There are primarily two types of capital – Debt and Equity.
Debt is capital that needs to be paid back. A personal or business loan is an example of debt capital. An individual or institution lends money to a business with an understanding that the money needs to be paid back.
It is similar to a personal loan in that you need to make interest and principal payments on a regular basis. Debt capital can be structured in several ways.
If you are borrowing money from a relative or a friend to start a business, you can ask for an interest free loan or you can structure it in a manner such that you can make the interest and principal payment after several years when your business starts seeing steady cash flows.
You can also structure it as an interest only loan where you make only the interest payments and make a balloon principal payment at a specified future date.
It is always a good idea to keep your cash outflows as low as possible during the initial years of your business.
Equity capital is capital that is given to a company or business in return for part ownership in the company. The investors are compensated from the profits of the company. That is, if the company makes any profits.
This is one of the least risky forms of financing because if your business goes bust you don’t have to pay back the capital. In case of debt capital, you have to pay back the capital borrowed even if you don’t make any profits.
Although, equity capital is the least risky form of financing, lot of entrepreneurs don’t want to part with ownership of their company. Getting equity capital is like getting partners and giving up part ownership of your company. Entrepreneurs see this as loosing control. But for the typical start up, equity is the best option. Lot of businesses fail because entrepreneurs use the wrong capital structure.
Vinil Ramdev is an entrepreneur, business coach and author of the ebook “How to write a business plan for astonishing results? In just 3 days!” He is also founder of StartupGrowthExpert.com
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