Types of Business Finance
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Why are these terms, and the differences between them, becoming more important to understand for operators of growing mid-sized businesses?
Until now terms like Private Equity and Venture Capital have typically been reserved to the lexicon of those operating either niche start-ups with huge growth potential, or larger well established businesses looking for non-bank financing.
For most growing SME and Commercial sized businesses, finance for business growth has usually come from one of three sources:
⁃ funds introduced by its current owners (equity funding)
⁃ banks and finance companies (debt finance)
⁃ accumulated cash surpluses generated from trading (retained earnings)
As concepts such as Open Banking (OB), Banking as a Service (BaaS) and Decentralised Finance (DeFi) become more common place, the evolving technologies that enable these will see increased accessibility to alternative finance options (finance that wouldn’t have traditionally been available to the typical SME or Commercial sized business).
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The difference between Debt and Equity is probably reasonably well understood by most business operators, but the distinction between different types of Debt Finance, and more so different types of Equity Finance to varying degrees may not be so widely understood.
Furthermore, there are benefits for operators of growing businesses in seeking equity investment (rather than debt investment). However sources of equity investment have traditionally been difficult to come by for many business operators. That is due to change.
Equity finance is typically higher risk for the investor, but equally comes with the upside benefit of the potential for higher returns on their investments.
For growing businesses, the benefit of seeking equity investment (as opposed to debt investment) can be that cashflow isn’t put under increased pressure to meet loan and interest payments irrespective of financial performance.
Equity investment, which we’ll cover in more detail in the next post in this series, will become more prevalent for growing SME and Commercial sized businesses in the next few years. Evolutions in online technologies will make it easier for investors and businesses to come together.
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Equity finance will be an emerging source of business finance for many mid-sized businesses.
Equity investment is typically higher risk for investors, and with returns on investments being far more dependent on the businesses performance - I.e.: where profits are higher that expected then return on investment can be higher, whereas diminished profits or losses can be more costly for investors.
In a event of liquidation, debt investors will get repaid first. Only if there is something left might equity investors get some part of their investment back, but often by that point there is little left for them.
Private Capital is in essence an umbrella term that includes:
⁃ Private Equity
⁃ Venture Capital
⁃ Private Debt*
(*just to confuse things, the term Private Debt, still falls under the umbrella term of Private Capital, even though as its name implies it is a form of debt finance).
We’ve included Private Debt here because, despite being debt finance, it has traditionally been a more difficult type of investment to access and because it is obtained from similar sources as equity investment.
Venture Capital (VC) is in essence a subsidiary of Private Equity (PE), although the term PE is not typically used in the way to include VC. Think ‘Venture Capital Private Equity’ (VC) vs ‘non-Venture Capital Private Equity’ (PE).
VC investors are typically focused on start-up ventures with big growth objectives - higher risks but with higher upside potential for investment returns.
PE investors (non-VC) typically focus on more established businesses with some proven track record of financial performance. The downside risks aren’t as high as VC investments, and so offer more stable return potential.
Refer this link for more on the differences between VC and PE: https://lnkd.in/gkMSR9pS
These different terms are going to become more important to understand, as emerging technologies see these alternative forms of business finance become more accessible.