Financial Capital

Why a business looks for outside money

Many entrepreneurs pay their startup costs (3.4 Business Expenses) with money they personally have or can personally borrow: their own savings, a personal bank loan, or personal credit such as a credit card. Paying for a business out of your own savings is called bootstrapping.

Often that is not enough, because startup costs are only the first bill. Rent, insurance and wages come due every month after opening, and in its first months a new business may sell too little to cover them. So an entrepreneur compares her personal funds with what the business will need. She adds up the startup costs, and she calculates how many goods or services she must sell in a period to break even, which means covering all of the business's costs for that period. If her own money cannot pay the startup costs plus the operating costs for as long as it takes to reach break-even, she needs external financial capital: cash from lenders or investors outside the business.

Established businesses seek external financial capital too, for other reasons: to finance new product development, to replace fixed assets such as worn-out equipment, and to grow their sales volume and revenue. New and established businesses alike also use it to manage cash flow. Customers may pay late or buy mostly in one season, but payroll and rent are due every month whether or not money came in.

Loans or equity

Most sources of financial capital are either loans or equity financing.

A business loan works much like a personal loan: the business must repay it with interest. Interest is a business expense, recorded as interest expense on the income statement. Both a higher interest rate and a larger loan raise the cost of borrowing, as the table below shows for a year in which the whole balance is owed.

Equity financing means issuing ownership shares. The people who buy them become part owners, so the original owner gives up some control over decisions and a portion of future profits. Nothing has to be repaid.

Which sources a business can reach depends on its age and on how it is organized.

• New businesses, typically those operating for less than two years, often borrow from the owners' friends and family, or sell ownership shares to friends and family or to outside investors.
• Established businesses, typically those operating for at least two years with proven revenue and the capacity to repay, can get business bank loans.
• Corporations can also issue bonds or shares of stock. A bond is a loan from an investor to the business. Stock is an ownership share, and it can be sold privately or publicly.

What lenders and investors get

Lenders and investors hand over cash because they expect something back. In exchange, they receive financial assets: loans (including bonds) or shares of stock. These assets can be resold to other buyers in a secondary market.

Lenders earn income from interest. A bond pays interest to whoever holds it, so if you buy a corporate bond from another investor in the secondary market, you become a lender to that business and its interest payments come to you.

Investors may earn income from dividends, their share of the business's profits. Some corporations pay no dividends and reinvest their earnings in the business instead. If you buy a share of stock in the secondary market, you become an investor in the business, also called a shareholder.

Either kind of asset can also bring a capital gain, which you get when you sell an asset for more than you paid for it. Bond and stock prices change with the business's performance, with investor demand and with PESTEL forces, such as an economic downturn or a new law.

To measure how an investment did, add the income it paid to any capital gain, then divide by the price of the asset. That is the annual rate of return. Suppose you buy one share of stock and hold it for a year.

• You pay $40 for the share.
• It pays you $1.20 in dividends during the year.
• You sell it at the end of the year for $44.

You gained 1.20 + 4.00 = $5.20 in all. Divide by the price you paid: 5.20 divided by 40 is 0.13, a 13% annual rate of return.

Risk, and who is willing to take it

Lenders and investors can lose money when a business performs poorly. A lender loses if the business cannot make its interest payments or repay the loan. An investor loses dividend income and sees the stock's value fall when profits decline, and can lose the entire stake if the business shuts down.

People and institutions differ in their risk tolerance, their willingness to take financial risks. Some consumers, and some institutional lenders and investors, have a high risk tolerance and will put money into risky or unproven ideas, like a startup with no sales yet. Others are more cautious. Whatever their tolerance, lenders and investors expect a higher rate of return for holding a riskier asset. That is why a young company with uneven profits has to offer a higher interest rate on its bonds than a large, steady company does. Otherwise lenders would buy the steady company's bonds instead.

Pitching to lenders and investors

Before they hand over money, lenders and investors often require a business plan. It lays out the business's value proposition, market research, marketing strategy and financial projections, and it uses them to justify a specific funding request, the rate of return a funder can expect and the level of risk. The owner then boils the key points down into a polished pitch meant to persuade.

For an established business, funders also study its financial reports and projections, along with outside data about its industry, to estimate the business's valuation, an estimate of what it is worth. A valuation tells an investor what an ownership share is worth, and it helps a lender judge whether the business can repay a loan.

A request is more likely to succeed when it shows evidence of product-market fit, meaning customer demand strong enough to make a profit, and gives a basis for its projections. "Crumb Street will sell 750 boxes a month" is a hope. "Crumb Street sold 420 boxes in a six-week trial at farmers markets, and a third of those buyers ordered again" is evidence. Lenders and investors generally prefer projects with lower risk and higher projected returns.

They also judge the people and the purpose. Is the leadership team qualified to run this business? Do its value proposition and mission fit the funders' own goals? An investor who backs clean-energy companies is likely to pass on a fast-food chain, however good its numbers look.