Determine the purpose of fund
This is the most important step. The entrepreneur should decide on the purpose for which funds are required, whether it is for expansion or working capital or any other reason. On the basis of this we can opt for financing through debt or equity.
Selecting the right type of fund
There are many types of funds available for a business viz debt, equity, venture capital, etc. The favourites being debt and equity. Small business owners who seek financing face a fundamental choice: should they borrow funds or take new investment capital? Since debt and equity are accounted for differently, the impact of financing on earnings, cash flows and taxes shall affect the choice of financing.
This type of finance is opted for in cases where there is a definite time frame involved. Debt is accounted for as a liability of the business which attracts interest and timely repayments. The interest portion can be claimed as deductible business expense. Although many feel that debt is expensive, yet it is equity which is the most expensive source of funding as it carries with itself higher risk. Further the entrepreneur has to plan cash flows for making the scheduled principal repayments along with interest.
Debt financing is used to fund a specific project or to meet the working capital requirements or to source expansion plans. It can be bifurcated into short term or long term depending on the purpose for which finance is required.
Equity represents an ownership stake in the business. When you finance through equity, you tend to give up a certain portion of your ownership interest in the form of shares, in exchange of cash. The investors receive remuneration in the form of dividend or a share in the annual profits. Though equity seems cheaper as compared to debt, it may prove expensive to the business owner since constant dilution of ownership interest may lead to possible loss of control.
Financing in the form of Equity is opted for in cases where the gestation period of returns is long i.e if the business owner feels that profits are going to take some time.