Every company needs money, no matter their size or experience. But the means of acquiring the necessary amount is far more complex than just a choice of cash or credit. That’s why internal economic capital is a more encompassing term than money or capital.
Internal economic capital, also known as financial capital or economic capital, is the money, credit, or similar funding structure used to finance a business. Sources of financial capital include traditional investors, government lending, crowdfunding, as well as unique arrangements with third-parties. So a company that crowdfunds its latest product and a company relying on a government loan are both seeking internal economic capital.
Economic capital can be further broken down into three types of capital: debt, equity, and specialty capital. We’ll cover the definitions, purposes, and implications for each of these on a business’s bottom line.
Be sure to check out our guide, Types of Capital to Grow Your Business.
Debt capital refers to money received by companies that they must pay back later with interest. For many budding startups, debt capital will be the most common means of raising funds. This is because debt capital can offer a company much-needed funds, without having to sacrifice a piece of their earnings to their debtors. However, it does place pressure on the company to turn enough of a profit to pay off the debt in a timely manner.
There are also different types of debt capital available besides peer to peer lending, including the sale of bonds to other companies, business loans, and credit card loans.
Benefits of Debt Capital
Retain ownership. Companies that have debt still have to pay their dues, but they don’t need to split their revenue or take orders from their debtors. This is important for building innovation and rapid growth for startups today.
Tax-deductible. Paying off interest can be deducted as an expense on your taxes.
Expense forecasting. Loan payment figures are easily determined and do not fluctuate, unlike stock ownership.
Disadvantages of Debt Capital
Risk. Failure to pay the debt off in time can restrict a company’s ability to grow. In fact, late payments may lead to even greater interest or even bankruptcy. Regardless of whether the company succeeds or fails, the loan will need to be repaid.
Credit rating. To be able to borrow from some lenders, you must have a good standing on your credit bills, loans, and other debts. Low credit could result in a rejection of your debt capital.
Equity capital refers to cash received from investors in exchange for profit share. At the start, entrepreneurs put their own equity into the venture. But as you seek out other sources of equity capital (such as investors, or from an initial public offering (IPO) of stock), other shareholders can gain equity within the company. So by giving up some control to investors, the company can receive enough cash for the business.
Keep in mind that the equity value of a company is not the same as book value. Equity value is calculated by multiplying the company’s share price by outstanding shares, whereas the book value (also known as shareholders’ equity or net worth) is the difference between the company assets and liabilities.
Benefits of Equity Capital
No debt. Equity capital is much less of a burden, in that there is no loan that needs to be repaid. No loan also means no interest. This can be a saving grace for companies that do not turn a profit early in their venture.
No credit check. Since there’s no debt financing involved, it also means you do not need to have a spotless credit score.
Stronger professional network. Equity also brings about less tangible assets, such as relationships with industry experts, exclusive partnerships, or access to unique organizations and events.
Disadvantages of Equity Capital
Profit-sharing. Every time your business turns a profit, you’ll have to split it with your investors. This isn’t inherently bad. At times the tradeoff could be worth it, but other times you may have significantly less for yourself.
Less control. Equity financing means giving up some of the power and decision-making involved with running a business. Such a task can be daunting, particularly for people that see the company as their own baby. And in some cases, the lack of control may even lead to conflict with other stakeholders.
As the name implies, specialty capital is capital with unique conditions. These conditions may remove limits to business growth, or buy additional time for a company. Compared to debt and equity financing, specialty capital has more relaxed expectations.
For example, a business partnered with a particular vendor may agree on a deferred invoice payment, buying the company much needed time to come up with the funds. This is also known as vendor financing.
Other examples of specialty capital include government grants, sweat equity, insurance compensation, and supply chain financing.
Benefits of Specialty Capital
Minimal requirements. Unlike debt or equity financing, you don’t need to pay interest, have good credit, or share profits. There are still requirements but they are far less taxing on the company.
Versatile. Specialty capital takes shape in many different ways, from buying a company time, to less conventional means of financing.
Capital isn’t just about money. It’s about other money-generating activities and assets that your company owns. These can be tangible assets, such as the people within the organization, the land on which your properties are located, or the supplies and equipment used every day.
But these assets can also be intangible. A single brand name and logo carries with it the public’s perception of the company’s reputation and value. This is highly subjective but can make the difference between a few dollars, and a few million dollars in valuation.
Similarly, a company may own a collection of intellectual property or IPs. These are the designs or manuscripts for creative works— such as Disney’s original programming, or Nike’s Air Jordan designs. These can’t be traded on the market, but the fact that no one else can use them lends itself value to the company. Other IPs include patents, trademarks, and copyrights.
Understanding how internal economic capital works is vital to ensuring the longevity and success of a business. There’s simply much more to financing a business than just loans or investments. With a stronger grasp on these concepts and systems, how will you support your business in a sustainable way?
Finding the right office space can be a challenge, but the right lease can help small businesses or startups better manage their economic capital. Learn more in CommercialCafe’s guide today.