When you decide to start a small business, one oI your Iirst questions is likely to be how to raise

money to Iinance your business operations. No matter how you plan to obtain Iinancing Ior your
business, you need to spend some time developing a business plan. Only then should you go
Iorward with Iinancing plans Ior even a simple small business.
Equity Financing
You may have some cash you want to put into the business yourselI, so that will be your initial
base. Maybe you also have Iamily or Iriends who are interested in your business idea and they
would like to invest in your business. That may sound good on the surIace to you, but even iI this
is the best arrangement Ior you, there are Iactors you must consider beIore you jump in. II you
decide to accept investments Irom Iamily and Iriends, you will be using a Iorm oI Iinancing
called equity Iinancing.
One thing that you want to be clear about is whether your Iamily and Iriends want to invest in
your business or loan you some money Ior your business. That is a crucial distinction! II they
want to invest, then they are oIIering you equity Iinancing. II they want to loan you money Ior
your business, then that is quite diIIerent and is actually considered debt Iinancing.
Advantages of Equity Financing:
O You can use your cash and that oI your investors when you start up your business Ior all
the start-up costs, instead oI making large loan payments to banks or other organizations
or individuals. You can get underway without the burden oI debt on your back.
O II you have prepared a prospectus Ior your investors and explained to them that their
money is at risk in your brand new start-up business, they will understand that iI your
business Iails, they will not get their money back.
O epending on who your investors are, they may oIIer valuable business assistance that
you may not have. This can be important, especially in the early days oI a new Iirm. You
may want to consider angel investors or venture capital Iunding. Choose your investors
wisely!
isadvantages of Equity Financing:
O #emember that your investors will actually own a piece oI your business; how large that
piece is depends on how much money they invest. You probably will not want to give up
control oI your business, so you have to be aware oI that when you agree to take on
investors. Investors do expect a share oI the proIits where, iI you obtain debt Iinancing,
banks or individuals only expect their loans repaid. II you do not make a proIit during the
Iirst years oI your business, then investors don't expect to be paid and you don't have the
monkey on your back oI paying back loans.
O $ince your investors own a piece oI your business, you are expected to act in their best
interests as well as your own, or you could open yourselI up to a lawsuit. In some cases,
iI you make your Iirm's securities available to just a Iew investors, you may not have to
get into a lot oI paperwork, but iI you open yourselI up to wide public trading, the
paperwork may overwhelm you. You will need to check with the $ecurities and
xchange Commission to see the requirements beIore you make decisions on how widely
you want to open up your business Ior investment.
ebt Financing
II you decide that you do not want to take on investors and want total control oI the business
yourselI, you may want to pursue debt Iinancing in order to start up your business. You will
probably try to tap your own sources oI Iunds Iirst by using personal loans, home equity loans,
and even credit cards. Perhaps Iamily or Iriends would be willing to loan you the necessary Iunds
at lower interest rates and better repayment terms. Applying Ior a business loan is another option.
Advantages of ebt Financing
O ebt Iinancing allows you to have control oI your own destiny regarding your business.
You do not have investors or partners to answer to and you can make all the decisions.
You own all the proIit you make.
O II you Iinance your business using debt, the interest you repay on your loan is tax-
deductible. This means that it shields part oI your business income Irom taxes and lowers
your tax liability every year. Your interest is usually based on the prime interest rate.
O The lender(s) Irom whom you borrow money do not share in your proIits. All you have to
do is make your loan payments in a timely manner.
O You can apply Ior a $mall Business Administration loan that has more Iavorable terms
Ior small businesses than traditional commercial bank loans.
isadvantages of ebt Financing
O The disadvantages oI borrowing money Ior a small business may be great. You may have
large loan payments at precisely the time you need Iunds Ior start-up costs. II you don't
make loan payments on time to credit cards or commercial banks, you can ruin your
credit rating and make borrowing in the Iuture diIIicult or impossible. II you don't make
your loan payments on time to Iamily and Iriends, you can strain those relationships.
For a new business, commercial banks may require you to pledge your personal assets beIore
they will give you a loan. II your business goes under, you will lose your personal assets.
Any time you use debt Iinancing, you are running the risk oI bankruptcy. The more debt
Iinancing you use, the higher the risk oI bankruptcy. Calculate the debt to equity ratio to
determine how much debt your Iirm is in compared to its equity.
$ome will tell you that iI you incorporate your business, your personal assets are saIe. on't be
so sure oI this. ven iI you incorporate, most Iinancial institutions will still require a new
business to pledge business or personal assets as collateral Ior your business loans. You can still
lose your personal assets.
