Equity & Debt Financing: What The Difference Means To Your Business
If your business is looking at commercial financing options, you’ve likely come across both equity and debt financing. While both have their advantages, which is best for your business for both the short term and the long term?
It’s a common enough dilemma facing many small business owners. You begin with a brilliant idea. You weigh the pros and cons and develop that idea into a concise, well-crafted business plan. You execute and watch that idea blossom into a stunning success—despite the odds. Now you’re faced with the task of taking your business to the next level. How are you going to finance the growth of your business?
For most entrepreneurs, the temptation of immediate capital funding through equity financing—even at the long-term cost of selling ownership shares—can be far too great. On the other hand, private equity firms and investors have their own risks; and funding simply may not be guaranteed. What are the measurable costs to debt funding vs equity funding? How will either affect your business in the long run? When it comes to equity and debt financing, how do you really know which option is best for you?
What Is Debt Financing?
To some people, the mere mention of the terms “debt” and “financing” might seem like enough to scare them off. It shouldn’t. Debt financing is very similar to most people think of when they think of any commercial or personal loan; money which is raised for working capital by offering collateral to private investors and institutions. In return for lending, investors and institutions become creditors of the collateral assets on a contract that interest and principal on the debt will be repaid.
Collateral for debt financing may be raised through the sale of fixed income products (such as bills, bonds or notes) or through offering tangible personal property; examples of the latter may include automobiles, insurance policies, bank accounts or a home. However, many businesses are unaware that collateral can also include operational assets such as equipment, inventory and even accounts receivable. For example, invoices that are owed to a business without substantial assets can be pledged to a commercial lender or factoring company for a sum advance; frequently anywhere from 80 to 90 percent of the combined value of an invoice. For companies without substantial inventory but frequent orders, this can be an ideal lending solution that serves as a bridge for businesses in need of immediate funding.
Debt financing is also conducted by traditional bank lenders along the same lines. One of the more popular choices for small businesses is an SBA (Small Business Administration) loan, which is administered by a federal agency through designated lenders. While an SBA loan is desirable for many businesses on account of longer terms and lower interest rates, they’re also more difficult to find approval for; especially if a business is not meeting current approved sales volume, credit ratings or has no substantial assets to account for.
Other alternative forms of debt financing can include personal and business lines of credit and merchant cash advances. Through some of these methods, business owners can repay a fixed monthly share of profits or pay on weekly/bi-weekly installments as opposed to monthly payments.
Long Term Debt Financing
Long term debt financing refers to assets your business is purchasing, where the repayment terms and estimated life of the assets generally extends over a period of several years. Because they’re designed to ensure the capital funding of a business over an extended period, lenders require long term loans be secured by the assets to be purchased; which, in instances of failure to pay back, can result in seizure, debt or bankruptcy.
Short Term Debt Financing
Short term debt financing refers to the daily financing of business operations; and typically, scheduled repayment takes place in one year or less. A line of credit is an example; however, these are also secured by the assets to be purchased and may also result in the same penalties.
Advantages & Disadvantages of Debt Financing
Debt financing, in many cases, is the most practical and efficient option for many businesses. It’s not hard to see why. It offers clear and complete terms, is readily accessible in flexible amounts, and outside of ensuring regular monthly payments (in which debt interest accrued is tax deductible as a business expense,) offers business owners full control over their day to day operations.
There’s just that catch: regular monthly payments. Depending on the loan, interest rates and terms can be unrealistically high; particularly if you’re a first-time borrower or have yet to establish a steady and predictable flow of income. Keep in mind that terms from lenders will often indicate the return generated from the loan should be substantially greater than the initial cost of financing; which is never an easy thing to guarantee to a bank when you’re also trying to guarantee your own profitability to your employees.
Another disadvantage of debt financing—particularly from large banks—is that many institutions are hesitant about working with startups and newer businesses because of that very risk; uncertain profitability. This is particularly true if your credit rating is anything less than exceptional. Tangible assets are frequently offered by small businesses as collateral as a result. These can include personal property such as real estate, automobiles, insurance accounts and financial investments; all of which can be seized or placed in lien for failure to pay back a loan and effectively bar you from future lending options.
What Is Equity Financing?
Equity financing is obtained through a private investor or institution by selling partial ownership and control in a company through shares of common stock. It’s become an increasingly popular alternative for smaller ventures in recent years, and first came to prominence as an alternative to traditional funding during the 2007-2008 recession as a result of increasing restrictions on lending capacities from traditional sources.
