Financing Growth: Own Funds, Loans, Subsidies, and Equity

Why growth is a financing question

A business wins a large order, hires two skilled workers, and buys a machine. Revenue rises, the bank balance falls. Wages, material, and installments are due long before the customer pays. Why full order books can lead to a squeeze is described in the analysis growth costs cash using the cash conversion cycle. This article picks up where the gap has been calculated: where does the money come from to close it?

The guiding question is: which source of financing suits which growth project of a small or mid-sized business? To answer it, we first clarify the terms, then introduce pecking order theory as a mental model, sort the sources, weigh two perspectives on outside equity, and finally arrive at a simple financing plan.

The best financing is not the cheapest, but the one that matches the duration and risk of the project.

Terms: internal and external financing, equity and debt

Internal financing means the money comes from the business itself: from retained earnings, from depreciation, or from having less money tied up in inventory and unpaid invoices. External financing means money comes in from outside. Here one distinguishes debt, money that must be repaid with interest, such as a bank loan, and equity, money for which a financier receives shares in the business or its profits.

How much equity German mid-sized companies (the so-called Mittelstand) have is measured annually by KfW, Germany's state-owned development bank. According to the KfW SME Panel 2024, the average equity ratio in 2023 was 30.6 percent of total assets, weighted by size. Small businesses are, on average, well below that. This matters for growth financing because the equity ratio helps determine how much credit a bank grants and on what terms. How banks assess today is described in the analysis how banks decide on loans to small businesses.

The mental model: pecking order theory

Pecking order theory goes back to the economist Stewart Myers, who developed it in 1984 together with Nicholas Majluf. It explains why companies use their sources of financing in a certain order: own funds first, then debt, outside equity last.

The reason is an information gap. The owner knows more about the situation and prospects of the business than any financier. The financier knows this and protects themselves: the bank demands collateral and interest, an investor demands a large stake because they cannot assess the risk precisely. The larger the information gap, the more expensive the money. Own funds require no persuading, a loan some, an equity stake the most.

This applies to small businesses in particular, because they publish fewer figures than large ones. Ferreira, Mota, and Pacheco (2026) analyzed data from 7,006 Portuguese manufacturing companies for the years 2016 to 2023. Before the pandemic, more profitable and more liquid businesses had less debt, while larger businesses and those with more fixed assets had more. This matches the theory: those with enough of their own money borrow less, and those who can offer collateral get credit more easily. The authors emphasize that their results come from a country where banks dominate corporate financing, similar to Germany.

The sources at a glance

Three institutions are typical of the German Mittelstand and often overlooked. First, development loans from KfW and the state development institutions. They are usually applied for through the house bank, meaning the business's main bank, and before the project begins. Second, the state guarantee banks (Bürgschaftsbanken), which take on part of the credit risk when a project is viable but collateral is lacking. Third, the state SME investment companies (Mittelständische Beteiligungsgesellschaften), which offer silent partnerships in which the financier shares in the profit but has no voting rights. Conditions and programs change regularly. You can find current terms at your house bank or directly from the institutions.

How the interest rate environment changes the calculation is described in the analysis interest rates and investment. One finding from it also applies here: for many investments, access to credit matters more than one percentage point more or less in interest.

Two perspectives: keep control or enable growth?

Many owners avoid outside equity on principle. Research calls this control aversion. Berggren, Olofsson, and Silver (2000) examined under what circumstances small and mid-sized businesses are prepared to grant outsiders influence in order to grow. They analyzed data from 281 Swedish manufacturing and service businesses with fewer than 200 employees. Attitudes toward financiers became more open when a business had to invest heavily in new technology, was financially weaker, was larger, or saw growth as necessary for survival.

The authors take up a distinction by the economist Robert Cressy: stayers, who rarely take in outside money and accept lower profitability in return, and movers, who use more external financing, are more profitable, but also bear higher risks. For the control-averse, own funds become the ceiling: they invest only what they can safely pay for themselves.

I consider both attitudes legitimate as long as they are chosen deliberately. Control aversion becomes a problem when it prevents a good project that would be viable with a silent partnership or a development loan, without the owner having to give up control. Between complete independence and an investor with voting rights there are many levels. Anyone taking on a partner with voting rights should settle roles, exit, and disputes early, as described in the analysis what shareholders should settle early.

How to finance a growth project: a five-step plan

Before a source is chosen, the need must be clear. Many businesses calculate only the investment and forget that growth also ties up working capital and takes time to ramp up.

1. Calculate the full need

   Investment, additional money tied up in material and unpaid invoices, ramp-up costs, and a reserve. The reserve is missing from most plans and needed in most projects.

2. Check internal sources first

   How much can be covered from profits and from releasing tied-up funds? Shorter payment terms and progress payments are often the cheapest financing.

3. Match term to useful life

   Long-lived assets are financed long-term, short-term needs short-term. A machine for ten years does not belong on the overdraft. In finance, this rule is called maturity matching.

4. Clarify subsidies before starting

   Development loans usually have to be applied for before the project begins. If you order first and ask later, you lose eligibility.

5. Prepare figures for the bank

   Annual financial statements, current management reports, a plan for two to three years, and a cash flow forecast. The smaller the information gap, the better the terms.

Limits of the financing ladder

Pecking order theory describes how companies typically behave, not how they should behave. Those who grow only from their own funds grow safely, but possibly more slowly than the market would allow. The studies on this come mostly from other countries, such as Portugal, Sweden, or the United Kingdom, and measure associations, not causes. For Germany, with its house bank principle and dense network of development institutions, the basic patterns fit, but the weights may differ.

A second limit is the growth target itself. A financing plan does not make an unrealistic target more realistic. Those who plan their targets from the bottom up, as described in the essay realistic growth targets, usually need less outside money than they fear. Those who want to grow through acquisition face their own financing questions, covered in the analysis growth through acquisition.

• The financing need includes investment, working capital, ramp-up costs, and a reserve.
• Internal financing has been checked before loans are discussed.
• The term of the financing and the useful life match.
• Development programs have been clarified before the project starts.
• Financial statements, management reports, and plan are prepared and available.
• The attitude toward outside equity has been decided deliberately, not out of habit.

Conclusion: which financing suits which growth

To answer the guiding question: ongoing growth and smaller investments suit own funds and the release of tied-up money. Long-lived investments suit long-term loans, ideally with subsidies and, where collateral is lacking, with a guarantee. Big leaps that exceed the business's own strength suit equity capital, where the owner can choose between a silent and an open stake. The order of pecking order theory is a good starting point for this, not a fixed rule.

The most important lever comes before choosing the source: calculating the need completely and preparing your own figures so that a financier understands them. Transparency toward financiers is not a weakness but the cheapest way to narrow the information gap that makes every form of financing more expensive.