Financing a Business Start-Up or Expansion

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When it comes to raising money for a business start-up or expansion, business owners often ask if it’s better to use debt or equity financing. In most cases, it’s better for the business owner to use public debt sources (banks), before going to private equity sources such as venture capital firms and private equity groups. Using private sources will usually cause the equity ownership of founders and early investors to be greatly diluted.

Bank Loans

First, it is typical and logical for a bank to want to protect its investment. If the owner dies prior to repayment of the loan and the business fails, the bank has no easy means of collecting. A simple, straightforward method of guaranteeing repayment is through life insurance.

During the business loan application process, the banker will encourage the business owner to either utilize an existing life insurance policy or purchase a new one in the amount of the loan, and for at least the period of the loan. For example, if the bank is making a loan for $500,000 to be paid back over 10 years, the policy proceeds would have to cover that specific amount and time.

The owner may not want to reallocate personal insurance away from his family to satisfy this business need, since they would presumably need the cash if income from the business was no longer available upon the owner’s death. Therefore, it is most common for business owners to acquire a new life insurance policy, which will be payable to the lender by a “Collateral Assignment.” This document entitles the lender to their amount at risk from the loan.

As the balance of the loan is repaid during the owner’s lifetime, the lender’s claim to the death benefit decreases. Any remaining policy proceeds not needed to repay the loan are paid to the owner’s named beneficiary and can supplement his personal life insurance to help offset other financial needs that arise from his premature death.

Borrowing from Family and Friends

Many businesses would never have been started if family and friends had not helped to finance the start-up. However, for most business owners, that may be the last resort. If the owner must borrow from family and friends, everyone involved must understand that the return on their investment will be reduced (or even lost) if additional capital has to be raised in the future from equity investors (non-banks). This is because early investors (family and friends) may be taken advantage of (or be cut out in some cases) by later equity investors. The point is that critical analysis needs to go into capital needs planning when launching or expanding a business. They need to think about how additional capital raises will be handled BEFORE the business is launched.

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