In contrast to equity financing, debt financing involves taking on debt to fund a business, rather than attracting investors by selling them shares of ownership. Whereas investors have a claim on the potential future earnings of the company, creditors expect to be paid back in full plus interest for their investment loan. If the company is not successful and goes bankrupt, then the creditors have a claim to the liquidated assets.
Banks and Commercial Lenders
A private lender is a financial institution like a bank or credit union. Many businesses that have strong personal credit and collateral can apply for a commercial loan with the intent to grow their business, such as by opening new locations or investing in new equipment.
Plan to take your time shopping around for the best rates. Credit unions typically offer more favorable rates, but they only lend to members. Additionally, private lenders will want to see a comprehensive business plan before making a loan offer. Make sure you understand all the terms and conditions of the loan before you sign on the dotted line.
Government Grants and Loans
Federal and state government agencies consider it to be in the best interests of the economy to help aspiring entrepreneurs hang out their proverbial shingles. This is why some businesses get funded with government grants or loans.
You may have a better chance of getting funding this way if your business will create jobs or if your company will be located in an economically-depressed area in need of revitalization. Some grants and loans are intended for specific industries, like STEM fields. The Arizona Innovation Challenge is a current example awarding hundreds of thousands of dollars each year.2
Friends and Family as a Source of Funding
If you’re finding it challenging to convince investors or banks of the quality of your idea, your family and friends may be more likely to believe in your dream and may lend you money at a low interest rate or even no interest rate. Approach friends and family with caution and only after you have bootstrapped and tried other sources of funding.
If you do go to friends and family for loans, it’s a good idea to make sure that each of you gets sound legal and financial advice. Don’t take their life savings; explain the extreme risk associated with start-ups. You don’t have a proven business — you have an experiment! Be honest and transparent about the fact that they could lose all their investment. Be careful if you decide to proceed this way, as there is the potential for harm to personal relationships.
Bonds
A bond is a financial instrument that indicates an investor has made a loan to the borrower. You may have heard of government bonds; it’s also possible for private corporations to issue bonds to raise funds. The bond specifies the details of the loan, such as the interest rate and the date(s) of payment.
