Debt versus equity in financing
There are two primary ways to finance a company: debt and equity.
Nearly every individual is familiar with debt, whether from student loans, credit cards or mortgages. Debt describes a sum of money borrowed by one party from another to be paid back at a later date. Like individuals, every company relies on debt financing at some point in its life cycle. Debt provides owners the ability to transfer their income across time and space … allowing them to use future earnings to finance present-day investments and pay back their lender later. The question isn’t whether the organization will use debt financing but how the business owner should use it to grow the business most efficiently in the short and long term.
Equity refers to the value of an investment of an organization. Equity financing describes the process of selling ownership stakes in a company in order to raise capital for the business. Rather than pay back the investment over time as with debt financing, the borrower agrees to exchange a percentage of the ownership or stock in the company in exchange for the capital invested.
In most cases with businesses, this equity will be purchased by a private entity — by friends, family, a private equity firm, a venture capitalist firm, etc. Companies may also go public and sell their shares on the open market; however, this route opens firms up to significant oversight and regulation. The average company going public has a multi-hundred-million- or billion-dollar valuation and high growth rates.
When considering equity financing, it is important to think carefully about the ideal exit plan for the business, as investors look to capitalize on the value on their equity. There are a number of different exit plans for business owners, including sale, IPO, refinancing or recapitalization.
• The benefits of debt financing
Debt enables owners to finance the company’s growth without diminishing ownership. Once the debt is paid off, the owner maintains claim to a hopefully stronger and more valuable business, and the relationship with the lender terminates.
Say, a demolition company wants to purchase an additional excavator but can’t afford it with current revenues. By taking out a loan, the company can generate revenue at a faster rate than the interest rate on the loan; the investment can end up paying for itself.
Debt also enables companies to smooth out their working capital. If a company has large swings in accounts receivable, with contracts coming seasonally or in lumps, loans can help cover payroll and daily expenses until the next accounts receivable are paid.
• The risks of debt financing
Minimizing risk is what lenders are primarily concerned with. If an owner is looking for a loan, lenders want assurance that they will be paid back on time and in full.
Companies that use debt capital must make regular payments to keep their lender afloat. A business owner can take on debt and maintain ownership of the company, assuming the business remains healthy. Eventually, debts have to be paid back, and many lending institutions require strong covenants in order to loan money in the first place. They will require a full financial report and will be able to mandate that the owner conduct business using certain guidelines or else be in default of the loan contract. In some cases, a company may put up assets as collateral against the loan — e.g., manufacturing equipment etc. In this case, if the company cannot make its loan payments, it may lose the equipment to its lender and/or be forced to file bankruptcy. Depending on the company’s risk profile and the loan terms, a business owner may in some cases be required to guarantee a loan with personal assets.
• The benefits of equity financing
The definition of equity financing is the act of selling some portion of the company to raise capital. If the business owner chooses to obtain funding for the company through private equity, there is no need to pay back the investment over time as would be the case with debt. What happens is the owner exchanges a percentage of ownership in the company for the funds invested. This means that the owner can continue to dedicate the capital to growth and business activities, without worrying about paying back a loan.
Any entity with an equity stake in the business has a vested interest in the company’s success. They want to see it expand and be successful and as such will leverage their skills, expertise and their associations to help boost the business’s worth. Savvy investors will often work with business owners in an advisory capacity, in addition to their funding support, which can help businesses grow in ways that may be near impossible without their support.
There’s money, and then there’s smart money. A million dollars is a million dollars. But if the business owner gets a million dollars from the right party, it might be far more valuable in helping to grow and advance the business.
If the company is in the retail business, the owner might obtain growth capital from a fund that has expertise in retail — in which case the owner is not just getting money, he is getting help with the supply chain, with distribution, with selling online. The right partner can open doors that never would have been opened otherwise.
• The risks of equity financing
Raising equity financing can be time-consuming. The company will have to create a business plan, give a management presentation, and put together a data room with contracts, agreements, and descriptions of intellectual property, and conduct other relevant activities. This can take executives away from their core business activities and pose challenges for the company. It is not a quick process for companies. If the world were perfect, it would take 90 days, but that rarely happens.
CEOs do not always anticipate the level of due diligence that financial firms do. I have seen situations where firms come in, and as a result of their due diligence, they may know the company’s numbers or business model better than the people who own and run it. If there are challenges in the business, I believe in laying them out up front, because they’ll be found out in due diligence. It is best to identify all the issues and address them with solutions early on.
In addition, while a business owner never has to pay back the money that investors give them to grow the business, he also never gets the equity he gave up back. Investors will want to have varying levels of control over the business, depending on the nature of the deal, their reasons for investing in the company and their ownership stake. At the very least, management will be expected to check in with investors regularly and keep them up to date on any issues or concerns.
Business owners may lose the power to make some management decisions unilaterally. I try to get people to look in the mirror and be honest with themselves. Can they really live with a partner? They may not be happy holding monthly or quarterly board meetings or providing periodic information, because they know their business and don’t want anyone else to tell them how to run it.
Business owners should also consider how contract provisions will affect their plans long term. For example, provisions in the agreements negotiated to exchange the equity may give investors the option to wind down or consider exiting the business. Meaning, they will get one or two times their investment before anyone else gets any of the proceeds.
Bob Wolter is Mergers & Acquisitions Advisor of Creative Business Services/CBS-Global.
Call us to 920-432-1166. All your inquiries are strictly confidential.