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Funding for a business results from two
primary sources; equity or debt. Equity is the owner's or stockholders
original investment and, as such, represents the owner's cash contribution
to the business. This funding can be obtained from various sources,
including the business owner's friends, family, and in limited instances,
venture capitalists. Equity funding is dollars, which remain in the
business and have no set repayment schedule for disbursement to investors.
Equity is critical to a business in need of
obtaining a loan to fund start-up or expansion. As a general rule-of-thumb,
equity requirements for a new business fall in the range of twenty-five to
fifty percent of the total projected cost of the business start-up. This
means that owners may be required to provide up to one-half of the funds
needed to open the business.
A loan or debt is the other funding source
common to business financing. This source becomes necessary when an owner's
equity investment is insufficient to finance the company's start-up or
expansion. These are funds obtained from a third party source, generally a
commercial bank, having a defined repayment schedule which stipulates both
principal (that portion of a loan repayment representing retirement of the
original loan amount) and interest (the portion of repayment which
represents the business' cost of obtaining third party financing)
requirements. Loans can either be secured or unsecured. Unsecured loans are
based solely on the borrower's financial strength, without pledging of
assets (collateral); while secured loans, also based on financial strength,
require pledging assets as collateral for the loan. Secured loans are the
common method used by third party financing sources.
Commercial banks offer loans with varying
interest rates and repayment terms. Interest rates are generally based on
the New York banks' prime interest rate given to their most creditworthy
customers, with a percentage add-on for the perceived degree of risk of
each individual lending situation. Repayment terms will vary with the
useful life of the asset financed.
There are also a number of governmental loan
programs available to finance a start-up or expansion. These are, however,
predicated upon a business being able to meet the necessary requirements of
the particular loan fund being considered. These loan pools represent
federal, state and local funds designed to spur local private investment
and aid local development efforts. Governmental loan programs require the
involvement of a private lending institution such as a commercial bank and
fall into two types: guarantee programs and direct loan programs. Under
loan guarantee programs, all loans are provided to the business owner by a
local commercial bank. The governmental program provides to the bank a loan
loss guarantee, which is similar to a co-signor. Direct loans, on the other
hand, are targeted to a specific group such as handicapped or veteran loan
pools and are limited in their scope of participation.
For a more detailed discussion of financing
and loan programs, please contact your local SBDC office.
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