While it is possible to “bootstrap” a business using your own funds, many startup and early-stage companies are often faced with the decision: if and how to raise outside capital to fund growth. These funds may be necessary to hire new personnel, buy equipment, invest in product development, or even acquire a competitor. Whatever the reason, the fundraising process can be overwhelming for any entrepreneur who, in addition to ensuring that his/her company is properly capitalized, must continue to actually run the business daily. Often, few have the depth of management that enables them to step away and concentrate wholly on fundraising.
Once it has been decided that outside capital is needed, the uses of that capital and how much is needed must be determined. These decisions, along with a few other criteria, will help guide you in deciding the type of capital that you need, i.e. debt or equity (or combination of both).
Uses of Capital
The risk level of the investment you are making in the business can help guide your decision as whether to raise debt or equity. For example, if you receive a purchase order from a large, well-known customer, and simply need funds to purchase materials from your suppliers to fulfill the order, then the risk level for these funds is very low. There is a high probability you will receive the funds from the customer and the need for capital is short-term. In this example, debt financing (purchase order lending) makes the most sense.
However, if you want to expand into a new geographic location by opening an office in a different city, that would be riskier. In this case, it may take substantial time for the investment to generate sufficient profits to pay off the debt (loan). Lenders (banks) may be unwilling to lend for a riskier project unless there are significant assets (either business or personal) to cover the loan AND sufficient cash flow to make monthly payments.
Does the company generate enough cash flow (profits) to support the payments that would be required to obtain debt financing? For example, if the company borrows $500,000 from the bank using a 5-year term loan at 5% annual interest, then the monthly payments would be $9,436. It is essential to know whether the company can afford these payments before assuming such a loan. In other words, the company would need to generate more than $9,436 in excess cash flow to cover the payments on this loan. This will be one of the bank’s, or any debt lender’s, requirements, before applying for a loan.
Lenders, i.e. debt investors, will need some sort of security for the loan that they are making to the business. There must be hard assets in the business, e.g. equipment, real estate, receivables, etc. that the lender can use as a source of repayment in the event the loan cannot be repaid. For companies that don’t have enough assets, lenders will look to the principals to determine if there are enough personal assets to guarantee the loan repayment. A “personal guarantee” will be required in virtually all cases as will a personal credit score so it is encouraged to keep that as high as possible.
Would you rather have a smaller piece of a larger pie, or a larger piece of a smaller pie?
Selling a Part of the Company
When raising capital using equity as opposed to debt, a piece of the business is being sold to a third party, either an individual (e.g. angel investor) or an institution (e.g. venture capital fund). The amount of capital needed will dictate who best to approach as a potential buyer. Lower capital amounts (under $1 million) are typically raised from high net worth individuals, whereas higher amounts are raised from funds. When executing an equity raise, the amount of capital raised is a percentage of the total value of the company. While it may be possible to buy this equity back someday, an owner must understand that typically this piece of the business is going to be permanently sold to someone else. As an example, if $500,000 is raised across several individuals (e.g. $100,000 each from 5 people) at a valuation of $2.0 million, 20% of the company is being sold. ($500,000 as a percentage of $2.0 million plus $500,000).
I often say to business owners and clients “be invested in your investment.” If you were to sell your business someday, there is a risk of getting substantially less than you want/expect because you have sold a stake to someone else. The tradeoff in this, of course, is that without this outside capital you may not be able to grow the business. It’s the age-old question: would you rather have a smaller piece of a larger pie, or a larger piece of a smaller pie? There is no right answer because there is no way to forecast the future. It is the input of your management team and trusted advisors, including financial review and your gut instinct that will lead you to the right decision.
Raising debt has several advantages: a) no dilution of ownership interest since you are not selling a piece of the business, principal and interest obligations are known amounts which can be budgeted, b) debt capital does not require the company to comply with state and federal laws and regulations, c) interest on the debt can be deducted on the company tax return; but disadvantages: a) debt must be repaid, b) interest is a fixed cost which raises the company’s breakeven point, c) cash flow is required on principal and interest payments, d) debt instruments can restrict the management from pursuing alternative financing options and non-core business opportunities, and e) the higher the debt-equity ration, the more risky the company is to lenders and investors.
When comparing debt to equity, there are several ways to evaluate the optimal path given the current state of the business, your goals, the return on the investment, and how comfortable the business is with taking on risk. You can even opt for a blend of both equity AND debt financing to offset the risk of each standing alone. With the information you gather there is no doubt that you can make an informed decision. However, information is only as good as what you do with it.