Which is best; debt or equity Iinancing? It depends on the situation. Your Iinancial capital,
potential investors, credit standing, business plan, tax situation, the tax situation oI your
investors, and the type oI business you plan to start all have an impact on that decision. The mix
oI debt and equity Iinancing that you use will determine your cost oI capital Ior your business.
Make this decision wisely!
Capital structure describes how a corporation has organized its capitalhow it obtains the
Iinancial resources with which it operates its business. Businesses adopt various capital
structures to meet both internal needs Ior capital and external requirements Ior returns on
shareholders investments. As shown on its balance sheet, a company's capitalization is
constructed Irom three basic blocks:
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noL due Lo be repald wlLhln Lhe nexL monLhs Such debL conslsLs mosLly of bonds or slmllar
obllgaLlons lncludlng a greaL varleLy of noLes caplLal lease obllgaLlons and morLgage lssues
9tefetteJ stock @hls represenLs an equlLy (ownershlp) lnLeresL ln Lhe corporaLlon buL one wlLh
clalms ahead of Lhe common sLock and normally wlLh no rlghLs Lo share ln Lhe lncreased worLh
of a company lf lL grows
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books lL ls made up of (l) Lhe nomlnal par or sLaLed value asslgned Lo Lhe shares of ouLsLandlng
sLock () Lhe caplLal surplus or Lhe amounL above par value pald Lhe company whenever lL
lssues sLock and (3) Lhe earned surplus (also called reLalned earnlngs) whlch conslsLs of Lhe
porLlon of earnlngs a company reLalns afLer paylng ouL d|v|dends and slmllar dlsLrlbuLlons uL
anoLher way common sLock equlLy ls Lhe neL worLh afLer all Lhe ||ab|||t|es (lncludlng longLerm
debL) as well as any preferred sLock are deducLed from Lhe LoLal asseLs shown on Lhe balance
sheeL lor lnvesLmenL analysls purposes securlLy analysLs may use Lhe companys markeL
caplLallzaLlonLhe currenL markeL prlce Llmes Lhe number of common shares ouLsLandlngas a
measure of common sLock equlLy @hey conslder Lhls markeLbased flgure a more reallsLlc
valuaLlon
CHUUSINC DEBT VERSUS EQUITY
It should be noted that companies may operate without Iunded debt or, more Irequently, without
any preIerred stock. By the very nature oI corporate structure, however, they must have common
stock and the related stockholders' equity accountthough, when the company Iares badly, the
equity can be a negative amount.
In arranging a company's Iinancial structure, 2anage2ent normally aims Ior the lowest Ieasible
cost oI capital; whereas an investor seeks the greatest possible return. While these desires can
conIlict, they are not necessarily incompatible, especially with equity investors. The cost oI
capital can be kept low and the opportunity Ior return on common stockholders' equity can be
enhanced through leveragea high percentage oI debt relative to common equity. But increased
leverage carries with it increased risk. This is the inescapable trade oII both management and
investors must Iactor into their respective decisions.
The leverage provided by debt Iinancing is Iurther enhanced because the interest that
corporations pay is a tax-deductible expense, whereas dividends to both preIerred and common
stockholders must be paid with aIter-tax dollars. Thus, it is argued, the lower net cost oI bond
interest helps accrue more value Ior the common.
But, oI course, increased debt brings with it higher Iixed costs that must be paid in good times
and bad, and can severely limit a company's Ilexibility. The Financial Handbook, spells out Iour
problems that tend to increase as leverage escalates: (1) a growing risk oI bankruptcy; (2) lack oI
access to the capital markets during times oI tight credit; (3) the need Ior management to
concentrate on Iinances and raising additional capital at the expense oI Iocusing on operations;
(4) higher costs Ior whatever additional debt and preIerred stock capital the company is able to
raise. Aside Irom the unpleasantness involved, it is noted that each oI these Iactors also entails
tangible monetary costs.
$till, because oI its tax advantages and stability relative to equity capital (common stock), some
Iinance theorists have argued that higher proportions oI debt capital may be advantageous to
corporations. Their advice is not always heeded, however. Although periodically companies use
debt to buy back common shares, a practice that can improve stock perIormance, most large
companies rely heavily on equity Iinancing.
The elusive "optimal" capital structure is that which minimizes the total cost oI a corporation's
capital. While complex mathematical Iormulas abound Ior devising varying capital structures
and projecting potential returns under a vast number oI scenarios, there is no proven way to
arrive at an optimal structure except, to some extent, by hindsight. In practice, there are no Iixed
rules on what represents an ideal capitalization. In any case, an appropriate capitalization must
depend greatly on the nature oI the business, prevailing economic and Iinancial conditions, and
sundry other shiIting Iactors.
