Growing Your Company
The essentials of debt and equity financing.
Growing your business is a challenge that all owners and managers face regularly. While there are several actions you can take to help accomplish this, here we’ll focus on the financial requirements of growth and discuss some of the challenges of obtaining capital.
Simply put, there are two ways to obtain money for your business: debt or equity. Yes, you have several options for the type of debt you may secure, and there are multiple scenarios for infusing equity into your company. At the end of the day, however, it will come down to either debt or equity. Let’s examine a few of the pros and cons of each type.
Securing capital via debt
Debt financing to obtain capital required for the growth of your business usually will be associated with the expansion of property, buildings, or equipment. Additional debt may also be used to finance or restructure some of the less favorable debt on your balance sheet or perhaps help even out your cash flow. When securing capital via debt financing, you have a few different options:
* Lease financing: Leasing is one of the more traditional ways to obtain financing for equipment, and numerous companies specialize in providing money through a variety of leasing programs. With equipment in our industry, these types of leases are usually paid out over 3 to 5 years or as close to the economic life as possible. A lease typically finances the entire amount of the equipment, leaving no residual value or a $1 buyout at the end of the lease.
The main advantage of these types of leases is that it is often easier to secure financing if your credit isn’t the greatest. Depending upon your banking relationships, the rates may sometimes be a little better. Leasing companies can also be a little more lenient on requirements such as personal guarantees.
One of the primary disadvantages of a traditional lease, however, is the lack of flexibility. While traditional financing agreements may have clauses allowing prepayments of outstanding balances, balloon payments, refinance terms and other options, leases typically won’t allow such terms. For example, if you wish to sell a piece of equipment with an outstanding balance, you’ll usually end up paying the full principle balance as well as all interest due through the remainder of the lease.
* Traditional debt financing: This type of financing is usually done through a bank or credit union. As with lease financing, traditional financing will typically tie the term of the loan to the useful life of the asset. Options here often include fixed or variable rates, balloon payments, prepayment clauses (usually after a fixed amount of time), refinance options, and other choices.
Having the flexibility in a financial instrument can become a significant advantage when financing assets, particularly equipment. If you decide to sell off older equipment for new and the debt term isn’t complete, a flexible loan can make it a much easier deal to pull off.
But as I mentioned earlier, traditional financing will probably require more stringent covenants. Unless you have well-established banking relationships with outstanding credit, you will likely have to pledge business collateral such as cash, accounts receivables, inventory, and possibly personal guarantees. These types of restrictions can also affect future financing needs if your current assets are already pledged.
* Line of credit: An established line of credit with a lending institution is often utilized when operating capital is needed. A line of credit can be used to smooth out the peaks and valleys of cash flow; in addition, a line of credit can be used for equipment financing. For instance, last year our company knew we would be investing in three or four different pieces of equipment at different times. With that in mind, we established an equipment line of credit with our bank for a fixed amount that would cover all of the equipment costs. As a result, when it came time to purchase the different pieces of equipment, the financing was already in place.
As the above description illustrates, a line of credit provides flexibility in terms of when you need to use it and how often. You can often negotiate some flexible terms with a line, such as variable rates and waivers of prepayment penalties. A line of credit carries with it the same disadvantages as traditional debt financing: more stringent covenants.
Equity: a blessing and a curse
Using equity instead of debt to obtain capital requires a very different business philosophy. Essentially there are two types of equity, inside money (meaning your own), and outside money.
Let’s examine first the advantages and disadvantages of personal equity. The obvious advantage of utilizing your own money to finance business operations or expansion is that you don’t have to pay interest on the money. Additionally, when there is no outside entity such as a bank or a leasing company involved, your assets remain unencumbered from collateral positions, allowing you future flexibility with the use of the value of your assets. As I mentioned earlier, debt financing often will require the personal guarantees of a small business owner. Whether it’s perceived as a blessing or a curse, when you use your own money, in effect, you have already issued a personal guarantee, but at least it isn’t to someone else.
The main disadvantage of personal equity is that you are, in fact, using your own money. If you have the money, whether it’s generated from the business or your own, there is certainly nothing wrong with that. Just make certain that this is the best time and place to use personal money in your business. That question depends on your assessment of personal risk, flexibility, future cash flow considerations both inside and outside of your business, etc. It may be exactly the right thing to do, just make sure you think through all of your options to be sure.
Obtaining investment capital from an outside source-whether it is through venture capital, a stock option plan, a rich uncle, or your own child-changes the rules of business the day it happens. It would be naive to believe that you can bring anyone into an ownership position at your business and assume that things will remain the same. That doesn’t necessarily mean it is a bad thing; adding additional partners into the management of your business may be just what you need.
Here, however, are some points to consider: Just as is the case with personal equity, outside equity avoids interest costs and the additional issues with debt financing. You may be in a situation that requires an amount of capital infusion beyond your personal capabilities. Partnering with an additional investor can be a solution to that problem. If you are in high growth mode and want to leverage that growth faster than your business operating capital or your personal equity will allow, using outside money is a great way to make that happen.
By far, the most challenging aspect of using outside money is that you lose some amount of ownership of your business. It may be a minority or a majority position, depending upon the amount of capital the outside investors put into your business, but you’ll now have new business partners. The reality of outside investment money is that virtually everyone putting their money into a business wants to have some say in the management decisions, and it’s usually more than you think. If a significant amount of capital is involved, it’s likely that the investors may even want a controlling position in stock ownership. The point is, if you choose this route to infuse capital into your business, go into the deal with your eyes wide open. For better or for worse, it will be different from that day on.
Of course, these are just a few of the basic options when it comes to obtaining capital for your business. If you’re serious about securing additional financing for the expansion of your business, be sure to examine all the possibilities available, consult your professional help, and determine which situation will work the best for you. Careful planning is the key to structuring a deal that will help your business grow to the level you desire.
Marty McGhie (firstname.lastname@example.org) is VP finance/operations of Ferrari Color, a digital-imaging center with Salt Lake City, San Francisco, and Sacramento locations.