Source: Colin Cunningham, Axial Forum
As the old saying goes: you need to spend money to make money. But sometimes, you don’t have the money to spend. Many business owners need some form of capital to run, grow, and maximize the value of their company.
While there are countless ways to finance your company, the two main forms of capital are equity and debt. Each can offer similar benefits – immediate capital to grow your business – however, they can have different implications. Below is a deeper dive into the three main factors that accompany capital: cost, risk, and flexibility.
The first consideration for financing your business is the cost of the capital. At the end of the day, the cost of debt vs the cost of equity is really a case of comparing short-term costs to long-term costs. Debt, which is typically viewed as the cheaper option, favors short-term costs.
Let’s look at an example:
You’re running a $100k revenue business and have the option to either take a $10k loan at a 10% interest rate, or trade 10% equity interest in your business for $10k. Both scenarios offer you the $10k you need to grow.
Now, assume your business takes in $30k profits in the next year. If you had taken the loan, you would owe $1k in interest ($10k x 10%) to the debt provider and keep $29k in profits. On the other hand, equity would commit $3k to your equity investor (30k x 10%), leaving $27k in profits. In this scenario, debt is the cheaper alternative.
Not only is the debt cheaper for this year, but once you pay off the loan you keep all of the profits going forward. The equity investment, however, is permanent. The other shareholder owns 10% of the company forever.
But what if your business isn’t growing that predictably?
Early stage businesses or companies growing faster than their revenue will usually see the situation reversed. Banks or other lenders are less willing to lend to unpredictable businesses since the company has a significant risk of default. If they did make a loan, the rate would be extremely high – probably 15% or more – and could threaten the limited available cash flow. Equity, by contrast, requires no capital commitments. If you sell 10% of your business for $10k and you don’t break even next year, you won’t owe anyone money.
Many stable companies (big and small) often look to debt first because of it’s relatively low cost. As long as your revenues are predictable, it often makes sense to start on the debt side of the spectrum as you consider your options.
Just because debt is cheaper doesn’t mean it’s always preferable. Depending on the current state of your company (and the economy), risk is also a necessary consideration.
One of the biggest risks to consider with debt is the company’s current capital structure. If your company had $100k in revenue last year and made $15k in profit, taking a loan that requires $12k in payments annually can be a significant risk.
Having a high debt-to-equity ratio can also make it hard to raise other types of capital. If you’re at risk of going into default on your loans, many investors will fear that your company is unsustainable. Equity investments don’t have the same default risk as debt investments, but it can still be a red flag.
When you take on debt, you are on a fixed timeline to either fully repay or default on that loan. Additionally, debt is dependent on market conditions. If you find yourself in need of capital during a bad economic climate, the cost of a loan may far outweigh its benefit. This is especially problematic if you’ve taken loans in good times at generous rates and find yourself needing to refinance the loan later when interest rates aren’t in your favor. You may not be able to get another loan and may end up bankrupt or the rates will be so onerous that your profits disappear. If you’re unable to refinance or make the payments on the loans, the debt provider has the right to take over your business or repossess property (in the case of an asset-backed loan).
From this perspective, equity seems like the less risky option for business owners. Although you will have to answer to a board and outside investors that will also share in the future profits of your business, your equity partners (as long as you own the majority share of your company) do not have the right to take your company from you. Still, equity has its own risks.
The primary risk of equity occurs if you need to raise more capital in the future. Typically, outside investors (either current or new) will provide more capital for the business in exchange for more equity. Over time you can lose control of the business you built for years.
Overall, equity financing has lower risks for a business, though it can get tricky for you as an owner if you need too many rounds of financing. Debt, on the other hand, can be much riskier in both the short run and, if you have to refinance repeatedly, over the longer run if your profitability is unpredictable.
Depending on the type of loan you choose or the amount of equity you give up, you’re entering into a contract that will somewhat limit your future options. All things being equal, debt provides less flexibility than equity.
In most cases, once you begin taking on debt, you will need to pay down your outstanding obligations before you can begin taking on more loans. While this cash burden can prove limiting, the biggest challenge is the covenants associated with the loans. For example, banks will often require quarterly or monthly books, have requirements on what your business is or is not allowed to spend money on, and may reserve the right to approve strategic decisions. The oversight can hamper a fast growing business if the bank or banker doesn’t understand your business.
Although equity comes at a higher cost, it does provide more flexibility than a loan. As long as you don’t give up a controlling interest in your company (>49%), you are in a position to direct the outcome of your company’s future. Also, since most equity providers realize their losses are capped and they’ve invested for the upside, they will often work with you to find the right strategic outcome.
Whether you’re taking on debt or giving up equity to finance your company, these three traits must be considered. These traits are further influenced by business life cycle, market trends, macroeconomic influences, how you want to optimize your own outcomes, and more.
About Scale Finance
Scale Finance LLC (www.scalefinance.com) provides contract CFO services, Controller solutions, and support in raising capital, or executing M&A transactions, to entrepreneurial companies. The firm specializes in cost-effective financial reporting, budgeting & forecasting, implementing controls, complex modeling, business valuations, and other financial management, and provides strategic help for companies raising growth capital or considering M&A/recapitalization opportunities. Most of the firm’s clients are growing technology, healthcare, business services, consumer, and industrial companies at various stages of development from start-up to tens of millions in annual revenue. Scale Finance LLC has offices in Charlotte, Raleigh/Durham, Greensboro, and Southern Pines with a team of more than 45 professionals serving more than 120 companies throughout the region.