Home > Corporate Finance > Financing your business: Debts versus Equity

Financing your business: Debts versus Equity


Financing Strategies

There are two basic types of finance:  debt and equity.  There are also a number of strategies to raise finance that go beyond these approaches, including:

  • product development: include customers – or even large corporate competitors – in strategic alliances to source funds for product development;
  • sales growth: include suppliers in an alliance to find new markets;
  • R&D: investigate available Government grants and/or tax incentives;
  • borrowing;
  • taking in equity.

Debt or Equity Funding?

Debt finance Equity finance
What is it?
  • You borrow the money from the bank (or someone else).
  • An investor buys a stake in your business (by buying shares in your company, for example).
Pros
  • You retain complete ownership of your business and the profits it generates.
  • Interest payments are generally tax deductible.
  • The investor shares your risk. If your business fails, there’s no need to pay them back.
  • There are no interest payments — but you may need to pay an investor a share of profits, which could be more than interest.
Cons
  • You have to pay interest on your borrowings.
  • You have to repay the amount you borrowed, even if your growth plans don’t come off.
  • In most cases, you’ll need to offer security for your loan, so this option is difficult if you don’t have assets.
  • You share ownership of your business so if it’s successful, a share of that success goes to someone else.
  • You lose control of your business. An investor may ask to sit on the board and take part in decision marking.
  • Depending on the option you choose, your investor may take a share of profits.

Debt and equity funding are each appropriate to different business needs and have very different implications.

Debt funding

Debt financing is appropriate when funds are required to finance a specific asset and you are confident that the cash flow in the business will allow you to service the loan.  Debt is useful to leverage returns from your business and helps multiply the return on your equity investment in the business. Generally, you should match the term of a debt to the expected life of the asset being financed.  Working capital should be financed by overdrafts or other short-term debt, while the purchase of fixed assets should be financed by appropriate term loans.

Before agreeing to lend money to your business, an investor or institution needs to be convinced that the business will be able to make interest payments on time and repay the capital on maturity.

Debt agreements cover such issues as the interest rate;  how interest is to be calculated;  the frequency of repayments;  and the term of the loan.  Other conditions in a debt agreement may include limitations on dividend payout ratio and the maintenance of current and other financial ratios.  If the agreement is breached the loan and interest may become payable in full immediately.

While debt can usually be negotiated quickly, its terms can be inflexible.  However, the interest paid on a debt is a tax deductible expense.

Equity funding

Equity funding is an option that will inject funds into your business and can help introduce new management ideas.  The owners of a company are its equity holders.  Thus anyone investing in the company’s equity is buying part ownership.  While the original owners can end up with a smaller proportion, issuing equity can also significantly enhance their wealth.

Equity holders can only claim the residual earnings of a business (ie after all other claims have been met).  These are paid out as dividends based on each owner’s share of the company.

The case of Yahoo.com demonstrates how business owners can grow their wealth by selling down part of their equity interest as the business grows.  David Filo and Jerry Yang started Yahoo.com as a web index in 1994.  Later that same year they sold 25% of the company to Sequoia Capital for $US1 million – a transaction that valued their 75% ownership at $US3 million.  After selling further shares of their equity to five venture capitalists and listing on the stock exchange, at one stage the value of the co-founders’ remaining 31.5% shareholding reached a staggering $US6.65 billion.

The cost of equity capital, or the return that equity investors require on their investment in the firm, is high because investors regard equity investment as risky.  They may seek a role in managing the company, or place conditions on its governance to manage their risk when investing in your business.

Organising equity funding by public listing or venture capital typically takes up to 12 months.  Equity funding from family and friends can usually be arranged relatively quickly.

Sources of equity finance

  • Family and friends
    Many business owners approach family and friends when looking for finance. Although you may get more generous terms, this option is not for the faint-hearted.
    You’ll have to disclose details of your business affairs, and if something goes wrong and they lose their investment, it can damage more than your business. This is unlikely to be a suitable option if you’re looking to raise large amounts (more than $500,000, say).
  • Business partner
    In professions like law and accounting, it’s traditional to grow by allowing new partners to buy into the business. This can work for other businesses.
    When taking on a partner, you need to be confident you can work together long term. You must have a written partnership agreement setting out how disputes will be settled and what happens if a partner wishes to leave the business.
  • Business angel
    Business angels are wealthy individuals looking for fast-growing businesses to invest in. Often they’re experienced business-people so they can also be invaluable as mentors and advisers.
    Typically, they’ll invest up to $2m, a good option for a business-owner looking for an intermediate amount. They’re likely to be on the lookout for businesses with exceptional growth prospects, so you’ll need to demonstrate your potential.
  • Venture capital
    Venture capitalists are professional investors who invest in promising businesses and help them grow, often to the point where they’re ready to be listed on the sharemarket. Rather than taking a share of profits, they make money by selling their share in your business, either on the sharemarket or to someonelse.
    A venture capitalist will typically seek to exit your business in three to five years with returns of 35% p.a or more, so you’ll need to have strong growth prospects. Generally they’ll look to invest between $2m and $10m, depending on your business and its potential.
  • Private equity
    Private equity investors focus on larger businesses. They’re often involved in management buyouts using borrowed funds. They aim to realise a large return in a relatively short time frame, covering their cost of funds and compensating them for their risk. Private equity investors can give you access to amounts of $2m to $10m plus. If you need a large amount of capital, they could be the right people to talk to.

Sources:

– NSW Small Business. Brief on Finance for Small Business. http://www.smallbiz.nsw.gov.au/smallbusiness/Resources/Publications/Brief+on+Finance+for+Small+Business/

– Commonwealth Bank Australia. Financing growth. http://www.commbank.com.au/business/betterbusiness/growing-a-business/financing-growth/#debtfinance

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