As with any capital intensive business, the ability to execute on your business plan depends not only on raising the right amount of capital, but also the right type of capital from the right source.
The “capital type” decisions comes down to one of two categories: debt or equity. If you want to raise equity, be prepared to give up a significant piece of ownership and possibly control of the business. Taking on debt avoids dilution of your equity, thereby allowing you to maximize the upside of your invested equity and maintain control of your company as long as you do not violate any covenants tied to your debt obligation.
How do you choose which type of capital is optimal for your business? It really depends on how you would answer three questions:
- How do you plan to use the money?
- Is the plan for use feasible with a high likelihood of success?
- What are you willing to give up for the money?
Equity
If you are starting a business most likely you will need equity. If you plan to raise money from outside equity sources, that money will be used to build the infrastructure of the business as outlined in the business plan. Typical expenses at this stage would include startup organizational costs, development costs, sales and marketing expenses, and initial capital expenditures. Outside investors will expect an internal rate of return of 30% or more on their invested capital. Your business plan will need to clearly explain how those returns will be achieved before smart money invests with you.
Once your business model has been validated (proof of concept) and you can show that you can scale the business rapidly, you are going to need to raise additional capital to support its expansion. Because you now can show how the business can scale, multiple funding options will open up for you, including venture capital and possibly going public.
Completion of a public offering has its plusses and minuses. On the plus side:
- Liquidity for you as the founder and for the other shareholders.
- Your stock can be used to acquire other companies.
- Stock or stock options can be granted to employees and potential hires as a recruitment and retention incentive.
- Having access to the capital markets allows flexibility in raising capital to manage the operations of the company.
On the minus side:
- Public reporting costs are significant.
- Public shareholders and their advisors may not agree with senior management on company strategy.
- Public shareholders may have a short-term focus on earnings which may not be congruent with senior management’s long-term vision.
Potential venture capital equity sources (private equity) will seek to maximize its return by minimizing the value of your firm in the early stages of equity financing. VCs seek to maximize the pricing spread between what they pay for their investment (pre-money valuation) and the future equity dollars that will capitalize the company.
Debt
If you need capital, but believe raising equity would dilute your ownership position unnecessarily, the alternative is to seek out debt financing. The downside risk of raising debt is that you will be contractually obligated to make interest payments in good times and bad. This creates a layer of risk to the equity you are trying to protect.
As much as debt increases the risks to equity, it also enhances its rewards. Securing an appropriate debt investor will enable your company to execute on its plan without excessive dilution, maximizing valuation and preserving ownership
Commercial banks often offer the most inexpensive capital with the least flexibility and strictest credit standards. Commercial banks will finance working capital and capital expenditures in most cases. The big negative to commercial bank financing is the inflexible structure and restrictive covenants governed by bank policies and governmental regulations.
Commercial finance companies offer an alternative to banks. Their primary advantage is their higher levels of risk tolerance. Commercial finance companies will usually lend against the existing assets of the company, such as accounts receivable, inventory, equipment, and real estate. The downside is that they tend to lend against a percentage of the estimated value of those assets, and those assets need to be unencumbered (no debt) in order for you to borrow against them. In other words, if you currently have some sort of bank financing in place, most likely your bank has a collateral position in those assets which makes additional financing from a commercial finance company almost impossible to get without jumping through major hoops.
An emerging market participant in corporate finance is the specialty finance company that provides secondary cash-flow based debt to the small and mid-market business community. These firms will provide additional capital on top of commercial bank financing and commercial finance loans. In essence they are providing higher leverage financing for companies that may have exhausted all of their existing financing options, but have enough cash flow to service new debt. For instance, the new cash flow facilities would be appropriate for a company that does not have assets to lend against or the company has assets that already have debt financing in place. Cash flow loans can cover the gap in working capital needed to get the company through a temporary cash crunch. And these loans can be closed in as little as 7 days, with interest rates starting at 6% and with 5-year terms.
Let us know if Cressida can assist you with your business financing needs.