This is article is one of a multi-part series to help our network understand the many facets of capital available to them. In this first article, we will focus on direct debt. In future articles we will address the concepts of securitization and convertible capital.
If Your Early-Stage Company Needs Capital Don’t Forget Debt
All too often we talk to customers who need capital to grow their business and most believe their only choices are equity (or convertible equity), but that is not always true. For many companies a debt financing alternative would be better suited to help them meet their capital needs and allow the company to achieve its desired goals.
Debt Financing vs Equity Financing: What’s the Difference?
Typically, debt financing occurs when a firm borrows money for working capital or capital expenditures through a debt instruments such as a secured or unsecured note with a lender, which could be an individual but is usually a firm or institution. On the other hand, equity financing is the process of raising capital through the sale of shares.
Most companies should use a combination of debt and equity financing, but there are some distinct advantages to both. The main advantage of debt financing is that a business owner does not give up ownership of the business as they do with equity financing. The main advantage of equity financing is that there is no obligation to repay the money acquired through the raise. Although equity investors do expect their money returned, with capital gains at some point either through a follow-on capital raise or sale of the company.
Companies often have a choice as to whether to seek debt or equity financing or both. The choice often depends upon the goals of the company and its current profile. The company’s management team needs to begin this process by asking a few questions. (What are our goals for the near term and the long term? Do we have cash flow, assets or personal net worth?) When thinking about the goals, you first must ask yourself questions: How much of the company you want to own today, tomorrow, and in five years? Next, you want to look at your company’s financial profile and projections to understand how much money the company will need today and how much will it likely need in the future? Lastly, you need to understand if you should or can consider debt as one of your business’s financial solutions.
When Should You Think About Debt Financing?
Debt financing is not for every business owner, and it is important to understand its the advantages for your business to succeed.
- If you want To maintain control: How important is maintaining control in your business? Debt financing does not require that the owner or manager of the business give up any of their control of ownership stakes. With equity financing, investors may want a seat on the board of directors or may require that a percentage of ownership becomes theirs. This could result in loss of profits and control over your business in addition to the shares they purchase.
- If you have cash flow: For fast-growing companies or any companies generating positive cash flow, debt financing may be a realistic consideration over equity financing. Given that cash flow positive companies typically have assets like accounts receivable that they can pledge to the lender, this may be a less expensive option when compared with equity and you get to keep ownership of the company.
- If you are looking for a lower cost alternative: Debt-financing is a less expensive option than equity financing since the risk is generally less for the debt provider as they will either require collateral, cash flow or a personal guarantee.
- If you have collateral to pledge: Collateral can be in the form of accounts receivables, inventory, purchase order, equipment or a building, just to name a few options.
- When your only obligation is to repay the loan: If you prefer your only obligation to be the repayment of loan plus interest and fees, debt-financing is a viable option.
- If you have personal wealth: Business owners with personal wealth can pledge personal assets as collateral versus having to liquidate your assets and use for capital. These are typically much cheaper loans, and the collateral is rarely liquidated as the lender does not want your asset, they really just want a focused and motivated borrower.
When Should You Think About Equity Financing?
- Not generating profits: With equity financing, there is no loan to repay. The business doesn’t have to make a monthly loan payment which is an ideal option for businesses that don’t yet general profits. This gives you freedom to channel more money into your business.
- Averse to having mandatory repayment obligation: The money obtained through equity financing doesn’t have to be repaid. It can help bolster your cash position without committing yourself to monthly payments.(Of course, with preferred stock and investors generally expect a periodic dividend, and under certain preferred stock, unpaid dividends cumulate until paid out.)
- Looking to learn and gain knowledge from partners: Some investors are willing to provide needed skills, industry knowledge and experience which could prove valuable to a growing business. They may even take an active role in your business’s growth and success. However, be cautious, as some partners have been known to give poor advice and take a lot of equity.
What Are The Different Types of Debt Financing?
- Purchase order (“PO”) financing: PO financing is an arrangement where a third party agrees to give a supplier enough money to fund a customer’s purchase order. In some cases, purchase order loans will finance an entire order while in other cases they may only finance a portion of it. When the supplier is ready to ship the order, the purchase order financing company collects payment directly from the customer. After subtracting their fees, the company then sends the balance of the invoice to your business. If you’re a small business owner worried about whether your company will have access to the cash it needs to fulfill the next large purchase order that comes in, PO financing may be just the solution you need.
- Bridge financing: Bridge financing, often in the form of a bridge loan, is an interim financing option used by companies and other entities to solidify their short-term position until a long-term financing option can be arranged. There are multiple ways that bridge financing can be arranged. Which option a firm or entity uses will depend on the options available to them.
- Factoring: A factor is an intermediary agent that provides cash or financing to companies by purchasing their accounts receivables. A factor is essentially a funding source that agrees to pay the company the value of an invoice less a discount for commission and fees. Factoring can help companies improve their short-term cash needs by selling their receivables in return for an injection of cash from the factoring company.
- Asset-based lending: Asset-based lending is the business of lending money in an agreement that is secured by collateral. An asset-based loan or line of credit may be secured by inventory, accounts receivable, equipment, or other property owned by the borrower. However, the most common ABL facility is secured by accounts receivable and inventory.
- Bank debt: Bank debt is typically the least expensive form of debt and can be short-term or long-term. You generally need three years of operating results, with at most moderate leverage, and cash flow. For a short-term borrowings, the bank will typically provide a line of credit which could be unsecured if the company has a strong financial profile; however, the line of credit is typically secured by the short term assets like accounts receivable and inventory. Long term facilities are also available for 3 to 5 years for equipment with buildings going for longer terms and even longer amortization. Also, often with the support of a bank, a small business may be eligible for Small Business Administation (SBA) financing, which is generally cheaper to the borrow as the SBA typically guarantees a portion of the borrowers debt making it less risky for the bank to lend.
- Mezzanine financing: Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest.. Most notably mezzanine debt is typically subordinated debt that requires the debt to be repaid after senior lenders and before equity investors. Mezzanine debt has embedded equity instruments attached, often known as warrants, which increase the value of the subordinated debt.
The Bottom Line
Debt and equity financing are two very different ways of financing your business. Debt involves borrowing money directly, whereas equity means selling a stake in your company in the hopes of securing financial backing. Both have pros and cons, and many businesses choose to use a combination of the two as an advantageous financing solution.
Exemplar Debt Capital Experts
At Exemplar, our Debt Capital Experts can help you understand your alternatives. We work with our clients to assist them in evaluating their needs and the solutions that work best to achieve their goals. Our vast network of capital providers know that there is a compelling story and a strong thesis around the opportunity when Exemplar brings a client to the market. Often there are several options available to our client. They are in a much stronger negotiating position with multiple lenders providing term sheets and an experienced partner in Exemplar to help them navigate the path to a strong solution.
Managing Director, Exemplar Companies, Pbc.
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