Capital Funding 101: Mastering the Fundamentals

Follow along as we break down the complexities of the world of capital funding for you. Capital funding is a crucial element for the growth and expansion of any business. With nearly 15% of the Indian population involved in startups or small businesses, it is essential for business owners to understand the ins and outs of capital funding. It is an essential aspect of business funding, yet often misunderstood. Capital funding refers to the process of providing financial resources to a business or organization, and it is a crucial element for scaling any business. In this article, we will take a deep dive into the topic of capital funding, including what it is, examples of capital funding, types of capital funding, and how capital is used in businesses. Let’s begin!

Understanding Capital Funding

Before understanding what capital funding is, let’s take a quick detour and understand what capital is and how it differs from money.

Capital vs. Money

Capital is a broad term that encompasses everything that might be of value or benefit to business owners. It doesn’t just mean money; it could be assets as well. For example, machinery for a factory. While all money is capital, all capital is not money. Capital usually means cash working for the company and generating more money for it. Funding, on the other hand, is the act of providing financial resources to a business. So, putting these two definitions together, we get the following one for capital funding: Capital funding is the act of providing capital to a business, such as equity or debt financing to a business.

What is Capital Funding?

Companies raise funds through various funding programs to acquire fixed assets such as machinery, building, and land or to build new products. While most companies make enough money to run their operations and pay their employees, they might not have enough funds to, say, start a new project. For that, they need capital. For example, a small business owner wants to expand their business by opening a second location. However, they do not have enough cash to finance the expansion. So, they might decide to apply for a Small Business Administration (SBA) loan, a type of capital funding. The SBA loan provides the business owner with the necessary funding to purchase equipment and inventory and cover the costs of leasing a new location. The loan is repaid over time with interest. This example shows a small business owner obtaining a loan as a form of capital funding to finance their business expansion.

Examples of Capital Funding

Some companies, like venture capital firms, exist to provide capital funding to businesses. A venture capital firm is a type of investment firm that provides capital funding, in the form of equity financing, to early-stage and growing companies with high growth potential. The venture capital firm will typically invest a large sum of money in exchange for a percentage of ownership or equity in the company. The company can then use the capital funding to finance expansion, research and development, or other growth initiatives.

Types of Capital Funding

Companies raise capital using two options:

1. Equity or stock issuance
2. Debt issuance

Equity Capital Funding

Equity capital financing refers to selling ownership stakes in a company in exchange for capital. Investors, such as venture capitalists or angel investors, provide the capital in exchange for a percentage of ownership in the company. Equity financing does not require paying back the funds, but the investor will have the right to share in the profits and losses of the company. Some types of equity financing are the following:

• Individual investors
• Angel investors
• Venture capitalists
• Initial public offerings
• Crowdfunding

Debt Capital Funding

Companies also acquire funding via debt, but issuing corporate bonds to investors. Issuing bonds is a way of acquiring debt - in that the company borrows money from investors, who get interest in return until the bond's maturity period. The interest or coupon rate, as it is called, is the cost of debt for the company. You can also raise capital funding via debt by taking out loans from lending institutions. The cost of borrowing the loan is the interest the company pays to the bank. These loans are added as long-term liabilities in the company’s balance sheet.

Business Capital Structure

A business capital structure in its balance sheet is split into the following:

• Assets
• Liability
• Equity

The mix of these three makes up a business’s unique capital structure. Equity financing means selling shares to gain capital. Hence it is added to the equity section of the balance sheet. Debt financing involves paying the principal amount and debt over time through scheduled liabilities, which is why it comes under the liability section of the balance sheet. Organizations use different metrics to analyze a business’s capital, such as:

• Weighted Average Cost of Capital: This represents the average cost of all the capital a company has raised, including debt and equity, weighted by the proportion of each type of financing.

• Debt to Equity: A financial ratio that compares a company’s debt to its equity, which measures the relative proportion of debt and equity used to finance a company’s assets.

• Debt to Capital: A ratio that compares a company’s debt to its total capital, which measures a company’s leverage and ability to repay its debt.

• Return on Equity: A financial ratio that measures a company’s profitability by comparing its net income to its shareholders’ equity. It shows how much profit a company generates with shareholders' money.

Why Do Businesses Need Capital Funding?

How Capital is Used

How capital is used varies from company to company. However, generally, a company needs and uses capital funding for the following reasons:

• Starting a new business: Capital funding is often needed to start a new business, as it is required to finance the costs of setting up the business, such as purchasing equipment, hiring employees, and renting a facility.

• Expanding operations: As a business grows, it may need additional capital to expand its operations. This could include building new facilities, increasing production, or hiring more employees.

• Research and development: Businesses may need capital funding to invest in research and development to create new products or improve existing ones.

• Working capital: Businesses need capital to cover the costs of day-to-day operations, such as purchasing inventory, paying employee salaries, and paying bills.

• Financing large projects: Businesses may need capital funding to finance large projects, such as building a new facility, acquiring a new business, or launching a new product.

