One of the major challenges faced by aspiring business owners is finding the most effective source of finance for funding their businesses. Growing businesses also face challenges funding their expansion. In this article, we will be looking at the various ways of funding your business; whether you are just starting a business or seeking to expand an already existing business. There are two major available options: Debt financing and Equity financing. Every business owner must decide on the most efficient way of either using just one or combining both.
Debt finance can be in form of borrowings, debentures, overdrafts and others. A key characteristic of this finance option is that the you, the borrower, would have to repay the principal plus interest. Let us look at how this works. James is a small business owner seeking to add an extension to his current shop to allow for the storage of additional goods. James approaches a bank to lend him NGN500,000 for a one-year tenure. The bank offers James the NGN500,000 at an interest of 10% per annum. When James is liquidating the loan after a year, he will pay the original NGN500,000 (principal) plus NGN50,000 (interest). Now that we understand how debt financing works, let us explore the various types of debt finance options available to business owners.
The most common type of debt finance is bank overdraft. A bank overdraft is a credit option available to current account holders. The bank allows for these account holders to withdraw more than the amount the person has in their account up to a specified limit. This is a form of debt finance as the account holder would have to repay the excess amount withdrawn. The key advantages of an overdraft are that it allows for the successful settlement of transactions and saves time that would have been spent arranging a formal loan facility. It is also important to note that overdrafts incur a service charge which is a form of interest that would be paid on the amount borrowed (CFI, 2020). There are two types of bank overdrafts, authorized and unauthorized.
An authorized bank overdraft is one where an arrangement is made in advance between the account holder and their bank. Both parties agree to a borrowing limit in exchange for a service fee that would be charged on the amount borrowed.
An unauthorized bank overdraft is one where there is no agreed arrangement between the bank and the account holder. This account holder simply spends more than what he or she has in the bank account. An unauthorized overdraft incurs a higher service fee than an authorized overdraft.
Another type of debt finance available to business owners is a bank loan. A bank loan is simply an arrangement where a bank offers to lend a customer money for an agreed time period at an agreed interest rate. A bank loan can either be secured or unsecured.
A secured bank loan is when a bank asks for a collateral asset. For instance, in securing the NGN500,000 loan James asked the bank for, the bank might have requested for James’ car ownership documents as a collateral asset. In the event where James does not repay the bank at the agreed time, the bank would take ownership of James’ car as repayment for the loan.
An unsecured bank loan is one for which the bank loans money to a customer without a collateral asset. This type of loan attracts a higher interest rate than the secured due to the additional risk the bank is exposed to.
Business owners could also obtain debt finance in form of bonds, family and credit loans, debentures, etc.
Equity finance is the process of raising capital through the sale of shares in one’s business. The difference between equity finance and debt finance is that in equity finance, the person giving you the capital owns part of your business and is entitled to a share of your profit (Majaski, 2020). Equity finance can be raised through an initial public offering of shares, business angels, venture capitalism, crowdfunding and others. This article will focus on two forms of equity finance: venture capital and crowdfunding.
A venture capitalist is an investor that provides finance to startup companies and small businesses that they believe have the potential for long-term growth. Venture capital usually comes from institutional investors, wealthy business owners, and investment banks. The advantages of venture capital are that it allows for a business owner to raise a large amount of capital from a single investor. The business owner also has access to the experienced leadership and advice of the venture capitalist. The main disadvantage is that the owner’s stake in the business is reduced. A venture capitalist differs from a business angel as business angels invest almost exclusively in startups while venture capitalists may also invest in already existing entities.
Crowdfunding is a process where an entrepreneur raises a small amount of capital from each individual investor. Crowdfunding makes use of social media platforms and crowdfunding websites like GoFundMe to access many investors. Crowdfunders could invest as little as $10. The main advantage of using crowdfunding to raise capital is that it gives the business owner access to a large group of potential investors. However, there are restrictions on who can fund a new business and how much they can contribute.
In most cases, business owners will use a combination of these financing options to run their business. Business advisors can be consulted in determining the most effective combination of financing options for their business. We hope this article was able to provide you with insight into the various funding options available to business owners.
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