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Equity Vs. Sub-Debt Financing

Do you need capital to expand your business? These tips will help you determine which of these two types of financing is right for you.
September 23, 2004
URL: http://www.entrepreneur.com/article/72734

When Joe Assell's company, GolfTEC, was ready to tee up for its next level of market penetration, he was looking for a tailor-made financing solution to fuel its growth. Poised to secure GolfTEC's position in the $62 billion golf industry, Assell needed a million-dollar influx of cash to expand his market-leading, high-tech, golf instruction business-he wanted to double the number of company-owned stores and expand the company's franchise operation.

"This investment was critical for us as we entered a new phase of the business," said Assell, president of the Greenwood Village, Colorado, company. "GolfTEC is a high-growth company and a market leader. We needed an investment structure that worked for us and our shareholders."

That investment structure ended up being in the form of subordinated debt, a solution that allowed Assell and GolfTEC to rapidly increase the company's growth.

For Barvista Homes, a leading off-site residential construction company in Johnstown, Colorado, equity financing was a perfect fit for their financial needs. Specializing in new home construction, Barvista offers customers a choice of more than 50 different home designs that are constructed off site and then transported to the home site for final assembly. The company received a $2 million first round of funding from private and institutional investors and plans to use it to expand its customer base beyond its current seven-state reach.

"In our first year of business, Barvista reached more than $9 million in sales," said Mick Barker, the company's CEO. "In our second year, we're targeting to increase that amount by 50 percent. This investment will help us continue to capitalize on the high growth we're experiencing."

Finding a source of capital to finance company growth can be a major challenge, particularly for small and midsized businesses in such sectors as recreation and residential construction.

Sadly, a great business is often only as good as its financing, and without the right kind, you may just end up flapping around like a turkey before ever getting the chance to soar like an eagle. If your business is literally hanging by the slender, golden thread of cash flow, it's crucial for savvy business owners to develop a broad understanding of the different financing options available to them. But sorting out the options to find the right financing fit can be difficult.

Equity financing, the capital source that most often comes to mind first for many business owners, is a good option for those who have a compelling enough business to attract investors. The catch with equity financing is that it can dilute the ownership of the company for the shareholders, potentially resulting in a loss of control.

Equity financing is generally recommended for a business that's experiencing very high growth with high investment risk. For example, an early-stage, high-growth company with limited revenues and prospects for negative operating income for the next few years would find this to be a good option.

GolfTEC's Assell used a lesser-known option, subordinated debt, which enables business owners to retain more ownership of their company while still receiving the capital they need. Subordinated debt financing is recommended for businesses that are in a high-growth sector with established revenues and are on a path toward positive operating income within a year. One example of this would be a retail company whose owners need capital to increase the number of company-owned stores, yet who don't wish to give up significant ownership in the company.

Subordinated debt enables a business owner to raise capital by relying on the company's potential income combined with the strength of the specific industry and its assets, rather than having lenders look solely at a company's tangible assets. Subordinated debt offers business owners access to capital they may be unable to obtain from a bank due to a lack of tangible assets to offer as collateral. This type of debt may also be more flexible than conventional loans, where a lower risk-threshold often exists, especially for young businesses.

Sub-debt, as subordinated debt's often referred to, is debt that ranks behind the main debt, known as senior debt, in priority of payment. Senior debt principal and interest-usually in the form of a bank loan-is paid off first while the subordinated debt principal and interest is paid off second.

This type of financing is not only a creative, flexible way to raise capital, but it may also improve a company's equity position. This is because bankers may consider it part of the "equity cushion" that supports the senior bank debt. For example, a project with 70 percent bank debt, 10 percent subordinated debt and 20 percent equity, could be viewed by the senior lender as a project having roughly 70 percent bank debt and 30 percent equity.

Other major advantages of this type of financing include putting dollars back on a company's bottom line because interest payments are tax-deductible, which lowers the company's taxable income. Finally, using sub-debt financing can lower the cost of capital for the firm.

With a clear idea of what to expect from subordinated debt as a financing option, what type of lender would an interested business owner look to? Typically, subordinated debt funds are the source for this type of financing. These lenders want to work with companies that have experienced management, strong industry growth potential and financial strength. They may also rely strongly on the existing or prospective cash flow of the business.

There are pros and cons with both equity and sub-debt financing. We've already identified the loss of ownership as a major drawback to the equity option. The primary drawbacks of sub-debt financing include the fact that (1) interest and principal payments are contractual and must be met regardless of the firm's financial position; (2) the loan may place restrictions on the company and its management; and (3) the use of debt may reduce the value of the equity.

When considering sub-debt versus equity financing, the following information should help you compare the two options:

Equity

Sub-Debt

If you're seriously considering sub-debt financing, ask yourself the following questions to determine if it's the right choice for you and your business:

1. Does your business have some type of asset(s) that can be financed, such as invoices, accounts receivable, contracts or compelling intellectual property/patents?

2. Is your company's current cash flow or prospects for cash flow strong?

3. Is your earnings history strong (that is, is your company profitable)?

4. Is your company a high-growth company?

5. Do you have solid books, records and financial controls?

6. Is your company free from any current performance obligations?

7. Is there modeling and forecasting already in place?

8. Are you willing to be a financial guarantor for the loan?

9. Are you willing to possibly have financial covenants and reporting disciplines imposed by a lender?

10. Do you need relatively short-term capital-between one to four years-for various company initiatives such as acquisitions or growth financing?

If you answered "yes" to the majority of the above questions, then sub-debt financing may be the right choice for you and your company. If not, it may be in your best interests to investigate equity financing.


As the managing director for Enhanced Capital Partners LLC, is responsible for overseeing investment activity in Colorado. He has more than 14 years' experience in venture capital, investment banking and strategic consulting, and has managed numerous private equity investments.