Debt Vs Equity, Which is Best?
Entrepreneurial managed companies are constantly on the search for new capital and it is seldom easy to come by. Top entrepreneurs understand that raising money is a way of life.
These top entrepreneurs realize that the financing of companies is done in stages and that they have to be flexible in identifying the latest trends in financing. Many first-timers erroneously believe that they can successfully generate sufficient cash flow on a near-term basis, then bootstrap their way to financial success. This does not work in today's fast-moving business climate, especially in many medium and high-tech areas. This section discusses this fact and other potential problems. The next section offers many solutions for the sourcing of financing. There Are Several Types of Financing: Debt and Equity Contrary to the dreams of many startup entrepreneurs, initial financing can be the hardest part of launching their new business. There are many popular misconceptions that an idea, a startup team, and a preliminary business plan will get them in the venture capitalist door. They expect to exit, happily, with the check in hand. They don't realize that traditional venture capital-venture capital funds that are supported by institutional investors-only finance a fraction of a percent of the new companies started each year. They are not cognizant of the fact that 90 percent plus of startup money comes from private sources and its up to the individual entrepreneur to identify and sell their project to these financing sources.
The first thing to do is to put together a business plan to use as a fundraising too.
Second is the actual raising of the financing, or financial marketing. Each alternative to raising money requires a different approach to the business plan. Financing never happens quickly; it is never simple. In fact, it is usually quite painful and exasperating. Entrepreneurs can find themselves chasing down blind alleys if they don't prepare properly. There are a number of sources of financing and a variety of forms of capital. Some are used to finance seed or startup companies while others are used for expansion. Start-ups are usually limited to the type of financing they can get, like personal savings used as equity or personally secured subordinated debt. On the other hand, companies with a proven track record have a much larger choice of financing alternatives--such as banks, venture capital firms, or public offerings. What all entrepreneurs soon discover is that there are several factors that they must constantly reckon with, in pursuit of the elusive dollar.
Your Two Basic Choices for Financing For all intents and purposes, the entrepreneur has two basic choices when considering financing: debt or equity, pledging a part of one's soul or giving away a piece of it. Commonly, one does both. In simple terms, debt is borrowed money secured in some fashion with some type of asset for collateral. Equity, on the other hand, is contributed capital, usually hard dollars. Debt may be secured by a personal signature only, and equity can also be in the form of a contributed asset. But most often new businesses require long-term debt or permanent equity capital to support major expansion and anticipated rapid growth. The
advantage of borrowing is that it is a relatively simple process to arrange. It does not take a great deal of time and does not dilute equity ownership. The disadvantages are that it is a high-risk strategy as far as company growth is concerned, in that incurring debt subjects the company to a firm obligation, usually including the principals as cosigners. A downturn in business or an increase in interest rates could result in the inability to service debt payments with the consequences being that the co-signers have to personally pay the company's debt.
Successful Entrepreneurs Use Combinations Unlike oil and water, debt, equity, self-funding, and external funding do mix well. In fact, it's a entrepreneurial secret. The best managed companies mix their financing sources and choices. Which to use, and when, becomes a matter of individual option, although there are some pretty well established precedents. Founders' personal investments, including both personal assets and family and friends' equity and loans, are usually what finances concept or seed stage companies.
Development or Start-Up stage companies commonly seek funding from private placements, early-stage venture capital firms, and various grants from both foundations and government sources.
Early/First-stage or production companies may receive financing from bank loans, leasing companies, and research and development partnerships (for incremental product development). Strategic partnerships are often entered into at this stage with potential customers, suppliers, and manufacturers.
Companies at the next stage of ramping up (Second Stage), which is full-scale production and expanded marketing, often receive additional dollar injections. These come from second and larger rounds of traditional venture capital, larger companies that are looking for product distribution opportunities, institutional investors, more venture leasing companies (for manufacturing equipment), and additional strategic partners (often seeking secondary manufacturing and distribution rights both domestically and for foreign countries).
After this stage, the entrepreneuring company has some heavy choices to consider. Here is where the harvest point (Third and Forth Stage) is a
natural if the plan has been to build a company and then sell out. They still need more money (what's new), but their choices are a lot broader:
more venture capital, bridge or mezzanine financing while going public, being acquired (perhaps by one of the earlier-stage strategic partners), or selling out to a cash-rich company.
So Debt or Equity? If we're saying that entrepreneurs use combinations, how do we distinguish which and when? The use of debt almost always requires that some equity has come in first. A rough rule of thumb is that a dollar of early stage equity can support a dollar of debt, if there is some additional security to further back the debt. Lenders feel that a start-up has little ability to generate sales or profits. Consequently, the lender wants to have their debt secured, and even then, they feel that the asset value will be decreasing with time and there's always the possibility that management may not be up to the company-building challenge at hand.
This debt will most likely be short-term debt (one year or less) to be paid back from sales. Short-term debt is traditionally used for working capital and small equipment purchases. Long-term borrowing (one year or maybe up to five) can be used for some working capital needs, but usually is assigned to finance property or equipment that serves as collateral for the debt. While commercial banks are the most common source of short-term debt, there are more choices for long-term financing. Equipment manufacturers provide some, as does the Small Business Administration (SBA), various state agencies, and leasing companies. More examples are given in the following section.
It's true, entrepreneurs can finance start-ups with more debt than equity, but there are some distinct disadvantages. For example; if they negotiate extended credit terms with several suppliers, this restricts their flexibility to negotiate prices. Heavily leveraged (i.e., debt-financed) companies are constantly undercapitalized and will experience continuing cashflow problems as they grow. Paying close attention to strained cashflow requires a lot of management time be diverted from company operations. It also affects the balance sheet, making it difficult to obtain additional equity or debt.
On the other hand, there is one big positive in using debt. Debt does not decrease or dilute the entrepreneur's equity position and it provides nice returns on invested capital. However, if credit costs go up, or sales don't meet projections, cashflows really get pinched and bankruptcy can become reality.
Top entrepreneurial companies use varying combinations of debt and equity. They determine which is the most advantageous for the particular stage of growth they're financing. Their aim is to create increasingly higher valuations or profit structures.