Chapter 16 / Finance Your Business
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Which Type of Financing Costs the Most? The cost of financing is usually related to the degree of risk involved. If the risk is high, so is the cost. 1. The least expensive money to use is your own. The cost to you is whatever you would have made on your money by investing it in other sources (savings, money market accounts, bonds, retirement plans, real estate, etc.). Note: At this point, we should mention credit cards. Many new business owners borrow heavily on their credit cards only to find themselves up to their ears in debt. Credit cards can be one of the most expensive sources of cash and have paved the road to bankruptcy court more than once. Don't get caught in this trap! 2. Friends and relatives: The next lowest in cost generally comes from friends and relatives who may charge you a lower interest rate. But don't forget that it may cost you in other ways. 3. Banks & other traditional lenders: The third on the cost ladder is probably the traditional lender (banks, SBA, etc.) This lender will want to know what the capital will be used for and will require that it be used for those specific needs. If the risk is too high, most conventional lenders cannot approve your loan because it would be a poor financial decision for the bank's investors. One default out of ten will undermine their whole program. 4. Outside lenders and venture capitalists: Traditionally, the most expensive is the outside lender who charges a high interest rate because of the risk involved and the venture capitalist who requires a percentage of your business.
Calculating the Cost Before you get a loan, take time to understand the terms under which the loan will be made. What is the interest rate? How long do you have to repay the loan? When will payments begin and how much will they be? What are you putting up as collateral? If you have venture capital injected into the business, what will be the overall price to you of the equity and control that you will forfeit? Any source of financing can and should be calculated as to cost before the financing is finalized. Again back to your business plan. Determine when the financing is needed, plug cash injection, repayment figures, and resulting income projections into your cash flow statement and checkout the result. Will the financing make you more profitable and enable you to repay the lender or distribute profits to the venture capitalist?
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