There are two kinds of capital: debt and equity. Both kinds are typically used by a company during its lifetime. Lenders have different objectives than investors and therefore look at different factors about a company when deciding whether or not to invest or make a loan.
Debt is money borrowed, which must be repaid at a set time period and generates income for the lender over that time period.
Lending sources include not only banks, but also leasing companies, factoring companies and even individuals.
Lending sources look primarily at two factors: how risky the loan is; and whether the company can generate sufficient cash to pay the interest and repay the principal. The growth potential of the company is secondary; the primary considerations are the track record and asset base of the company.
Equity capital is money given for a share of ownership of the company. Equity can be provided by individual investors, sometimes known as "angels", venture capital companies, joint venture partners, and the sweat equity and capital contribution of the founders of the company.
Equity providers are more interested in the growth potential of the company. Their objective is to invest an amount now and reap the rewards of a 5 to 1, or even 10 to 1, payoff in three to five years.
In other words $100,000 now will be worth $1,000,000 in three years if invested in the right company.
So, Debt Or Equity Capital?
The answer is dependent on the answers to several questions:
What Is The Financial Condition Of The Company?
In certain situations the company's financial condition will suggest one kind of capital over the other.
If the company needs all its cash to fund its growth, then a loan is not feasible, because the company could not afford interest and principal payments.
If the company just needs a line of credit to fund a cyclical increase in orders, then it doesn't make sense to bring in an equity investor.
What Impact Will The Financing Have On The Ownership Position?
The last issue and probably the most important one is, how will the owners react to having their ownership and management control diluted.
An investor can often contribute experience and management expertise, as well as money, and has a vested interest in the success of your company.
A lending source has no impact on the company (other than any loan covenants discussed above); its primary objective is to be repaid.
So Debt Or Equity? The choice is yours.
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There is a myth that no debt is good debt. Whenever we’re talking about owing money these days, it’s almost always in a negative light.
You hear it every day: homeowners are underwater, the national deficit is surging, consumers are saddled by shortsighted credit card spending, the nation’s graduates are buried under student loans.
For businesses, the truth about debt is far less ominous. As the high finance set understands, not all borrowing is bad. For small business owners who might not have a masters degree in finance, keeping the following four things in mind will help them use debt to gain leverage, rather than getting weighed down.
Paying interest on debt reduces tax burden.
Many entrepreneurs aren’t aware of this surprise benefit of borrowing. The cost of interest reduces your taxable profit and, therefore, reduces your tax expense. The effective interest you’re paying is lower than the nominal interest because of this.
It is this lower cost of capital that should be factored in when calculating the return from taking on debt. Leveraged buyout firms have used this strategy for ages to rake in the dough.
Small businesses, too, can use it to improve their company’s finances.
Credit Card Purchase
With a debit card, you’re withdrawing money from your own funds, but with a credit card you are effectively borrowing from the provider for a short period. If you pay the money back in full by the due date, you generally will not pay interest.
However, if you pay less than the full amount, you will pay interest on the continuing balance. While interest rates vary from about 10% to over 20% for those with bad credit ratings, the average credit card APR is around 16%.
Monica graduated with a degree in finance and worked as a manager at a national bank. Now she helps people get car title loans.