When you decide to start a small business, one of your first questions is likely to be how to raise money to finance your business operation. No matter how you plan to obtain financing for your business, you need to spend some time developing a business plan. Only then should you go forward with financing plans for even the simplest of small businesses.
You may have some cash you want to put into the business yourself, so that will be your initial base.
Maybe you also have family or friends who are interested in your business idea and they would like to invest in your business. That may sound good on the surface to you, but even if this is the best arrangement for you, there are factors you must consider before you jump in. If you decide to accept investments from family and friends, you will be using a form of financing called equity financing.
One thing that you want to be clear about is whether your family and friends want to invest in your business or loan you some money for your business. There is a significant difference between the two! If they want to invest, then they are offering you equity financing. If they want to loan you money for your business, that is considered debt financing.
Advantages of Equity Financing:
- You can use your cash and that of your investors when you start up your business for all the start-up costs, instead of making large loan payments to banks or other organizations or individuals. You can get underway without the burden of debt on your back.
- If you have prepared a prospectus for your investors and explained to them that their money is at risk in your brand-new start-up business, they will understand that if your business fails, they will not get their money back.
- Depending on who your investors are, they may offer valuable business assistance that you may not have. This can be important, especially in the early days of a new firm. You may want to consider angel investors or venture capital funding. Choose your investors wisely!
Disadvantages of Equity Financing:
- Remember that your investors will own a piece of your business; how large that piece is depends on how much money they invest. You probably will not want to give up control of your business, so you must be aware of that when you agree to take on investors. Investors do expect a share of the profits where, if you obtain debt financing, banks or individuals only expect their loans repaid. If you do not make a profit during the first years of your business, then investors don't expect to be paid and you don't have the monkey on your back of paying back loans.
- Since your investors own a piece of your business, you are expected to act in their best interests as well as your own, or you could open yourself up to a lawsuit. In some cases, if you make your firm's securities available to just a few investors, you may not have to get into a lot of paperwork, but if you open yourself up to wide public trading, the paperwork may overwhelm you. You will need to check with the Securities and Exchange Commission to see the requirements before you make decisions on how widely you want to open up your business for investment.