When small business owners need capital in their company, they go out looking for “money.” Unfortunately, they should first decide what kind of cash infusion is best for the business. When it comes to starting or expanding a business, the source of that cash influences how the company will operate and grow in the future.
The Two Types of Capital
In simple terms, there are two types of capital a company can obtain.
Cash Loan: A cash loan is an obligation to pay back money at a certain interest rate over a specified period of time. One advantage is that the source providing the loan has no voice in managing the business. Another is that it’s not entitled to your business’ profits nor responsible for its losses.
The disadvantage is that if the business is not able to repay the loan, the owner may be personally liable for its repayment depending on its terms. If a business isn’t able to pay the loan back, the business owner may lose the control of the company to the creditor.
Cash Investment: A cash investment is the purchase of equity in a business (i.e. shares of stock) from a buyer. It typically requires additional expenses incurred from accountants and lawyers to document the sale. The owner may also be required to convert their company into a C corporation to shield the investor from liability. The advantage is that if the money is lost, the owner has no obligation to pay it back.
The disadvantage is that the investor typically gets to give input on how the business is run and gets a share of its profit. When accepting investors, the business owner has also taken on a partner in their company to whom they are required to report results.
How to Decide Which Form of Capital Infusion Is Right for Your Company
Get a loan when:
- The money is needed for a short or defined period. This time frame is typically for less than two years and the money can be paid back in time. There should be sufficient cash flow to pay interest and principal, or an affordable balloon payment at the end of the term. Your ability to pay back the loan can be determined through cash flow financial modeling typically available from information inside your accounting system.
- The money is needed to purchase equipment, seasonal inventory or other items that have a market value. In this way, the loan can be specifically secured by these assets and therefore may be available at a lower interest rate.
- Money can be sourced from family members or friends. As a result, the loan can be paid back at an agreed to time, and your lender will not have input into running the company.
- Less than $250,000 is needed in the next year. Depending on the size of the business, this should be less than 10% of the company’s overall annual capital needs.
Get an investor when:
- The money is needed for a long or uncertain period of time. This type of investment is sometimes referred to as permanent capital. The cash investment period is typically three years or more, depending on the industry and size of the company.
- The money is required to fundamentally scale the business to a larger size. In this case, the company has been proven as a profitable one, and the required amount of money that is needed to build it to its full potential is quantifiable. Achieving that sum may include hiring a professional management team, additional sales people or opening up more locations.
- The small business needs additional management help or contacts that can access resources not currently available to them. In this case, the investors are called “smart money.” In other words, their value to the business goes beyond their capital infusion. They generally help in the form of finding new customers or supply chains for the business.
- The company is unable to financially qualify for a loan. It’s important to remember that banks will only charge a low rate for loans that are not considered to be “high risk.” They are not investors whose returns are based on company success. If the company is early-stage, not cash flow positive or the owner does not have assets to personally guarantee the loan, then an investor may be the only path forward.
- The owner does not want to personally guarantee a loan. This action is required in many cases especially when money is secured from a bank or other commercial lender.