We have all most probably found ourselves faced with this question of where do I find funds to start so and so business? Here we list the sources of capital.
Well, I might have that answer. We have 2 large categories of this that are Equity and Debt Finance.
Debt Finance as one of the sources of capital is fixed return finance as the cost [interest] is fixed on the par value. It involves the borrowing of money to be paid back at a future date with interest. It could be in form of a secured or an unsecured loan. A firm or an organization takes up this loan to either finance working capital or an acquisition.
Debt means the amount of money that needs to be repaid back while financing means providing funds to be used in business activities.
Debt Financing is a time-bound activity where the borrower needs to repay the loan along with interest at the end of the agreed period. The payments could be made monthly, half-yearly or towards the end of the loan tenure.
Debt financing sometimes comes with restrictions on the company’s activities that may prevent it from taking advantage of opportunities outside the realm of its core business.
Disadvantages of Debt Financing as one of the sources of capital
Debt financing comes with cons too.
- The main disadvantage of it is that the interest must be paid to lenders this is to say that the amount paid will exceed the amount borrowed.
- The High-interest rates especially by banks and financial institutions make it hard for other companies to raise funds to return the borrowed money.
- You will need collateral to secure the desired financing. The collateral may include cash, and hard assets like land.
- It can create cash flow challenges for some businesses. Some companies sell the same number of products and services each month. Others have some times that are quite busy and then moments when there is no activity at all. This means that your income levels vary from season to season.
The main advantage of debt financing is the ability to pay off high-cost debt, reducing monthly payments by hundreds or even thousands of dollars.
Classification of Debt Financing.
This is whereby entrepreneurs commonly borrow money from friends and relatives and commercial lenders. The loans vary in different terms like short term, medium term varying from 2-5 years, and long-term loans vary from 6 years and above. The terms are relative and they do depend on the borrower.
Business loans are intended for reaching a company’s objectives such as to onboard new staff and upgrading company Assets.
One will however be required to repay the loan with interest.
Leasing is a contract between the owner[lessor] of the asset who grants to the other party [ lessee] where the lessee is given the right to use the asset [ without legal ownership] and undertakes to pay the lessor rental charges due to generation of economic benefits from the use of the assets.
Leases can be short-term [ operating leases] in which case the lessor incurs the operating maintenance costs of the assets or long-term [ finance leases] in which the lessee maintains and insure the assets.
This finance is ideal to use as bridging finance in the sense that it should be used to solve the company’s short-term liquidity problems, particularly those of financing working capital. It is usually secured finance unless otherwise mentioned. Overdraft finance is an expensive source of finance and the over-reliance on it is a sign of financial imprudence as it indicates the inability to plan or forecast financial needs.
A debenture is a marketable security [ a type of investment] issued by a business or other organization to raise money for long-term activities and growth. It is thus a certificate or document that evidences debt of long-term nature whereby the person will have given the issuing company the amount usually less than the total par value of the debenture. These debentures usually mature between 10 to 15 years but maybe endorsed, negotiated, discounted or given their maturity date. The current interest rate is payable twice a year and it is a legal obligation.
B. Sources of capital – EQUITY.
Equity financing as one of the sources of capital is the process of raising capital through the sale of shares. It represents the value that would be returned to a company’s shareholders if all the assets were liquidated and all of the company’s debts were paid off.
Equity can be thought of as a degree of residual ownership in a firm or asset after subtracting all debts associated with that asset.
It involves selling a portion of a company’s equity in return for capital. For example, VISHNU LTD may need to raise capital to fund the expansion of the business. The owner, therefore, decides to give up 5% ownership in the company and sell 10% of ownership to an investor in return for capital.
The advantage of equity financing over debt financing is that there is no loan to repay hence there is less burden. The business does not have to make a monthly loan payment but the money is being channeled to make a profit and grow the business.
Types of Equity Financing – Sources of capital
1. Individual Private Investors.
One way to raise money for a business is by reaching out to individual investors. This can include your friends, family, and other colleagues. Some business owners feel like this is the easiest type of equity financing to secure since they are working with people they have a prior relationship.
However, this will mean that you will need many individual donors in order to make a serious impact. Individual donors are likely to have less money to invest in your business.
2. Angel Investors.
These are investors capable of investing a large amount of money in a business and are most typically looking to invest in an industry they are familiar with and have experience working on.
The name “angel investor” reflects the fact that they make a large financial investment in your business but they can also provide very valuable guidance.
3. Public Offering.
Some businesses looking to receive equity financing in smaller dollar investments from the public may make an Initial Public Offering [IPO] and list their stock for purchase by the public.
Doing so can be an effective way for them to expand, with the added benefit of publicity from being traded on the public market.
If your company does secure an IPO though, you may reap the benefits of upfront capital investments made by smaller-dollar investors who would expect to receive far less control than angel investors or venture capitalists.
4. Venture Capital.
It is a form of investment in new small risky enterprises required to get them started by specialists called venture capitalists. Venture capitalists are therefore investment specialists who raise pools of capital to fund new ventures which are likely to become public corporations in return for an ownership interest. They buy part of the stock of the company at a higher price and therefore make a considerably high profit.
Venture capitalists also provide managerial skills to the firm. They include pension funds, wealthy individuals, insurance companies, etc.