Debt vs. equity financing: Deciding which way to go

Question: I?m planning to start a business that will tie Internet online shopping together with our local retail stores. I estimate I?ll need about $900,000 to start this business. What is the best way to get this capital?

Answer: Financing for a business usually comes in two forms: debt and equity. Debt is obtained from borrowing and must be repaid from cash flow. Equity is contributed by owners or outside investors and involves no direct obligation to repay any funds, but does involve selling a partial interest in your company.

Consider the following questions to help you decide which form to choose:
? What information about my business will I need to give to potential financiers?
? How much control am I willing to give up?
? How highly leveraged do I want my company to be?

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The biggest advantage of debt financing is that it allows the business owner to retain control of the company. Debt also provides you with some financial freedom. Once the debt is repaid, the lender has no further claim on your business.

However, making monthly payments on a loan is the biggest disadvantage of debt financing. Interest rates may be high, and there are normally severe penalties for late or missed payments. Another disadvantage is that if you?re starting a business, it?s very difficult to obtain debt financing.

With equity financing the biggest advantage is that you don?t have to repay the money invested by others on a regular basis (depending on the agreement that is made). Also, the equity investor may be more likely to listen to ideas on how to make improvements, since they have an interest in the success of the business.

The disadvantage of equity financing is that the owner has to give up some control of the business, and it may be difficult to retain control in the future. The paperwork can also be very complicated and will require the advice of an attorney and accountant.

Most people get the money from their personal savings, banks or credit unions, friends and relatives, venture capital firms or angel investors. No matter which source of funding you choose, you must have a business plan prepared before approaching any potential investor or lender to be taken serious.

It?s important to note that when a lender or investor evaluates any proposal for funding, the three C?s of credit are taken into account ? character, capacity and collateral.

1. Character. Character is actually a check on your financial status and personal credit history, including your previous loan payment record. The theory is that people are creatures of habit. If you?ve repaid a loan on time before, you?ll repay this one as well. Conversely, if you have defaulted on a previous loan, the danger is that you?ll tend to default again.

Also considered is experience in the type of business you?re trying to finance, including level of responsibility, education and business management training. If your prior business experience is not relevant to your current venture, investors will be leery about your ability to run the new endeavor successfully.

2. Capacity. Prudent investors always have looked first to the cash flow of the business as a sign of success, which underlines the importance of preparing a cash flow statement with future cash flow projections before presenting your funding request. Doing so indicates to the investor that you are knowledgeable about the cash coming into your business and being spent and, therefore, better able to avoid a cash shortage that would jeopardize the business.

3. Collateral. While cash flow is the primary lifeline of the business, investors may want a backup or secondary source as an ?exit of last resort? should your business not prove profitable. Collateral is defined as ?anything of value used as security for repayment of their investment.? Collateral could be real estate, stocks and bonds, savings account passbooks, equipment, accounts receivable or the cash value of life insurance policies.

Finding the money you need to start or expand your business requires hard work and determination. It may be the largest obstacle you face, and you may be turned down several times for financing. Perseverance is key.

Remember, it is OK for you to consider a variety of financing alternatives, and more than likely you will need to use a combination of sources to adequately fulfill your changing needs for capital. Do your research, and find out as much information as you can about each source.

If you have a good idea, you?ll receive the financing you need. Look for every way to prove success by searching for equipment, materials or labor that can be provided at a reduced rate. Search for all sources that are available and don?t ever lose sight of the dream that your business can and will succeed.

Greeley resident Russell Disberger is a founding member of Aspen Business Group LLC, a Colorado-based organizational consulting firm. He can be reached at (970) 396-7009 or via e-mail at russell@aspenbusinessgroup.com.