What Kind of Capital is Appropriate for Your
Business?
by Dee Power and Brian Hill
Published on this site: May 3rd, 2006 - See
more articles from this month
There are two kinds of capital: debt and equity. Both
kinds are typically used by a company during its lifetime.
Lenders have different objectives than investors and therefore
look at different factors about a company when deciding whether
or not to invest or make a loan.
Debt
Debt is money borrowed, which must be repaid at a set time
period and generates income for the lender over that time
period. Lending sources include not only banks, but also leasing
companies, factoring companies and even individuals.
Lending sources look primarily at two factors: how risky the
loan is; and whether the company can generate sufficient cash
to pay the interest and repay the principal. The growth potential
of the company is secondary; the primary considerations are the track record and asset base of the
company. Usually the debt must be secured against the assets
of the company and very commonly must also be secured against
the assets of the owner of the company, also called a personal
guarantee.
Assets of the company are not usually given full book value
in securing a loan. In other words, if your inventory has
a book value of $50,000 (or it cost you $50,000 to produce
that inventory) a lending source will only give you 50% to
75% of that value. The reason being is that the lending source is
not in your business and would have to quickly liquidate the
inventory, rather than selling it at market prices.
Accounts receivable, or money that is owed to you from customers
who have previously purchased your product but not paid for
it yet, are also discounted. Using the same example, $50,000
worth of accounts receivable may only be worth 60% to 70%
of that value to the lending source. Customers may not pay the full amount owed, or feel they have to pay for the product
at all, if an outside lending source is demanding payment.
And so on.with equipment, land, buildings, furniture, fixtures
and what ever other assets the company has, the same general
rule applies.
The lender often requests that the personal assets of the
owner of the company are pledged as a contingency and as a
gesture of faith by the owner. Obviously, if the owner of
the company does not believe in his/her own company's ability
to repay the loan, why should the lending source?
Equity
Equity capital is money given for a share of ownership of
the company. Equity can be provided by individual investors,
sometimes known as "angels", venture capital companies,
joint venture partners, and the sweat equity and capital
contribution
of the founders of the company. Equity providers are more
interested in the growth potential of the company. Their
objective
is to invest an amount now and reap the rewards of a 5 to
1, or even 10 to 1, payoff in three to five years. In other
words $100,000 now will be worth $1,000,000 in three
years if invested in the right company.
Since the objectives of investors are different from lenders,
the factors they evaluate in determining whether to invest
are different from lending sources. Investors like to put
money in companies that have the potential for rapid growth.
Growth potential is based on the quality of management of
the company, product brand strength, barriers of entry to
competitors and size of the market for the product.
So Debt or Equity Capital?
The answer is dependent on the answers to several questions:
Why does the company require additional capital? What
stage is the company at? What is the financial condition of
the company? How much capital is required? What constraints
will the financing source put on the day-to-day operations
of the company? And finally, what impact will the financing source
have on the ownership of the company?
Why Does the Company Require Additional Capital?
The reasons funds are required, or how they will be put to
use, may lend themselves more to debt than to equity or vice
versa. Debt is often a source of funds for the day-to-day
operations of the company or to refinance a current loan.
Expansion capital can be debt or equity. Start up funds most
often come from equity sources. A turnaround situation, refinancing
a delinquent loan, covering a deficit in revenues, could be
either, but in these cases the financing will come with a
high price.
What Stage is the Company at?
Companies grow through several different stages: seed,
start-up, first stage, and second stage. The stage of the
company can be an indicator of the risk involved. While neither
debt nor equity would be prohibited at any stage, the older
and more established the company is, usually the less risky
it is.
- Seed Stage - the idea for a product or company
is in the mind of the founder, but there is still substantial
research and development necessary to determine whether
the idea is viable.
- Start-up - the company has a business plan, a defined
product, and basic structure, but little or no revenues
are being generated. The product may still be just a prototype.
- First Stage - the product is either ready for
market, or is generating some revenues. The structure of
the company is in place.
- Second Stage - full scale production. The company's
product has been selling and accepted by the marketplace.
The company is ready for a major national introduction of
the product or introduction of a second product.
Established - the company has been operating successfully
for at least three years.
