If you want a business to be owned by the existing shareholders and you don’t want to open up equity to third parties, one way you can fund your business is using the retained earnings or injection of additional capital. The other way is to lease or borrow. You can borrow to do a capital expenditure like buying furniture or equipment or business vehicles or borrowing for working capital. What funding option should you take? When you are considering getting financing through debt or equity, there are several factors you need to consider:
1) Requirements
If you are looking for a loan, your business must be profitable, your business model must be tested and profitable; it’s able to generate money. Some lenders ask for collateral; you need to have collateral. In the case of equity, it is very different. They want to see potential because these are people you are invited to buy shares into your business. For them, what they’re looking for is potential that your business has potential to grow.
2) Effort
There are many options for debt. It depends on how much time you need to set aside when looking for a specific type of debt. When looking for equity investment, it might take months to find and pitch investors. It takes many days or months before investors do the due diligence and evaluate your business. Even after you pitch, it takes time for them to find interest and buy into your vision.
3) Ownership
With debt you completely keep 100% ownership of your business as you do not part with any part of your shares. When you’re looking for equity, you have to part with a percentage of your business e.g. $5 million for a stake of 10% of your businesses, it depends on how you look at it as an entrepreneur, are you willing to give a share of your ownership.
4) Rates
The interest rates for procuring debt might be very high and payment begins almost immediately. You must consider the interest that you need to pay, payment methods and how frequently you need to pay. Is your business able to accommodate the loan repayments? What if, for example, your business is only having a net profit of 50%, and then you get a loan, and the lender declares that you need to be paid $200,000? How do you sustain that?
With equity, there’s no pressure, it’s about how you’re going to negotiate. There is no predetermined rate and pressure to make early returns as they have become part owners of the business. Most of the time the returns required by investors are generally higher than interest on debt. In practice, the amount of loan you get from a financier is determined by the ability of the business to pay and how long you intend to pay back the facility.
5) Predictability
That is why banks always ask for your financial statements so that they can analyze and predict your capacity to pay. The loan repayments are predictable as they are predetermined by the lender.
For investors who have acquired equity, they can decide to exit at any time if they feel they are not getting the agreed return on their investment. Though this is subject to negotiation during due diligence and can have a redemption clause included in the definitive documents, e.g., exit after five years, exit after they have recouped their return on investment, that clause is open.
6) Oversight
What funding option should you take? If you have a loan, you still have the general oversight, the lender has no oversight. Even though there are certain credit facilities like invoice discounting that the bank requires some level of oversight as the bank tends to own the client because they will recover the money from the client. So a bit of oversight is lost there.
With equity, since you have invited people to come and take shares into your business, you need to report to them since they have vested interest in your business. They will put measures for you to report when making certain key decisions because they want to be involved. Such key decisions may include when you want to hire or let go of staff; when you want to expand; when you want to introduce a new product etc.
7) Cash flow
What funding option should you take? Most loans require regular payments to be made towards reducing the loan amount, and this depletes cash that would have been used to run the business operations or expansion. For the investor there is no regular repayment required, and this allows the entrepreneur to re-invest profits back into the business. All that they need to do is to make sure that the business succeeds because they have also put in their share and are willing to support you.
Conclusion
What funding option should you take? As a business owner, you should evaluate your priorities when seeking debt or equity funding options. More often early-stage and start-up businesses find it hard to obtain credit because they have not created enough traction in the market that they can show and convince lenders to give them credit facilities. Your decision should be guided by the factors mentioned in this article.