Whether you are starting or running your business, financial capital is essential to the overall success of the company. Financial capital gets defined as an economic resource that is necessary for business operations and has a monetary value. Hence, the money you require, to start, expand, or maintain operation in your business gets defined as financial capital.
As far as acquiring financial capital, you can get the money from:
- The government
- Private institutions
- Other lending business
However, it is essential to first understand the different types of capital available for your business. This enables you to have a clue of the implications every type of capital levies on your business.
In addition to the learning about the various types of capital, you are also going to get a comprehensive guide into how to determine which type of capital is best suited for your business.
What are The Three Main Types of Financial Capital?
As mentioned above, there are numerous types of financial capital. However, all the various types of capital fall under three main categories.
- Debt Capital
- Equity Capital
- Specialty Capital
Each group has different characteristics that affect your business in multiple ways. To better understand, the implications of each class, we have provided elaborate definitions of each category as well as the pros and cons of each category.
Debt Capital Financing
Debt capital is money/capital borrowed from an individual or institutions to get utilized in the business. This type of capital comes in the form of a loan lent to the company with predetermined conditions.
The predetermined conditions include the amount of interest to get paid as well as how long until the money needs to get repaid by the business. Hence, it is up to the business owner to ensure the terms of the loan do not get broken.
The interest paid on loan gets considered as the lender’s profit for lending you their capital. As a business owner, you can think of the interest as the cost of using someone else’s money.
In most cases, the business will be expected to pay small amounts every month towards the repayment of the initial sum borrowed plus the interest acquired. The interest gets calculated as a percentage of the principal sum borrowed.
Hence it is essential to note that the longer you take to repay the borrowed capital, you will pay more in interest in the long run. However, if you borrow a substantial amount of money, repaying over an extended period enables you to pay small monthly sums towards repayment.
Examples of debt capital include:
- Peer-to-peer loans
- Business loans
- Credit card loans
- Credit line advances (borrowing on invoices)
- For small businesses, this type of capital financing is the best as it doesn’t involve any equity allocation to the lender.
Pros of Debt Capital
1) You retain 100% ownership of your business because you do not lose any equity
2) You can get a tax deduction if you file the principal amount borrowed and interest payments as business expenses
3) Lower interest rates: Tax deductibles also have an impact on the interest rates you get to pay. For instance, the government taxes 30% of your business’s income, and your lender charges 10% on loan. After your tax deduction, your interest on the loan will be at 7%.
4) Provided you meet your lenders’ requirements, you can borrow as much as you need.
Cons of Debt Capital
1) If your business fails to make sufficient income, repaying the debt can become a hassle. Should you fail to repay the debt, you may get forced into bankruptcy, and your credit score will get damaged.
2) Despite the interest rate deduction due to tax, you may still get to pay high interest rates. Depending on your lender, interest rates vary according to several factors. The problem with high-interest rates is that they eat into your profits.
3) When you borrow money, it affects your credit rating. If you fail to meet the terms of the loan, your credit rating will decline. Hence, the next time you borrow, you will incur higher interest rates, or some lenders will not consider you for a loan.
4) A business’s income varies month to month. When income is low, the monthly interest payments on the loan will cause you to experience cash flow difficulties.
Equity Financial Capital
Equity capital often gets referred to as Book value or Networth. Equity capital is cash invested by shareholders in our business. This type of capital financing stipulates selling a piece of your business to an investor in exchange for the capital you require. Many businesses looking to expand exponentially opt for this option because there is no repayment required. However, giving away your equity has various conditions attached to it. For instance:
Your investors have a say in your business. All business decisions will have to pass through them for approval.
You have to pay a dividend to your investors indefinitely
In case your investors acquire more equity in the business than you; they can legally take over the company from you.
Out of the various examples of financial capital available, equity capital is perhaps the only type of funding that doesn’t incur any interest. However, it has its advantages and disadvantages.
Advantages of Equity Financing
1) There is no debt to this type of capital financing. With Equity financing, you are not borrowing any money. On the contrary, you are selling a portion of your company to investors for funding.
2) There are no interest rates or monthly repayments. Since there is no debt, there is nothing to repay. Hence you do not incur any interest for the capital or have to pay monthly installments.
3) Minimizing liability: Equity financing allows you to distribute the businesses liabilities among the investors. Hence, if the business is unable to repay its debts or goes bankrupt, it is the investors who lose the most amount of money.
4) If you get valuable business people as your equity investors, they can help you take the business even higher. Plus you get the opportunity to learn from them.
5) Equity capital financing doesn’t require a credit score check. Hence, if you have a poor credit rating, it is still a viable option.
6) Since you are not borrowing or have to return the capital, your credit score remains the same.
Disadvantages of Equity Financing
1) Profit sharing: Because your investors own a share of your business, they are also entitled to the proportionate share of the business’s profits.
2) Shared control of the company: Equity provides investors with a say in the business. Hence, any business decision will have to get deliberated with the investors before implementation. If the majority of your investors are against your ideas, then you may have to take a back seat.
3) Majority share hold: If you sell more than 50% of your business’s equity, you are no longer the controlling shareholder. Hence, you could lose control of the company if the other shareholders decide to go against you.
Specialty Capital Financing
This type of financing allows businesses to acquire funding with minimal economic costs on the company. Unlike debt and equity financing where something substantial (interest or share equity) gets exected in return, specialty funding has minimum expectations.
As the name suggests, this type of funding is only applicable for special and specified conditions. Examples of specialty funding include:
- Grants on specific areas of business such as technology
- Vendor financing
- Insurance compensation
- Sweat equity
- Specialty capital financing typically consists of any funding that doesn’t have direct ties to the banking system. As a result, it is not a common source of funding for the average small business.
For instance, the chances of getting a grant are minimal for the average business that has no proprietary product or service. Additionally, insurance compensation only happens when your business gets destroyed or damaged by a peril covered under your insurance policy.
Vendor financing is an exciting type of funding in the form of offered loans. In this option, a vendor lends your business capital to purchase good or services from the seed vendor. However, a transfer of your business shares to the vendor may get required as collateral.