Updated: Mar 29, 2019
All businesses need some form of capital. Capital is often in the form of money but it could be anything of value to the business. Acquiring capital is an essential step in beginning a business and an integral part of operating a business. Without adequate capital businesses fail to thrive. Although you can raise capital from your own bank account, in general raising capital is the process of asking other people to use their money.
There is always a cost associated with using other people’s money. That cost comes in various forms including interest, dividends, equity interests, options for equity interests, and government regulations. There are three basic types of capital for businesses. The two most commonly used forms of capital are equity capital and debt capital. Often these two forms of capital will be combined in creative ways to create hybrids of equity and debt, such as convertible notes or preferred stock. A third and new type of capital can be achieved through crowdfunding. Briefly, crowdfunding capital is obtained through third party crowdfunding websites where very small amounts of money are pledged to the business by a large “crowd” of people who are interested in the business. Typically, this “crowd” makes a commitment of capital to the business in exchange for rewards, recognition or products/services. However, some crowdfunding websites allow pledges of capital in exchange for ownership interests in the underlying companies.
One of the most common forms of capital for the very early stages of a new business is debt. Most of the debt capital used by early stage businesses come from personal loans, credit cards, home equity and personal assets. However, debt capital can also be acquired by borrowing money from a bank, financial institution, or from friends and family. Debt is the right to temporarily use the lender’s money with an obligation to repay the lender both principal and interest. Some common types of debt capital include notes, bonds, debentures, and mortgages. The obligation to repay the borrowed funds usually starts within a month or two of borrowing. This repayment obligation can sometimes drain cash flow from a new business making it difficult to survive. Entrepreneurs who are unable to acquire or afford debt capital turn to equity capital as their best and sometimes only alternative.
Equity capital is acquired through the issuance and sale of equity securities in the underlying company to interested investors. In other words, entrepreneurs will sell a portion of their business to investors in order to raise the money they need to start and grow their operations. There are many sources of equity capital. Friends and family are the typical starting point for raising capital through the sale of securities. When resources of friends and family are exhausted entrepreneurs look to the venture capital markets. Angel investors are individual investors in the venture capital market. They have very high net worth and have an interest in investing in high risk/high reward businesses. Once a business has proven its concept in the market, it may be able to source equity capital from venture capital firms. Venture capital firms pool funds from institutional investors, pension funds, insurance companies, wealthy families and private endowments. These pooled funds are then used to acquire securities in promising companies.
For entrepreneurs, part of the lure of equity capital is freedom from debt service and often a strategic alignment with experienced investors. However, one of the drawbacks is complex regulations at both the state and federal levels as well as within the capital markets industry via self-regulatory organizations, also known as SROs, such as FINRA, NASD and the stock exchanges. Whenever an entrepreneur engages in the sale of any kind of interest in a business the securities laws and regulations will apply and should inform the decision-making process as well as the structure of the contemplated transaction.
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