• Repaying debt: Some businesses may need capital funding to repay the existing debt they have incurred.

• Improving cash flow: Businesses may need capital funding to improve their cash flow, which can help them meet their financial obligations and invest in new opportunities.

• Preparing for unexpected events: Businesses may need capital funding to prepare for unexpected events, such as an economic downturn or a natural disaster, which could disrupt their operations and reduce revenue.

What Are the Pros and Cons of Financing Capital Through Equity?

Debt financing is a way for a company to raise capital without diluting ownership. In contrast, equity financing allows a company to raise capital by selling ownership stakes and diluting the ownership of existing shareholders. Some pros and cons of equity financing are as follows:

Pros of Equity Financing

• Alternative to debt: You don’t have to repay any debt. Plus, it’s the best option if you’re not eligible for a loan. Moreover, it is a lower-risk financing option because your investors seek a return rather than asking you to pay them back. Even when you issue bonds, you must pay back the principal amount.

• Expertise: Most equity investors, like angel investors and venture capitalists, are masters in the industry. They can offer you valuable insight into the industry, expertise, and advice. They can also help you with business contacts and help you network. They are more interested in your success because their rewards would also be substantial.

Cons of Equity Financing

• You have to share the profits: Whatever profit figures you clock in a financial year, you will have to share a significant portion of it with the investors. Plus, you must consult them whenever you want to make any decision impacting the company.

• Diluted ownership: In exchange for the capital they invest, they own a part of your business. This means you have less control over your business than normal.

• Costlier than debt: Sometimes, investors can charge interest rates more than banks. Plus, the dividends you pay them are not tax deductible, whereas interest payments on loans are.

While considering equity or debt financing, consider the following factors:

• What source of capital is the most accessible for you?
• How will it affect cash flow?
• How much control do you want to retain over the company?

If you go for equity financing and lose even a bit of the company's share, you will have to buy their stake in the business. This process is called buy-out, which involves buying the investors' shares. However, the cost of the repurchase is far higher than the original money investors gave you.

How Does Capital Financing Through Debt Work?

In debt financing, a company raises money for capital by selling debt instruments to investors. A company can sell fixed-income products, like bonds, bills, or notes, as debt instruments. Institutional or retail investors buy these bonds and get an interest amount in return. The business pays the principal amount to the investors at a pre-agreed date in the future. However, if the company files for bankruptcy, debt lenders (not shareholders) have the highest claim when liquidating assets.

What Are Some Characteristics of Capital Funding Institutions?

Some characteristics of capital funding institutions, such as angel investors and venture capitalists, include the following:

• Risk appetite: Capital funding institutions, such as venture capital firms and angel investors, typically have a high-risk appetite.

• Long-term investment horizon: Capital funding institutions typically have a long-term horizon and are willing to hold onto their investments for several years.

• Active involvement in portfolio companies: Capital funding institutions often take an active role in the companies they invest in, providing strategic and operational support to help them grow and succeed.

• Strong networks: Capital funding institutions often have strong networks of industry experts and other investors that they can tap into to help their portfolio companies grow.

• Professional management: Private equity firms and venture capital firms typically have professional management teams responsible for sourcing and evaluating investment opportunities and managing the portfolio of investments.

• Regulated: Capital funding institutions are regulated by the government and must comply with specific regulations to ensure the safety and security of the investments.

There are many organizations whose sole purpose is to provide capital funding to businesses.

Is Venture Capital the Best Option for Companies? // Fund Your Way to Success With BridgeUp

In conclusion, capital funding is vital to business growth and expansion. Understanding the different types of capital funding, including equity capital funding and debt capital funding, and the pros and cons of each can help a business make informed decisions about how to finance its growth. Additionally, understanding the characteristics of capital funding institutions, such as venture capital firms and angel investors, can help a business find the right partners to help it grow and succeed. By understanding capital funding and its various forms, businesses can make smart decisions that will help them grow and succeed in the long run. Whether you choose equity financing or debt financing, compare the cost of the two. Do you want to dilute the ownership of your company or incur a higher interest rate? If the decision is hard to make, then maybe you can look into new-age investment options for your new-age business. BridgeUp is India’s leading provider of recurring revenue financing options. We offer a simple, subscription-based financing model that allows you to access funding based on your company’s revenue stream. To determine funding eligibility and amount, we evaluate your revenue stream and provide a score. The entire process, from evaluation to funding, typically takes less than a week. To learn more about how we can help, reach out to us at +91-9819660287 or fill out our contact form.

FAQs

What are the main sources of capital funding? The two main sources of capital funding are equity and debt. Some companies can also use retained earnings and reinvest them in businesses. Is capital funding a loan? Capital funding is not a loan, per se. The loan is a type of capital funding — it comes under debt financing, which is one of the ways of securing funding. Does credit score impact capital funding? Sometimes, a capital lender asks for a credit score of more than 500. While a lower credit score won’t disqualify you, your lender may increase the interest rate.