There are a variety of options to finance your business operations and capital investments. Deciding which is right for your business varies with each company and situation.
Three of the more common financing options for businesses are as follows:
- Term loans typically have set monthly payment terms over multiple years at fixed interest rates. Term loans are not as flexible as revolving loans (described below) which lack set payment terms. One advantage of term loans is that you can typically borrow more money up front because of the specificity of what the funds are being used for and the continued payment schedule.
- Revolving loans typically have variable interest rates without set payment terms. Revolving loans, as the name implies, allow the borrower to borrow up to an approved dollar limit, pay down the loan, and then borrow again. These loans provide more borrowing and repayment flexibility. However, revolvers may have downsides, such as requiring a zero balance at some point during the year or fees for not utilizing the revolver.
- Equity financing involves the sale of additional equity interest to current owners or outside investors. In equity financing, there are no repayment terms. However, it puts additional owners’ capital at risk and may reduce existing owners’ control of the business if equity is sold to new investors.
When should these finance options be used?
Term loans match up well with long-term investments in equipment or business expansion because repayment terms often mirror the useful life of these long-term investments, allowing the company to match cash payments to cash inflows generated from the new investments. Accordingly, term loans work well when building more production or warehouse capacity, or acquiring another business.
Term loans allow the business to finance the investment and pay for it over time using the proceeds generated from the business without the need to put more of the owners’ capital at risk or dilute ownership interest.
Revolving loans are best suited for funding working capital requirements, particularly in companies that are seasonal. These loans are typically used to provide cash while working capital is tied up in inventory or receivables. Having access to a revolver can give owners peace of mind that capital is available without having to find ways to personally finance the operations if cash flow is tight.
Equity financing works well for long-term investments, similar to term loans. The advantage of using equity to fund long-term investments is that the company is not required to pay it back and can use the future cash flows to reinvest in the business instead of paying down debt. The disadvantage, as previously discussed, is that it puts more of the owners’ capital at risk and may reduce the level of existing owners’ control if equity is sold to third parties.
Equity financing can be used for short-term working capital needs. However, if bank agreements limit the amount that can be distributed to owners annually, owners may not be able to quickly reduce the amounts at risk even after working capital has improved.
When evaluating your financing options, you need to consider your business’s goals, objectives, and operating cycle. Choosing the wrong financing option can be burdensome to the company and its owners. Utilizing the guidelines above can help you design a financing plan that works for your business.
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