Too many entrepreneurs assume loans are the first form of
financing they should look into for their emerging ventures. But
the prospect of taking on long-term debt for your small business
can appear quite daunting when first put through an analysis of
sales, costs and breakeven. Many entrepreneurs feel borrowing money
isn't nearly as attractive as securing equity investors, but
they know that securing venture capital partners might be
unrealistic, given the size and scope of their enterprise. Most
hesitations regarding loans focus on issues of being locked into
periodic installments, having to pay large interest costs over
time, tying up vital company assets as collateral and jeopardizing
profit margins.
So how do equity and debt stack up to each other, and what are
the trade-offs you should consider? Draw a large "T" on a
piece of paper and write "Equity" on the left and
"Debt" on the right. Under the equity section, write:
- Take On Partners
- High Expected Return
- Larger Funding Amount
- No Short-Term Payments
- Open-Ended "Exit" Date
- Less Restrictions
Under the debt section, write:
- Take On Creditors
- Low Expected Return
- Smaller Funding Amounts
- Periodic Payments
- Maturity Date
- More Restrictions
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Now you're ready to assess the relative merits of each form
of funding for your specific business.
Partners/creditors. Whoever provides your firm with
funding will, to some degree, become part of your management team.
An equity partner will have direct input into decision-making--a
lender doesn't have this access.
Company returns. Equity partners will likely expect your
venture to generate after-tax annual profits of 35 to 45 percent on
the equity they invested. Creditors are only concerned with your
ability to generate pre-tax cash flow to cover periodic interest
expenses on the debt.
Funding amount. Equity partners can provide your firm
with more up-front capital to allow you to fund all the projects
necessary to achieve your growth objective. What a lender can fund
is based solely on your ability to make loan installments, and that
will likely be quite small early on in the life of your
business.
Payments. Equity doesn't get "paid back"
each month or each quarter--it represents partners in the firm. But
lenders will expect loan repayment to begin the month after you
close escrow on the loan.
Maturity. Equity partners have no guarantees on when they
may get their funds plus a (hefty) return out of your business. It
could be after an acquisition, a subsequent round of funding or the
IPO. Creditors, however, are removed from the balance sheet at a
set date upon the final payment on the loan.
Restrictions. Both funding types can require contractual
terms that limit your use of funds and the types of policies
implemented, but lenders often have much more restrictive loan
provisions than do equity investors.
You must examine each of these trade-offs in detail before
deciding which is best for your firm. Then you can establish a set
of funding priorities to guide you in your negotiations with
potential equity or debt funding sources.
David Newton is professor of entrepreneurial finance at
Westmont College in Santa Barbara, California. He is the
contributing editor on growth capital for Industry Week Growing
Companies and a moderator on small-cap stocks for eRaider.com. His
books include Entrepreneurial Ethics (Kendall-Hunt) and
How To Be a Small-Cap Investor (McGraw-Hill), named November
1999 book-of-the-month by Money magazine and a 1999 Top 10
book by Forbes. His latest book is How To Be an Internet-Stock
Investor (McGraw-Hill). He has written or contributed to more
than 80 articles for publications including
Entrepreneur, Your Money, Business Week and
Solutions, and has been a consultant to emerging, fast-growth
entrepreneurial ventures since 1984.
The opinions expressed in this column are those
of the author, not of Entrepreneur.com. All answers are intended to
be general in nature, without regard to specific geographical areas
or circumstances, and should only be relied upon after consulting
an appropriate expert, such as an attorney or
accountant.