Noelle Merwin

Most small businesses need cash infusions at some point, and how you secure the funding can make all the difference between whether your business succeeds or struggles. To help determine which is best for your business, let’s break down the three primary types of funding available: debt, equity and hybrid financing.

Debt: Borrowing to grow

Debt financing involves borrowing money and repaying it with interest over time. This includes traditional options like bank loans, lines of credit, and Small Business Administration (SBA) loans.

The main benefit of these options is that you retain full ownership of your business, though loan payments can put a strain on cash flow. Also, lenders often require collateral—like equipment, real estate or other assets. If payments are missed, creditors can seize the collateral and, in some cases, pursue legal action against the business or owners.

This option works best for businesses that have stable revenue and are able to make timely payments. And since you retain ownership, you preserve control over decision-making. However, if your cash flow can’t sustain the regular loan payments, debt financing is not a workable option.

Equity: Trading ownership for capital

Equity financing means selling a portion of your business to investors in exchange for capital. Common sources of equity funding include:

• Angel investors
• Venture capital firms
• Crowdfunding platforms

Unlike debt financing, equity financing doesn’t require repayment, but it does mean giving up some ownership and potentially sharing future profits.

This option is often best for start-ups or high-growth businesses that may not qualify for traditional loans due to limited profitability or lack of a solid credit history. While equity investors can offer valuable guidance, expertise, and networking opportunities, it’s important to consider the trade-offs like shared decision-making and less control over the direction of your business.

Hybrid financing: Combining debt and equity

Hybrid financing combines elements of both debt and equity financing. Examples include convertible notes, where debt is converted into equity under certain conditions, and revenue-based financing, where repayments are based on a percentage of future revenue. These options offer more flexibility by aligning payment terms with your business’s performance.

Hybrid financing is a good choice for business owners looking for tailored funding solutions. It allows you to leverage the benefits of debt and equity, but the terms can be complex and require careful negotiation to ensure they fit the needs of your business.

Financial statements matter

Accurate financial statements are essential when seeking funding for your business. Lenders and investors will want to see a detailed and comprehensive financial package that includes:

• Income statements, which show revenue, costs, and profits
• Balance sheets, which summarize your assets and liabilities
• Statements of cash flows, which detail how money flows in and out of your business

Additionally, you might be asked to provide supporting reports like accounts receivable aging, detailed expense breakdowns, and information about owners and key employees. These documents provide a clear picture of your business’s financial health and operations, so potential funders can evaluate the risks and potential rewards of their investment.

Most lenders and investors will expect to see at least two to three years of historical financial data, along with projections for the next two to three years. These reports should tell a clear, compelling story about your business’s financial stability and growth potential.

What’s right for your business?

Choosing the right way to fund your business comes down to your business model, growth stage, goals, and how much risk you’re willing to tolerate. As your business’s needs evolve, you might end up using a combination of debt, equity and hybrid financing.

Your Smolin advisor can help you keep your financial records in check and walk you through the pros and cons of each option. Reach out and let’s talk about how to fund the next phase of your business’s growth.

Starting a business with partners and not sure which entity to choose? An S corporation could be the perfect fit for your new venture.

One benefit of an S corporation

One big perk of an S corporation is that shareholders aren’t personally liable for the company’s debts. To keep that protection intact, make sure you:

• Properly fund the corporation
• Keep it separate from personal finances
• Follow state requirements (like filing articles of incorporation, adopting bylaws, electing a board of directors, and holding organizational meetings).

Handling losses

If you expect early losses, an S corporation offers a better tax advantage than a C corporation.

While C corp shareholders don’t get tax benefits from losses, S corp shareholders can deduct their share of losses on personal tax returns—up to the amount they’ve invested in the business. Losses that exceed your basis can be carried forward to offset future profits when there’s sufficient basis.

Profits and taxes

Once the S corporation starts earning profits, the income is taxed directly to you, regardless of whether it’s distributed. This income is reported on your personal tax return and combined with your other earnings.

Your share of the S corporation’s income isn’t hit with self-employment tax, but your wages are subject to Social Security taxes. If the income qualifies as qualified business income (QBI), you can take a 20% pass-through deduction, subject to certain limitations.

Note: The QBI deduction is set to expire after 2025 unless Congress extends it. However, there’s a good chance it will be extended—and possibly even made permanent—under ongoing Tax Cuts and Jobs Act negotiations.

Fringe benefits

If you’re offering fringe benefits like health and life insurance, keep in mind that while the company can deduct the cost for shareholders owning more than 2%, the benefits will be taxable to the recipient.

Protecting S status

Be careful about transferring stock to ineligible shareholders (like another corporation, a partnership or a nonresident alien), as it could terminate your S election, turning the corporation into a taxable entity.

To avoid this risk, have shareholders sign an agreement to prevent transfers that would jeopardize the S status. Also, remember that an S corporation can’t have more than 100 shareholders.

Final steps

Before settling on your business entity, reach out to your Smolin advisor to discuss your options. We’re here to answer your questions and help set your new venture up for success.