There are two fundamental ways through which a business can be financed: debt financing and equity financing.
In debt financing, money is borrowed to be repaid over a fixed period of time, generally with interest. Debt financing may be short-term (repaid in full in less than one year) or long-term (repaid in full in more than one year). The lender derives no ownership interest in the business and the business has no other obligations except full repayment of the loan. Personal guarantees are normally required for small businesses and therefore personal credit history becomes very important.
In equity financing, money is exchanged for a share of ownership in the business. So the business raises funds without incurring debt and has no obligation to repay specific sums at specific milestones. The ownership interests of the principals may become diluted and their control can become eroded especially as additional investors are added.
There are several major types of equity investments for a small business:
1. An Equity Loan
This extends an ownership position to induce the loan or may be originally a note (debt) with an option to convert from debt to equity.
2. Seed Financing
Generally used by a business in the startup phase with no operating history. This kind of investment depends heavily on a business plan, the management team, a strong marketing plan, and sound financial analysis.
3. 1st Round Financing
For a company getting ready to go to market. Research and Development is most likely complete and the company is ready to grow. This loan typically takes the form of a convertible bond.
4. 2nd Round Financing
Company is achieving early stage maturity and is looking for a merger or acquisition, or is looking to go public (IPO)
5. Mezzanine Financing
Company is ready for an Initial Public Offering (IPO). Venture capital will be used to support the IPO.
6. Later Stage Financing
Company is now mature and is in need of funding for expansion either in facilities or product lines. Their financial state should be profitable or at least not losing money.
7. M & A Financing
Two companies combine resources and if one survives it is the acquirer. If both survive then there is a merger.