Turnaround - the company has been operating for a number of
years but is underperforming. A hard turnaround refers to
a company that is not only underperforming, but has been in
a cash deficit position with little hope of returning to a
positive position without major restructuring.
What is the Financial Condition of the Company?
In certain situations the company's financial condition will
suggest one kind of capital over the other. If the company
needs all its cash to fund its growth, then a loan is not
feasible, because the company could not afford interest and
principal payments. If the company just needs a line of credit
to fund a cyclical increase in orders, then it doesn't make
sense to bring in an equity investor.
A lender looks at the asset base to secure a loan, and the
cash that has been generated to pay the interest. They also
look at what other debt or liabilities the company has and
very often the debts and liabilities of the owner(s). The
old adage that it's easiest to get a loan when you don't need
one is close to the truth. A strong balance sheet, top heavy
on cash, and light on the side of liabilities is easier to
finance.
Investors look at how healthy the company is by reviewing
trends in the operating statements and the balance sheet.
A company that has demonstrated a positive trend in the past
is looked upon favorably. However, the future outlook for
the company's product and market is just as important to an investor
as the past performance. A company with a somewhat shaky past
in a currently booming industry is probably preferable to
an equity investor than a great performance in the past in an industry that's on the downslide.
But what if your company is a start-up and doesn't have much,
if any, history?
Then other factors will be reviewed such as:
- How much money the owners contributed to the company.
- How strong is the management team.
- How dedicated to success is the management team.
- What other proprietary assets might be available such
as patents, trademarks, goodwill, etc.
What barriers to entry to the marketplace are there?
While both debt and equity come at a price, the company must
generate enough cash to repay the principal of the loan and
the ongoing interest expense. Equity does not have to be repaid
according to a fixed schedule. Equity investors are seeking
long-term returns.
How Much Capital is Required?
A small amount of capital required for a short time is not
often an attractive situation to either traditional debt or
equity sources. Lenders are not interested in loans that cost
them as much in processing as in the income that can be generated. Investors feel that the due diligence required
to fund a small amount of capital is nearly the same as that
to fund a much larger amount.
On the other hand a very large amount of capital may only
be obtainable if broken into stages that are funded based
on achieving performance levels. For example: you have an
idea for a diagnostic test that would be a medical breakthrough
and revolutionize the treatment of all disease as we now know
it. But you need $3.5 million to get the product ready to
market. The initial funding may be as little as $50,000 to
perform a literature and patent search to see if anyone else
is working on the same idea and to determine the size of the market demand
for the product. If the search shows that no one else is working
on the idea, and the market is every doctor's office worldwide,
the second stage of $500,000 could be available to acquire
lab equipment, hire lab technicians for six months, and hire consultants to develop a business and marketing plan. If the
lab technicians develop a prototype test apparatus by the
end of the six months, then $1,000,000 more could be available
to develop a working prototype and patent it. When the working
prototype is patented then $750,000 would be available to
obtain FDA approval and independent tests.
What Constraints will the Financing Source Put on the Day-to-Day
Operations of the Company?
You must consider how the financing source may limit the company's
operations. Loan covenants often restrict what the company
can do with excess cash. They can also put limits on how much
the company can spend, and on what type of expenditures, as well as demanding that the company maintain
certain balances in their accounts, collect their receivable
within certain limits, even determine the credit policies
that the company extends to its customers. The company may
not be able to take advantage of some opportunities because
of these restrictions.
Equity investors can demand the same restrictions and in addition
require that they have veto power in certain instances, or
expenditure approval, even if they are in a minority ownership
position.
What Impact will the Financing have on the Ownership Position?
The last issue and probably the most important one is, how
will the owners react to having their ownership and management
control diluted. An investor can often contribute experience
and management expertise, as well as money, and has a vested
interest in the success of your company. A lending source
has no impact on the company (other than any loan covenants
discussed above); its primary objective is to be repaid.
So Debt Or Equity? The choice is yours.
Brian Hill and Dee Power can be reached through
http://www.capital-connection.com
They are the authors of "Business Plan Basics,"
"Inside Secrets to Venture Capital," "Attracting
Capital from Angels," and the novel "Over Time"
Money,Love, and Football, all the important things in life.
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