First Line Of Financing
Our Finance Expert explains the difference between equity and debt financing.
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
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.
David Newton is a professor of entrepreneurial finance and head of the entrepreneurship program, which he founded in 1990, at Westmont College in Santa Barbara, California. The author of four books on both entrepreneurship and finance investments, David was formerly a contributing editor on growth capital for Industry Week Growing Companies magazine and has contributed to such publications as Entrepreneur, Your Money, Success, Red Herring, Business Week, Inc. and Solutions. He's also consulted to nearly 100 emerging, fast-growth entrepreneurial ventures since 1984.