3.5 Financial Capital

Why a business goes looking for money

Most founders start with bootstrapping: funding the startup from personal savings, and for some founders from personal bank loans or personal credit cards. The first test an entrepreneur runs is a comparison, holding personal funds against the business's initial needs. A founder with $6,000 of saved money facing a $21,000 launch has answered the question already, and the gap has an exact size.

The second test is break-even, which asks for the sales volume that covers a period's costs exactly, leaving neither profit nor loss. If projected monthly costs at opening are $6,000 and each unit sold contributes $4.50 after its own variable cost, the business needs 1,334 units a month, roughly 45 a day. An entrepreneur reaches for external financial capital once personal money can no longer fund both the launch and the months of operating costs it takes to arrive at that line.

The need does not end at launch. A business already running raises outside money for four documented reasons: to build new products, to replace fixed assets that have worn out, to push sales volume and revenue upward, and to smooth cash flow, since sales arrive unevenly while rent and payroll keep to a calendar.

Deal one: loans

Nearly every source of financial capital is one of two deals. Debt financing is the first. A fixed sum is borrowed and then repaid on a schedule, with interest added. That interest counts as a business expense and takes its own line on the income statement, and what borrowing costs climbs with both the rate charged and the amount owed.

A concrete structure makes the arithmetic visible. A $15,000 loan repaid over five years in sixty monthly payments of $300 returns $18,000 in total, so the cost of borrowing is $3,000 of interest, about 7.4% a year. When the structure is flat, every payment splits the same way, $250 of principal and $50 of interest, and only the interest half is an expense. The principal half retires the debt itself.

Who may borrow is a separate question from what borrowing costs. A business younger than about two years has produced no revenue record, which leaves a bank no way to judge whether it can repay. That is the business-scale twin of a consumer who earns steadily and has no credit history. New businesses therefore borrow from the owners' friends and family, put family credit behind a bank loan through a co-signer, or turn to equity investors. An established business with two or more years of proven revenue can borrow on its own record.

Deal two: equity financing

Equity financing raises money by issuing ownership shares. Cash comes in, whoever supplied it becomes a part owner, and that stake carries a permanent claim on a slice of future profits together with a say in how the place is run. No repayment ever happens, because nothing was borrowed, and that single fact is simultaneously the appeal and the price.

Comparing the two deals is an arithmetic exercise a founder can actually run. An offer of $15,000 for a 25% stake values the whole business at $60,000, since $15,000 divided by 0.25 is $60,000, and that estimate is what a valuation is. If the business nets $18,000 in a year, a quarter of that is $4,500 a year, permanently, plus a vote in every hire, flavor, and price. A loan costing $50 a month in interest costs $600 a year and ends at payment sixty.

What lenders and investors get, and risk

Both deals hand the provider a financial asset, either a loan or an ownership share. A lender's income is interest, and a creditor who advances $15,000 and collects $18,000 has earned $3,000. A lender's risk is nonpayment, and a co-signer is the arrangement that moves that risk onto a third person, who carries the lender's risk without earning the lender's interest.

An investor hopes to be paid two ways. Dividends are the investor's share of distributed profits, though some corporations pay none at all and reinvest every dollar instead. A capital gain arrives at the sale, when an asset sells for more than it cost. Financial assets can be resold in secondary markets, and the price there responds to how the business performs, to how badly investors want the asset, and to the PESTEL forces introduced back in Unit 1.

r = \frac{\text{income} + \text{capital gain}}{\text{price paid}}

One measure covers every asset. The annual rate of return takes the total dollars gained, meaning income together with any capital gain, and divides by what the asset cost. A $100 share that pays $3 of dividends and resells a year later at $105 has gained $8 on $100, which is an 8% return. Losses are equally available on both deals. Payments that stop cost a lender. Falling profits cost an investor her dividend income, a shrinking business costs her value, and a closure can cost her the whole stake, since owners stand last in line. Providers therefore sort themselves by risk tolerance, and every one of them demands a higher expected return as risk climbs.

The corporate versions: bonds and stock

Scale both deals up and the corporate forms appear. A corporation borrows by issuing bonds, and a bond is a loan from an investor to a business that pays the holder interest. A corporation raises equity by issuing shares of stock, ownership sold privately or to the public. The secondary market is what makes this personal: buying a corporate bond makes a consumer a lender to that business, and buying a share makes that consumer one of its owners.

The pitch, and what funders check

No capital moves without persuasion. Lenders and investors ask for a business plan. Four things go inside it: the value proposition, the market research standing behind it, the marketing strategy, and the financial projections. Those four together have to justify the size of the request, the return a funder can expect, and the risk being taken on. Compressed into a presentation, that document becomes the pitch.

A funding request wins on evidence rather than enthusiasm. What funders want to see is proof that the product fits its market, and a stated reason behind every projected number, and they will always prefer less risk attached to a higher expected return. The people get read as well: how qualified the leadership is, and whether what the business exists to do matches what the funder cares about. Once a business is established the review goes deeper. Its financial reports, its projections, and independent industry data combine into an estimated valuation, which answers two questions at once. An investor learns what one share is worth. A lender learns whether the business can carry the debt.

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