You may be wondering whether there is a formula or a written rule that business owners should abide by regarding their personal investment into their business relative to other shareholders. The answer is that o basic measure is used to gauge an owner’s equity as compared to that of investors.
However, in business financing, owners’ equity is an important aspect of the business and has a huge impact on its financial well-being. It is important to note that outside investors often require that the owner invests cash into their business and be financially vested in the enterprise.
It demonstrates that the owner is financially committed to their business plan, and they strongly believe in their business strategy and model. Logically speaking, no one wants to invest in a business knowing that the owner or founder has not invested their own money there.
When does a business owner invest cash in a business?
The owner of a business may decide to invest cash for several reasons, including;
- Capital projects– When the business projects are underway, more finances are required,d hence making the owner invest money in the business.
- Expansions– Expansions in a business are an indication that the business is growing, which is what all entrepreneurs want. Infrastructure, among other amenities, may need to be adjusted to fit the growth hence the owner investing cash in catering for the expansions needed within the business.
- Extra financing– An owner can invest cash in a business to increase its capital.
Remember that an owner’s contribution is not limited to cash alone. Any other contributions like equipment to the company or vehicles all increase the owners’ investment account.
Meaning of Owner Investment
Think of owner investment as the owner giving money to the company. Every time the owner gives money to a business, his stake in the business, also called an owner’s capital account grows.
Therefore, an owner’s investment account is a temporary equity account that has a credit balance. The investment account after every year is closed, increasing the owner’s capital account balance.
When the owner withdraws cash from the business, it has the opposite effect on their capital account. Every withdrawal or distribution reduces their stake in the assets of the business.
Owners can invest in their business or company in two different ways; cash and other assets increase their stake in the business asset.
What happens when an owner invests cash in a business?
When the business owner invests cash in a business, as earlier mentioned, his owners’ equity increases, assets also increase, and the owner’s capital.
What is Owner’s Equity?
Sole proprietorship puts the owner of a business in a unique ownership circumstance. You own everything in your business except what is owed to other people.
Equity could mean ownership or something that is of worth or value. When looking at equity, you need to consider the value of something. The much you owe is on that value and what is left over is the equity.
Owners’ equity is the owners’ possession or ownership in the business, the value of the assets they own in the business. It is the money invested into the business minus the amount the owner has removed from the company or business.
Owners equity is a term commonly used for sole proprietor businesses since they involve only one owner.
How does Owner’s Equity Work
An owner’s equity could change based on different business activities, increased capital contribution, or increased business profits.
An increase in capital contribution means the owner investing more money into a business, and it is one way to increase the owners’ equity.
Increasing business profits by decreasing expenses within the business and increasing sales is another way to increase the owner’s equity in the business.
When a business owner removes money from their owner’s equity, the withdrawal can be considered as a capital gain hence the owner paying capital gain tax on the withdrawn amount.
Other Ways for a Business Owner to Finance a Business
1# Family and Friends
A majority of entrepreneurs fund their business by bringing family and friends on board to invest in the business. Besides investing personal cash in a business, you can invite your family and friends to make equity investments or give you a business loan.
There are disadvantages, however, of funding your business through friends and family. You risk losing or affecting your relationships in case the business fails.
Remember, people can be extremely sensitive with money issues, and you, therefore, have to consider whether you are willing to risk those relationships for the business’s sake.
Another disadvantage is that you risk gaining a business partner even if you weren’t looking for one. Once a friend or family has invested their money in your business, they may become opinionated and involved in your business decisions.
Having friends and family to finance your business is a good option but one that needs you to be very careful. Ensure to have a lawyer draft up an agreement for you. Educate your investors well on the risks involved with your business beforehand and remind them to invest only the amount they can afford to lose.
2# Credit cards
credit card s are a great way to extend the flow of cash and finance your business. A credit card can be used to pay your suppliers, and they will often earn you rewards, certain protections, and discounts. Their downside, however, is that they are directly tied to your credit score.
