Reading: Lesson 5 - Types of Business Capital

8.5.A - Types of Business Capital

1. METHODS OF OBTAINING CAPITAL

1. In the Reality Check, Alana faces a problem many successful business owners face—how to get needed financing. On a balance sheet, capital is the value of the owners’ investment in the business after subtracting liabilities from assets. Capital also refers to the money required to start or expand a business. Businesses need capital to acquire assets. Capital comes from many sources. Owners can provide it from their personal funds or from money they have accumulated in other businesses. They can also raise capital by obtaining loans, by making business purchases on credit, or by leaving earned profits in the business. Business executives and business owners need to be familiar with various methods for raising capital and understand the advantages and disadvantages of sources of capital.
   
2. Business owners have several options for obtaining the capital needed to start and operate a business. One way is to contribute their own money to the business. Business owners’ personal financial contributions to the business are called equity capital or owner capital. This capital may come from personal funds, such as from accumulated savings, or from funds the owners borrow using their homes or other forms of property as security for the loan. As shown in the Figure below, growing businesses rely heavily on equity capital. Alana can consider those sources if she decides to open additional Diaz DigiPrintz studios. However, because she opened one store using all of her savings then available, it is not likely she has a great deal of money to use as equity capital. If Alana wants to use equity capital to finance expansion, she will likely need to attract other investors willing to use their money in return for partial ownership of the business. 
   

   
   

3. A second way to obtain capital is through retained earnings. Retained earnings are the profits that are not taken out of the business but instead are saved for future use by the business. Retained earnings are a type of equity capital, because profits belong to the owners of the business. As Alana’s business becomes profitable, she may be able to accumulate retained earnings and use them for future business expansion. A third way of financing a business is through debt capital, or creditor capital—money that others loan to a business. Banks and other types of lending institutions usually will not lend money to a business unless the existing equity capital exceeds the debt capital. As a result, businesses in financial difficulty often have trouble getting debt capital. McGraw’s Pet Shop, as shown in the Figure below, might be able to get an additional loan from the bank because its liabilities, or debt, are much less than its equity capital. However, if its liabilities were $240,000 and its equity capital were $160,000, the shop would be far less likely to get the loan. 
   

   
   

2. OBTAINING EQUITY CAPITAL

1. Acquiring equity capital is approached differently depending on the business’s ownership structure. Because equity capital is money invested by the owner, the type of ownership structure determines who can provide the equity capital and how it is obtained and invested in the business. 
   
2. Sole proprietors must rely on their personal assets for capital if they want to retain ownership of the company. If owners are wealthy or the needed amount is small, they can invest more of their own money in the business. If they do not have available cash, they will likely have to sell personal assets to raise the money. Other options include mortgaging personal property such as a home or obtaining a personal loan using the collateral of fully owned assets such as automobiles, insurance policies, or other property. Of course, funds invested in the business by the proprietors are at risk and can be lost if the business is not successful. In addition, even personal assets that were not invested in the business can be lost if the business fails. If the sole proprietor cannot provide additional financing for the business and chooses to use equity capital, alternative sources will have to be considered. When others provide equity capital, the form of business ownership will need to change. The sole owner of a business can obtain additional funds by (1) forming a partnership and requiring the new partner to invest money in the business or (2) forming a corporation and bringing in additional equity and owners by selling stock.
   
3. When a business expands by creating a partnership, the new partner may or may not be required to invest money. A partner may be brought into a business because of his or her business expertise rather than the need for additional capital. However, partners usually invest their personal resources in the business to balance the amount of money each owner has in the business and to spread the financial risk among the owners. When a proprietorship is reorganized into a partnership, a formal partnership agreement must be created that identifies the financial contributions of each partner and how business profits will be shared. As with the sole proprietor, a new business partner may need to use personal finances to provide the required equity capital. Those resources could be from personal savings, income from the sale of assets, or personal loans and mortgages. And just as in the sole proprietorship, the money invested by each partner as well as any other personal assets that were not invested are at risk if the business fails. If the assets of one partner are inadequate to cover the debts of a business, assets from other partners can be taken. When a sole proprietorship expands ownership by forming a partnership, the owner gives up individual control over management and decision making. If Alana decides to expand Diaz DigiPrintz by forming a partnership, she will share ownership privileges and management responsibility with her new partners.
   
4. The third way to raise equity capital is by forming a corporation and bringing in additional owners through the sale of stock. The use of a corporate structure for a small business may be an effective way to raise equity capital because the individual monetary investment is usually much smaller than if a partnership is formed. Also, stockholders are not involved in the day-to-day management of the business. Therefore, the person who was the original owner may be able to continue as the primary manager of the business. Investors in corporations are protected financially; they ordinarily can lose no more than the money they have invested if the business fails. This might be viewed as an advantage to Alana because she would be a stockholder based on her investment in the business, and any losses would be limited to that amount. Currently, as a sole proprietor, all of the money she has invested in the business and all of her personal assets are at risk in the event the business fails. Stockholders who invest in a business expect that the business will use their investment effectively and that they will make money. Stockholders earn money on their investments through dividends paid from profits earned by the business or through the sale of their stock. Depending on whether a corporation is organized as a public corporation or a close corporation, stockholders have more or less flexibility in the sale of stock and input into the direction of the business. If Alana decides she wants to expand the number of DigiPrintz studios very rapidly, she may need to choose to reorganize as a corporation. If the prospects for her business are good, she may be able to attract a number of investors who will purchase stock, giving her the needed capital. There are advantages and disadvantages to each form of ownership in terms of the amount of equity capital that can be raised, the risk to the owners, and the role of investors in managing the business. To raise equity capital, therefore, a business owner must estimate whether it will be more advantageous to remain a sole owner or to form a partnership or a corporation. Alana must deal with this question if she decides to expand Diaz DigiPrintz.