One of the most critical questions facing the entrepreneur is the question of financing. In many cases businesses fail because the financing is underestimated, and even though there is a great demand for the product/service, the failure to provide adequate financing means that the marketing and distribution of the product/service falls short and the business fails to take in the revenue that is out there but inaccessible because of the lack of funding.
In planning to start, or expand, a business it is therefore very important for the business planning to include a well documented plan on the aspect of financing. Not only is it important to document the requirement but also to determine what the cost of the financing is relative to the expected return.
The failure to do so could result in the failure of the venture, thus leaving someone else to capitalize on the idea you would have generated.
In determining the financing requirement, there are basically two sources. These are debt or equity financing, and the entrepreneur will have to determine which one is best for the long term viability of the business.
Debt
Debt financing is where the business borrows money, which is repaid at a cost, usually an interest cost. Debt can be in the form of a loan, bond, IOU, or some other instrument that involves a promise to repay the amount advanced at an agreed time and cost.
The main advantage of debt financing is that ownership is not diluted as the existing shareholder(s) take all the risk – cost – of the debt and does not have to give up any portion of their ownership but has the responsibility for repaying that debt. This they will usually secure by personal guarantee or with existing company assets.
In deciding whether to use debt or not the entrepreneur should determine (i) what the cost of the debt is in relation to the projected return on the debt investment; (ii) is all that is needed is money capital, or is intellectual capital also needed; (iii) what is the time for which the financing is needed; and (iv) compare the return from the debt versus the return from equity, as even if one is diluting the ownership the return of equity can in fact be greater.
The major disadvantage of debt is that the full risk is with the entrepreneur and badly managed it can send a company into liquidation.
Equity
Equity financing refers to funds raised that offers the person/organization providing the financing a part of the ownership structure. This is the main disadvantage of equity financing, that is dilution of ownership.
This type of financing can come from personal funds, contribution from family and friends, or business associates. It is usually used for general financing over the long term.
The main advantage of equity financing is that it shares the risk of capital, and does not have any direct future cost associated with it – although it has an opportunity cost. It also provides a greater ability for business expansion than debt, as it is long term financing at no cost.
Debt to Equity
Important considerations in determining whether to go with debt are:
- How long the funds are needed for
- What is the cost of the debt in relation to the specific return from any project being financed
- What is the debt to equity ratio
- Is the financing for general needs or a specific project requirement
- Is there a requirement for intellectual capital along with the monetary capital
- Is the debt/equity enough to meet the developmental goals
In order to gain more specific insight into this you can access the “Ask your expert” or any discussion forum that deals with the issue.
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