Some credit companies also offer cash advances, which may be another source of funds for your business. However, most companies charge high rates and have imposed limits for their cash advances, which may make it an expensive option. With no other option, cash advances may be considered as a last resort.
In conclusion, a credit card can help alleviate your cash flow problems and extend capital, but you need to be careful as your credit card is affected by how the card is used.
You can finance your working capital by factoring, which means lowering the number of accounts receivable. For example, if you send a client an invoice, but it takes them 90 days to pay, you can trade the invoice to a factoring company for a certain price.
The factoring company then gives you a loan or pays for the invoice, so you don’t have to wait for 90 days for your client to pay while you still need operational capital to run the business. The factoring company can also take the risk of your client not paying up at all.
For the factoring financing method to work for your business, however, you need to pay customers. It becomes really useful when you deal with long payment terms in your business. Without a client in your business, factoring will not be an option.
For businesses with corporates whose invoices take long to be paid, there is nothing much to do about it, but factoring can be a good solution to keep your working capital flowing.
4# Lines of credit and Business loans
Lines of credit and business loans are products well-known to business owners. Both involve the bank providing finances to run the business. For loans, banks give the business owner an amount of money to be paid back over a certain period.
Like the credit card, a line of credit offers a revolving facility to be accessed and used when needed and repaid regularly.
To get a loan or line of credit, the bank has to look at your track record of generating cash and the substantial assets in your business to determine your ability to repay. Despite the two being great ways to finance a business and handle cash shortages, they may be difficult to get and are seldom a choice for small businesses.
Accion is one of the biggest small business lending network and microfinance in the US, with offices set up in every state.
Accion offers business owners startup finances and also fund ongoing expenses. To qualify for the general financing by Accion, they should have done business for at least six months. The business also requires to have a sufficient flow of cash to repay debts.
For small businesses well rooted in their communities, Accion is a great source of funding to consider.
6# Angel investors
Angel investors are small groups of executives or private individuals who invest by maki equity purchases in businesses. Angel investors can help grow a startup business by providing money, guidance, and expertise.
Before investing in your business, an angel investor has to see potential and growth in your business. Your business should also have a viable plan with a good exit strategy. An exit strategy allows the investor to take their profits and recover their investment out of business in case of anything. Most angel investors invest mostly for a period of three to five years.
Finding an angel investor who can share industry guidance, experience, contacts, and funding with you is a great advantage to your business.
However, it is important to have legal guidance and an accounts specialist to guide you in understanding how to structure the equity sale of your business. Angel investors can be found at Angel Capital Association.
Leasing is a good option for businesses that have to invest largely in assets like machinery and computers. Instead of making full payments of the investment at the moment of purchase, leasing helps a business spread the payment over a long period.
Leasing is a perfect option for capital-intensive businesses or companies dependent on sometimes very expensive assets.
8# Revenue-based financing
With revenue-based financing, an investor funds a startup business and, in return, gets a small percentage, say between 2%-5% of the revenue to be generated by the startup in the future.
This type of funding is offered during the beginner stages of the startup, and below are some of its perks to small businesses;
The owner of the business does not sell equity of their business, meaning theu]ir equity shares remain intact.
Unlike normal bank loans, revenue-based financing payments are based on generated revenue. It means that if revenue decreases, the amount to be repaid also decreases. The percentage of revenue payment arrangement ensures the business avoids cash flow issues.
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In conclusion, the owners’ equity stakes in a business look way better than secured and short-term loans. With the owners’ equity high, it makes the business more attractive for outside investors to invest. When the need arises, there are other ways to fund your business. However, a business owner needs to do their due diligence and research to establish the best way to finance their business to avoid possible liquidity and cash flow problems.
Bijay is an entrepreneur and start-up founder having more than 14 years of IT industry experience. He is the co-founder of TSInfo Technologies, a SharePoint development company.
A dedicated professional and very passionate about public speaking and also wrote thousands of technical blogs in various technologies. He also wrote a lots of blogs on entrepreneurship, investment, startup, business, manage money tips, etc.