receivable, inventory, real estate, and other tangible and intangible property. Additionally, it is quite common for lenders lending to privately owned companies to require the owners to personally guarantee repayment of the loan. Loans will usually be evidenced by one or more promissory notes.
Term loan
The term loan is the simplest form of commercial bank financing. With a term loan, the business borrows a specific amount of money that is paid back over a specified period of time (usually more than a year). A term loan is usually repaid in equal periodic installments of principal and interest. However, some term loans reduce or eliminate principal payments until the loan is due; at which time the entire outstanding principal amount is payable.
Line of credit
A line of credit is a non-binding commitment by a lender to lend a specified amount from time to time. Lines of credit usually do not exceed one year but may, at the bank's option, be renewed in succeeding years.
Revolving credit loan
A revolving credit loan is similar to a line of credit. The lender commits to loan up to a specified amount from time to time as required by the borrower. Usually the loan is payable in full within a year or less. The terms of a revolving line of credit are almost always set forth in a formal loan agreement. Unlike a line of credit agreement, the bank is obligated to lend the amount requested by the borrower provided that, at the time of each request, the borrower is in compliance with all the terms and conditions of the loan agreement. Amounts borrowed and prepaid may be re-borrowed during the term of the agreement so long as the total amount of borrowed funds at any one time isn't more than a specified maximum amount. Revolving credit loans often have other provisions governing renewal of the loan or requiring periodic repayment of the entire amount of the loan.
Banking is regulated by numerous federal and state laws and regulations, including laws prohibiting discrimination in lending practices. Additionally, there are laws that make it a crime to intentionally provide false information to a lender when obtaining a bank loan.
Securities Offerings
A "security" is an interest in an enterprise that is intended to provide a return to the purchaser. While most securities involve the issuance of "stock" or "shares", like purchasing 100 shares of IBM, this broad definition covers a great many financing arrangements, including ones which the participants don't realize involve the creation of a security. A "security" can be in the form of a note, a bond, an investment contract, a certificate of interest in a profit-sharing agreement, or any other arrangement which amounts to an investment that is expected to provide a return to the investor. A security is also any "derivative security" such as an option, warrant, put, call, or straddle.
If a company is offering securities, the securities must be registered with the Securities and Exchange Commission (SEC) and with the states from which, and in which, the securities will be offered, unless there is an applicable exemption from registration. The securities registration process is geared toward providing very detailed and accurate disclosure to potential investors regarding the business and financial condition of the company offering securities. The securities registration process is very time consuming and expensive and will not be the means by which most start-up businesses will raise capital.
There are a number of federal and state exemptions from registration depending on factors such as:
The amount of capital being raised
The number of persons offered securities
The number of persons actually purchasing securities
The depth of disclosure provided regarding the business and financial condition of the company offering securities and other factors
As a result, non-registered offerings of securities may have a significantly reduced cost to the company offering securities but, nonetheless, depending on the factors described above, can still be quite costly. Because of the complexity of the securities laws, under no circumstances should anyone attempt to issue securities without the assistance of counsel knowledgeable in this area of law.
Business owners are usually surprised to learn that if they solicit friends, family, or strangers to invest in their business, they may fall under the federal and state securities laws which require registration. This can be the case whether the family members or friends invest as stockholders or as lenders who receive promissory notes evidencing the debt. Business owners may be violating these securities laws if they fail to follow the required registration and disclosure requirements. Violations may make them subject to liability under the civil laws, and possibly under the criminal law as well. Additionally, the business owner may have personal responsibility to repay the investors if they incur a loss on their investment.
Venture Capital
Venture capitalists are firms or individuals who invest in start-up or mature businesses that are not ordinarily in a position to publicly issue securities to obtain capital. These businesses may be at the limit of their bank lines of credit or unwilling to increase their indebtedness for a variety of reasons. Venture capital financing may be an excellent means of getting the financing quickly, with far fewer up-front costs than those associated with a typical securities offering. Venture capital firms may purchase equity, make loans, or both. A venture capital firm's goal is to have the company in which they invest go public within a four to seven year time frame or be sold to another company within that period. When the company goes public or is sold, the venture capital firm will sell all or part of its stake in the company, hopefully at a large profit.
Although a venture capital transaction will almost always involve an offering of securities, the business and financial expertise of the venture capital investor will usually permit the offering to go forward with less expense on the part of the company offering the securities because the venture capital firm will conduct its own detailed due diligence. As a result, it is usually unnecessary for the company offering the securities to produce an extensive disclosure document or make extensive filings with federal or state authorities, although certain notice filings may be required.
Because venture capitalists ordinarily invest in higher risk companies and a significant percentage of their investments will not be successful, they usually demand a greater return on their investment. As a result, they often require the financed companies to:
Give up a significant percentage of their equity, whether immediately or at a later date, through exercise of options or warrants granted to the venture capital firm as part of the deal.
Vote one or more designees of the venture capital firm as members of the company's board of directors.
On the other hand, an experienced and well-managed venture capital firm can assist a company with management expertise, business and professional contacts, and other support. The infusion of capital by the venture capital firm may enable a company to achieve its goals earlier than would otherwise be possible.