Choosing The Best Funding Strategy For You
From credit cards and credit unions to VCs and IPOs, a dizzying array of financial tools can help entrepreneurs grow their businesses. With so many options, it's important to pick the best tool for the job. Finance professionals call this "structuring" your business finance, and the right structure can mean the difference between building a monumental company and sinking in the quicksand of debt.
Pam DeLissio, 49, knows something about structuring finance: Her 15-year career in the not-for-profit sector was spent raising money for worthy causes. So when she resolved to go into business for herself, she set about raising the money she needed--more than $2 million in all--to buy Pennsylvania Online, an ISP in Harrisburg, Pennsylvania.
Paper or Plastic?
Whether you need $10 or $10 million, there are only two kinds of money: debt, which is borrowed, and equity, which is traded for ownership of the company. The first step to raising the right kind of money is to decide between debt and equity. Usually, the choice depends on personal preference.
In DeLissio's case, the decision was easy. "I'm a little bit of the controlling type," she says. "Nobody gets equity." Tightly controlling company ownership means DeLissio never has to answer to anyone. It also means her company has taken on a significant amount of debt-no small feat for a technology services company with few assets to use as collateral.
"If you've got a company with real estate or heavy equipment, and if you'd prefer to pay interest rather than give up ownership, then debt financing is the way to go," says corporate transaction attorney Mark Mihanovic, partner at McDermott Will & Emery LLP's Palo Alto, California office. "Lenders like to see those kinds of assets."
Purchasing such assets usually involves leases and loans backed by the equipment itself. Many equipment manufacturers offer built-in financing--as is the case with PC leasing, for example--but traditional banks and credit unions are also good sources for loans backed by hard assets. Either way, the term, or duration, of a lease or loan should more or less match the expected life span of the asset backing it.
On the other hand, raising money through equity offers serious advantages to businesses, says Mihanovic. "If you issue equity, you reduce the amount of pie you own, but you potentially improve your creditworthiness."
Equity financing can come from individual angel investors, traditional venture capital or--most common for growing businesses--mezzanine lenders, who combine equity and debt to purchase a business or fund large growth opportunities.
And therein lies one key to achieving maximum growth for your company: using equity and debt together. "Equity provides an asset base that can facilitate bank borrowing," says Mihanovic. "With equity, you can lev-erage a little further." Not only is the equity money itself an asset that a bank can use as collateral, but partners and shareholders may use their personal credit scores to enable additional borrowing.
Timing Is Everything
Purchasing an entire business, as DeLissio did, is a long-term investment. Likewise, most of the capital raised for such a transaction should be relatively long term. That usually means equity, since equity partners and investors generally don't demand repayment until the business is sold or liquidated. But long-term money can also come from long-term loans, which is why so many entrepreneurs use funds from 30-year home mortgages to finance their companies' growth.
For a purely commercial loan, however, growing businesses don't typically qualify for 30-year terms. Even when real estate is involved, businesses are likely to find that 15- or 20-year terms are the norm. For most other business purposes, five years is considered long term.
Of course, there are plenty of times when long-term money is exactly the wrong solution. If a fast-growing business needs cash to meet payroll or simply wants to purchase office supplies, taking out a mortgage doesn't make any sense. Credit cards, short-term loans, revolving credit lines and factoring are all much better options for freeing up cash to meet short-term needs. Banks are often the best sources of credit cards and small or revolving credit lines. For more flexible financing, such as factoring, specialty lenders or corporate finance companies will fit the bill.
Wherever you go looking for money, remember the golden rule: short-term loans for short-term needs; long-term loans or equity for longer-term needs.
Get More Than You Pay For
"At the end of the day, a key element is the price [of the money]," says Mihanovic. In the case of a loan, the price is the inter-est rate. Credit cards and other short-term loans with no collateral have the highest rates, so they are the most expensive way to borrow-which is another reason not to use them for long-term needs. Longer-term loans, particularly those backed by assets, will be cheaper. Calculating the price of equity is tricky, but don't forget that even patient investors want a payday eventually. Since each investor receives a percentage of the total value of the company, equity is usually the most expensive financing option.
Whether the price of the money is 2 percent or 20 percent, it should always be lower than the return you expect from spending it. That is to say, don't invest money in any project that won't generate enough profit to more than cover the loan payments, including interest.
In DeLissio's case, Pennsylvania On-line had very predictable revenue each month from subscribers' monthly fees. That made it easy for DeLissio to com-pare the price of her various loans to the projected corporate profits, and to compare the loan payments to the actual cash flow available from the business. She knew that analyzing both these factors was necessary to determine whether the business purchase was viable.
The trick, she says, was accurately mixing the various loans into a recipe that preserved her cash flow while keeping the average interest rate low. "I borrowed some money for less than 8 percent and some for more than 12 percent," DeLissio says. Finance professionals call that "optimizing the structure" of the deal.
Structure and Restructure
No matter which flavors of money you choose to finance your deal, building a successful business will give you new options for financing. As you prove to the world that you can use money to make money--and pay back what you borrowed--you'll be able to negotiate from strength.
DeLissio, for one, wasted no time in looking for an even better deal. "After just 24 months, we went back and started talking to the banks about restructuring [the loans]," she laughs. "And I'm [going] to raise a little more capital this year to reduce the balance of my mezzanine debt."
Meanwhile, she hasn't forgotten that it takes a strong business to structure strong financing. "You have to know your numbers, and that you can still afford the deal when the dust settles."