Examining Types of Business Capital
When implementing a new business concept, only one definition captures the real essence of capital: “It takes money to make money.” From the aspiring entrepreneur designing new software in a home office to the executive of a multinational corporation looking to expand foreign distribution channels, launching any new business concept requires capital, or money, as a basis to execute the business plan. One of the most common reasons businesses fail is a lack of or inappropriately structured capital resources.
For the sake of simplicity, capital is the amount of financial resources needed to implement and execute a business plan. Before a business sells its first product or service, it needs financial resources for product development, sales, marketing, administrative support, the company’s formation, and countless other critical business functions.
Capital should not be perceived as just the amount of “cash on hand” but rather the amount of financial resources available to support the execution of a business plan.
While financial resources come in countless forms, types, and structures, two basic types of financial resources are available to most businesses: debt and equity.
- Debt represents a liability or obligation of a business. Debt is generally governed by mutually agreed upon terms and conditions as provided by the party extending credit. For example, a bank lends $2 million to a company to purchase additional production equipment to support expansion. The bank establishes the terms and conditions of the debt agreement, including the interest rate, repayment term, collateral required, and other elements. These terms and conditions must be adhered to by the company, or it runs the risk of default.
- Equity represents an investment in the business, usually doesn’t have set repayment terms, but the owners of the equity investments do have a right to future earnings — they may be paid dividends or distributions if profits and cash flows are available. For example, a software technology company requires $2 million in capital to develop and launch a new software solution. A venture capitalist group invests the required capital under the terms and conditions present in the equity offering, including what their percentage ownership in the company will be, rights to future earnings, representation on the board of directors, conversion rights, and so on. The company isn’t required to remit any payments to the capital source per a set repayment agreement but has given up a partial right to ownership (which can be even more costly).
Of course, many variations, alternatives, subtypes, and classifications are present for each type of capital. If it were as easy as debt versus equity, there wouldn’t be much need for bankers, accountants, venture capitalists, and the like (which would be a welcomed change to most business owners).
You may be wondering whether debt or equity capital is best suited for your company. This decision really depends on the company’s stage in terms of its operating history, industry profile, profitability levels, asset structure, future growth prospects, and general capital requirements, as well as where the sources of capital lie.