If you run your own business, at some point, you may need to access business financing. Even corporations may need financial injections from time to time to fulfil short-term obligations.

If you do need business financing at some point, it is important that you identify an appropriate funding model. If you borrow money from the incorrect person or organization, you run the risk of losing some of your business or being forced to adhere to repayment terms that will limit your ability to expand for many years to come.

In this article, we take a look at three different types of business financing that are available and their associated advantages and disadvantages.

Debt Financing

The Benefits of Debt Financing

The following are some benefits of securing debt financing for your company:

  • The lending institution does not own your company, and it has no influence over how you run it.
  • Your relationship with the lender comes to an end once you have repaid the debt. That is especially crucial as the value of your company rises.
  • You can deduct interest paid on debt financing from your taxes as a business expense.

The Disadvantages of Debt Financing

It is important to note that there are significant drawbacks to using debt finance for your company:

  • A debt payment is included in your monthly expenses. As such, you will need to make enough money to cover all business expenses, including the debt payment. That is frequently far from certain for early-stage businesses.
  • If things don’t go quite according to plan and you encounter issues, you will be personally responsible for the debt if you are a sole trader. For this reason, you may benefit from securing small business insurance if you have taken on debt financing.
  • During recessions, small business lending can be significantly slowed. If you aren’t abundantly qualified, it could be challenging to get debt financing during leaner economic times.
  • Small firms may find it more difficult to obtain approval for loan funding during economic downturns.

Equity Financing

An investor, not a lender, is used in equity financing. In the event of bankruptcy, the investor simply loses their investment because they are a part owner of the business and are not owed anything.

Equity Financing Benefits

There are various benefits associated with raising capital from investors:

  • The lack of a repayment obligation. Investors are not considered creditors if your company files for bankruptcy. They hold a portion of the company’s ownership, so when your business fails, their money also does.
  • Because you do not have to make monthly payments, you frequently have more readily available cash for operating costs.
  • Investors are aware that starting a firm is a lengthy process. You won’t be under any pressure to have your business or product succeed quickly in order to receive the funding you require.

The Disadvantages of Equity Financing

Similarly, equity financing has a number of drawbacks:

  • You will be required to give up a percentage of your company’s ownership. The investor will seek a larger interest in an investment the more substantial and risky it is. You could need to sell off 50% or more of your business. This partner will always take half of your profits unless you subsequently come up with a plan to buy the investor’s stake back.
  • Before making any decisions, you must also get the opinion of your investors. If an investor owns more than 50% of your business, you no longer own it exclusively, and you now have a boss who you must report to.

Mezzanine Capital

The best aspects of equity and debt financing are frequently combined in mezzanine capital. Debt capital typically offers the lending institution the right to convert the loan into an equity interest in the firm if you do not repay the loan on time or in whole, though there is no defined framework for this sort of business financing.

Mezzanine Capital Benefits

There are various benefits to using mezzanine capital:

  • This kind of financing is suitable for a young business that is already expanding. If a company does not have financial information going back at least three years, banks might be hesitant to lend to it.A younger company, however, might not have as much information to offer. The bank has a greater safety net by including an opportunity to purchase an interest in the business, making it simpler to get the loan.
  • Mezzanine capital is accounted for as equity on the balance sheet of the company. Future lenders are attracted to a corporation that has equity rather than a debt commitment.
  • Mezzanine financing is frequently offered relatively rapidly and with minimal due diligence.

The Disadvantages of Mezzanine Capital

Mezzanine financing is not without its drawbacks.

  • Because the lender considers the company to be high risk, the coupon or interest is frequently greater. Mezzanine capital is sometimes subordinate to existing debt or equity commitments when it is supplied to a company, which raises the likelihood that the lender won’t be paid back. A 20% to 30% return may be required by the lender due to the high risk involved.
  • The possibility of losing a sizable chunk of the business exists, just like the risk of investing equity capital.

Please keep in mind that mezzanine financing is less common than debt or equity financing. The arrangement will be unique to each side, as will the risk/reward profile.