Equity financing minimizes the strain of monthly repayments and interest rates by allowing private entities shareholder rights within the life cycle of a business. However, the most obvious result of this is shared ownership and control of a company by outside entities which can bring its own unique challenges; not least of which is voting stakes and, for businesses who aren’t careful (for those who sell over 49 percent of their company’s shares, for example) loss of majority ownership.
Equity financing is a broad term that’s applicable to numerous avenues. It can be defined as anything from offering partial stake in a business to friends and family to offering substantial IPOs (initial public offerings) of shares on the stock exchange. Private equity companies and investors typically fall into two categories:
Venture capital is the most common form of equity funding; and, the most selective. Typically, a venture capital firm will only evaluate previously established businesses or those who have a proven competitive advantage. These are shrewd investors who will examine every aspect of your business and senior management before they commit any capital. Their goal is to maximize their investments—which means they’re likely to insist on a majority share of the company as a condition of investment.
Angel investors invest smaller amounts than venture capital firms (usually under $500,000); but allow for more adjustable payment options. Angel investors have very flexible investment criteria because they aren’t subject to same institutional scrutiny as banks and venture capital firms. Angel investors typically prefer to not have any involvement in the management of a company’s operations. Their focus is on providing quickly, without the long due diligence process of institutions.
One variation of equity financing has emerged recently, enabled in part by the popularity of digital investment platforms. Equity crowdfunding allows businesses to sell small shares of their company to multiple investors who typically will seek an equal or slightly greater return. However, these campaigns require both a great deal of marketing communications, outreach and often simply sheer luck in order to gain traction and should not be considered a “quick fix” solution to funding.
Advantages & Disadvantages of Equity Financing
Most businesses without an established history will likely find equity financing more difficult to obtain than traditional commercial bank financing; even with less than stellar credit. Because equity financing is obtained from private institutions and investors, the need for assurance of a company’s profitability is significantly greater. High growth industries—such as life sciences, technology, construction and healthcare—tend to be favored by equity investors.
Equity financing places less substantial operational budget constraints on your business. Without the required monthly payments associated with debt financing, your company has more capital available to invest in business growth. But that’s the other catch—business growth. Without historical indicators of your industry’s growth (even if you’re merely a startup), you will likely find yourself met with closed doors.
But it’s not necessarily enough to simply have a company in a high growth industry to obtain equity financing. You’ll still need to present a business plan that takes both profitability and realistic goals into consideration. You’ll still need to ensure a solid financial outlook. You’ll need to present a qualified management team. You’ll need a strong personal network of connections. And most of all, you’ll also need time and patience, as investors generally request regular updates, reports and predictions in addition to their potential shared ownership; all of which can prove far from realistic for many first-time startups.
On the other hand, you’re not just receiving a loan from an equity investor. In many ways, you’re receiving a business mentor; an investor who has knowledge, expertise and contacts that can help drive your business. And because there is a certain level of good faith and trust on a personal level, equity investors will often ask for an initial contribution from first time business owners as seed funding towards their enterprise as a sign of their commitment. They’re also more inclined to overlook poor credit scores and sometimes even sales history if you can assure them of your company’s potential growth.
TAG: Which Is Right For My Business—Debt Financing Or Equity?
Unfortunately, you may find that neither traditional bank lenders or equity investors are likely to provide instant turnaround if you’re looking for immediate financing. The process of developing a convincing business plan, perfecting your pitch, drawing up contracts and establishing a solid financial outlook is a time-consuming process; and you may find yourself with just as many dead ends as leads when choosing either. However, short term debt financing may prove to be the easiest route if you’re looking for a prompt solution for operational cash flow.
Traditional debt financing can range from small loans of less than $10,000 to… well, millions; least of which is contingent on the value of your collateral. Equity financing, on the other hand, rarely falls below the six-figure range. If you’re looking to expand an inventory line or purchase additional equipment, you may well find that both traditional and non-traditional lenders offer flexible options. However, if you’re looking to substantially expand your operations through additional properties or even acquisition of other companies, both your profitability as well as the potential for growth in your industry will dictate which source is more likely to work with you.
Private equity firms and investors are focused on one thing; growth. Venture capital firms have an interest in seeing companies go public and take their business to a national—if not global—scale; after all, it indicates a greater profitability on their initial investment. If your business is not prepared to expand drastically, debt financing is probably going to be a much safer option. Your capital funding may be less and interest rates may be higher, but there’s less potential for risk on your end.
Knowing where to find the right resources at the right time is critical to ensuring the success of your business.
Everything else is simply a question of success.
And hard work.