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Financing Using Equity vs. Debt

At various times in the life of a company there are going to be requirements for outside assistance in order to grow the business. One requirement will be the need for additional capital.  Choosing which financing vehicle is best for your company is very important. It’s choosing the right tool to fix the problem.

Deciding whether to seek out equity capital or debt financing is the first step. Usually companies trying to get equity capital are very early stage with little or no real assets. While companies on their way to a steady growth curve use debt financing.

As the owner of a business idea, plan, or company – you hold ownership to a subjective value called equity. The equity of any type of property whether intellectual or physical is the value someone is willing to pay for it minus any liability attached to it. In business that could mean the value of an entity today measured in time and money invested versus the value in the future measured by comparable growth.

Once the owner and investor determine the “valuation” of the equity, the owner can then sell parts of the equity in order to raise capital. There are a variety of methods you can raise equity capital (Seed, Angel, Venture) and you should learn the pluses and minuses for each.  An equity capitalist is interested in picking a company that shows great potential. They are expecting that there will be significant  growth due to their involvement. That could mean that the company will grow tenfold within five years.

Without a doubt, first and foremost on any equity capitalist’s due diligence list will be the management team. Even before the idea itself, it is commonly stated, great idea’s with a bad team will get nowhere, whereas, bad idea’s with a good team still have a chance to make it big. You should also realize, that once invested, the equity capitalist will be having an active role in the decision making of the company. Because they have "bought in" to your company they are now your partners, how active they become needs to be sorted out up front.

Conversely, raising capital through debt financing does not entail "selling" your equity, but instead works by "borrowing" against it. Debt financing is only available to business owners who have something of value that the lender can instantly liquidate. The debt finance company is not interested in becoming a partner in your endeavor, instead they are in business to make money from their money, letting you use it for periods of time.

Like equity financing there are a variety of methods available to raise debt financing. Traditional banking will always be the least costly source for your financing, but along with that bankers are not in business to take on risk. When they ask for three years of company tax returns its because they want to see a steady reliable set of profitable growth numbers. Borrowing from the bank relies on two variables, the collateral that secures the loan, and your ability to repay the loan. You might have enough collateral, but if your business is losing money, the bank can’t expect you to handle the added expense of loan payments.

Many early stage companies turn to private commercial financing which is better suited to deal with riskier issues. Factoring companies use the loans you make to customers (invoices for finished work) as the collateral for their loans. Here the emphasis will be the creditworthiness of your customers rather than the credit of your company. Equipment leasing companies will allow you to purchase new equipment and pay for it over time, usually three to five years.

When seeking outside capital, whether equity of debt, remember that certain sources are familiar and like to work with particular industries. Take the time to look around and be sure that the source you are considering is well-aquatinted with your type of business.

This Financial Management article was written by Gary Honig on 3/18/2005

Gary W. Honig is President of Creative Capital Associates, Inc. a accounts receivable factoring company providing operational capital to emerging businesses nationwide.