There is a good body oI research that suggests companies tend to employ debt under certain
circumstances more than others. For example, a survey Irom the late 1980s reported that CFOs
oI major companies decided whether to use debt based on the nature and risks oI the cash Ilows
associated with the capital investment. Another mid-1990s study produced compatible Iindings.
When diversiIying into new lines oI business, the study suggested, companies that are moving
into related Iields tend to use equity capital and those entering unrelated Iields tend to use debt.
Ownership structure is also an inIluence. Firms with a high degree oI management ownership,
Ior instance, are less likely to carry high levels oI debt, as are corporations with signiIicant
institutional ownership.
#egulated utilities represent a special case. Agencies and organizations acting as consumer
advocates regularly argue that utilities should be held to an optimal capitalization standard
optimal invariably meaning a heavy layer oI debt so as to permit a higher percentage oI proIits to
Ilow to the common, thus reducing the need Ior rate increases. Utility management in its turn
warns oI the danger oI too much debt and the need Ior a stronger equity cushiona structure that
will require more revenues (i.e., higher rates) Ior the utility to earn its authorized rate oI return.
In earlier days, a debt-Iree structure was oIten considered a sign oI strength and many industrial
companies that were able to Iinance their growth with an all-common capitalization prided
themselves on their "clean balance sheet." specially in the rapid expansion aIter World War II,
however, the vast demand Ior capital and low interest ratesmade even lower thanks to tax
deductionsmade debt Iinancing increasingly attractive. Not only was the immediate demand
on income relatively modest but since the interest requirement remained Iixed, all Iuture income
growth Iinanced by this debt capital would Ilow straight through to the common.
Benjamin Graham and avid odd, oIten considered the Iathers oI modern security analysis and
noted Ior their advocacy oI prudent investing, long ago pointed to the advantages oI a "sound"
but not "excessive" amount oI debt in the corporate structure. In conIronting the "debt-Iree is
best" argument, they shrewdly asked how one could advise a conservative investor to buy good-
quality bonds iI the very act oI issuing bonds implied that "the company had taken a dangerous
and unwise step?" Graham and odd recommended: "In most enterprises, a bond component no
more than|but| not too Iar belowthe amount that careIul Iinancial institutions would be
ready to lend . would probably be in the interest oI the owners."
STRATECIC LEVERACE
The leveraged buyout (LBO) stampede oI the 1980s brought a new twist to the capitalization
issue. Large corporations with conservative, low-debt capitalizations became especially
vulnerable to capture. Corporate raiders with limited Iinancial resources, had the ability to raise
huge amounts oI noninvestment-grade ("junk") debt to swing the deals. The captured companies
could then be dismembered and stripped oI cash holdings so the raiders could pay down their
borrowings; in short, the prey's own assets were used to pay Ior its capture.
As a takeover deIense, many potential targets began to assume heavy debt themselves, oIten to
finance an internal buyout by its own management. Again, success would oIten depend on the
successIul sale oI major assets.
The raiders make no apology Ior such actions. As described by Harvard proIessor Michael C.
Jensen, they can purposely leverage the Iirm so highly (at times with current income insuIIicient
to meet current interest requirements) so the company cannot continue to exist in its old Iorm.
But, he argued, this "generates beneIits. It creates the crisis to motivate cuts in |low-return|
expansion programs and the sale oI those divisions which are more valuable outside the Iirm."
The problem with this theory, to some observers, is that it assumes any value tucked away by
existing management is automatically Iair game Ior distribution to stockholdersincluding those
who move in Ior just that purposeand makes no allowance Ior the company's long-term needs.
As applied, the theory also made little distinction between good and bad management, but tended
to brand the management oI any targeted company as either inept or Ieathering-its-own-nest or
both.
Whatever the merits oI the opposing arguments, the Ilood oI LBOs brought with it an essentially
new type oI securitythe junk bond, a bond rated as noninvestment grade or speculative.
The position oI junk bonds in a capital structure, Irom a legal and accounting standpoint, is
clearly that oI debt. It is usually subordinated to the claims oI many other lenders, but ranks
ahead oI any equity holders. From the investor's standpoint, iI the bond portion oI the portIolio is
intended to represent a relatively saIe anchor, with a dependable return on well-protected
principal, it is important to stick to investment grade issues. For those willing to assume (and
able to recognize) the increased risk, a holding oI junk bonds, preIerably a well-diversiIied
selection, can be justiIied as part oI the more speculative part oI the portIolio.

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