Let’s use Portia as an ongoing example. Portia can consider using external financing, which refers to funds invested by outside investors and lenders. External financing is divided into equity and debt financing. Portia can either borrow money with the agreement to repay the borrowed sum plus interest or can obtain funds in exchange for equity, or use a combination of equity and debt financing.
Portia can consider debt as a source of external financing. Debt financing increases her financial risk because debt must be repaid regardless of whether or not the firm makes a profit. If debt is not repaid according to an agreed upon schedule, creditors may even force the enterprise into bankruptcy. Alternatively, equity investors are not entitled to more than what is earned by the enterprise.
Lines of credit – this is when bank agrees to make money available to the business. Agreement is made for up to a certain amount and is not guaranteed, but only in place if the bank has sufficient funds available. Such agreement is generally made for a period of 1 year.
Revolving credit agreement – this is similar to the lines of credit but the amount is guaranteed by the bank. A commitment fee of less than 1% of the unused balance is generally charged. Therefore, such arrangement is generally more expensive for the borrower.
Term loans – such loans are generally used for the financing of equipment. The loan is generally corresponds to the useful life of the equipment.
Mortgages – such loans are long-term loans and are available for purchase of the property which is used as collateral for the loan.
Portia can also consider equity financing. Private equity investors include venture capital firms and business angels. Venture capital firms raise a fund and then select portfolio of businesses in which to invest. Portfolios generally include start ups and existing businesses.
In exchange for investment, venture capital firms obtain partial ownership of the business. Convertible preferred stock or convertible debt is usually preferred. This is because the venture capital firm would like to have the senior claim on assets in case of liquidation but still wants to have an option to convert it to common stock if the business becomes successful.
Business angels, which are also referred to as informal venture capital, are wealthy private individuals who invest in the firms in their individual capacity. A very small percentage of start ups manage to get such funding. Therefore, entrepreneurs should have other options available as well.
There are also government supported financing options available to Portia which are specific to Portia’s location.
Further, Portia can use personal sources of funds. The “personal” sources could be personal savings, credit cards, borrowing from friends and relatives or any other way of obtaining money such as selling an asset, such as a car or a summer house, to free up funds for investment in the enterprise.
Personal savings are usually the leading source of “personal” funds. Credit cards are often used but needed to be used with extreme caution as interest rates on outstanding amounts can be incredibly high.
Borrowing from friends and family is also very tricky and should be done with extreme care. If Portia’s business fails or does not perform as expected and money is not repaid when agreed than it can destroy or severely damage relationships. When borrowing from friends and family, it is a good guideline to ensure that it is seen as an investment rather than a gift by the lending side of the transaction. An agreed upon deal should be put in writing since memory is not always reliable. Moreover, the amount borrowed should be repaid as soon as possible.
Overall, Portia has a number of the sources of external financing to choose from. Portia needs to evaluate upsides and downsides of each option and consider all options in light of the unique situation of the business to choose the best option or combination of options.