Equity and Debt Capital — What's the Difference?
It’s common for companies growing faster than their current income to seek outside capital to keep up the momentum. An under-capitalized business will find it difficult to make the leap required to grow incrementally.
A clear first step to lining up outside capital is to determine whether equity investment or debt financing (or a combination of the two) might be the best route. This article just outlines what the difference between the two are. Which one to use is another matter entirely.
As the owner of a business concept or company, there is subjective value attached to it called equity. The equity of any type of asset (whether intellectual or physical) is the value someone is willing to pay for it, minus all its liabilities. That could mean the value of an entity today measured in time and money invested, versus the value in the future measured by comparable growth.
Once the owner and investor determine the “valuation” of the asset, the owner can then sell parts of the equity in order to raise capital. There are a variety of methods to raise equity capital including Seed, Angel, and Managed Venture Capital. You will need to spend time to learn the pluses and minuses for each type. An equity capitalist is interested in picking a company that shows great potential. They are expecting that there will be significant growth due to their involvement. That could mean that the company will grow tenfold within five years.
Without a doubt, first and foremost on any equity capitalist’s due diligence list will be the management team. Even before the idea itself, it is commonly stated, great ideas with a bad team will get nowhere; whereas, bad ideas with a good team still has a chance to make it big. Also, once invested, the equity capitalist might have an active role in the decision making of the company, even to the extent of changing the personnel running the operation. Because they have “bought in” to your company, they are now your partners, how active they become needs to be sorted out up front. Only deal with professional investors, failure to do so will result in complications and potential inability to raise additional capital later.
Commercial Debt Financing
Securing outside capital using collateral does not entail “selling” your equity, but instead works by “borrowing” against it. Commercial financing is only available to business owners who have something of value that the lender can instantly liquidate. The finance company is not interested in becoming a partner in your company, instead they are in business to make money from lending their money — letting you use it for periods of time.
Like equity financing, there are a variety of methods available to secure debt financing. Business loans through traditional banking will always be the least costly source for your financing, but remember bankers are not in business to take on risk. When they ask for multiple years of company tax returns, it is to see a steady, reliable set of profitable growth numbers.
Borrowing from the bank relies on two variables: the actual collateral that secures the loan, and the cash flow showing your ability to repay the loan. You might have enough collateral, but if your business is losing money, the bank will not expect you to handle the added expense of loan payments.
Many early stage companies turn to private commercial financing, which is better suited to deal with riskier situations. Factoring companies that offerA/R or P.O. financing use the loans you make to customers (invoices for finished work) as the collateral for their funding. Here the emphasis will be the creditworthiness of your customers rather than the credit of your company. Equipment leasing companies offer equipment financing that allows you to purchase new equipment and pay for it over time, usually three to five years.
A final note regarding capital, when seeking any sort of outside capital, whether equity or debt, remember certain sources are familiar and like to work with particular industries. Take the time to look around and be sure that the source you are considering is well-acquainted with your type of business.
About the author
Gary Honig has been active with the factoring industry since the early 1990’s where he began as a business development officer for the existing Creative Capital Associates. In March 1997 he spearheaded a takeover of the company and reformed it as a Maryland corporation. Mr. Honig has been at the helm since and oversees all aspects of running CCA which still provides commercial invoice factoring nationwide. He is a participating member of the International Factoring Association (IFA) which is the long standing factoring industry association. He is routinely called upon as an expert with thorough knowledge of the receivables factoring industry.
He can be reached at firstname.lastname@example.org and on Twitter @garyhonig.
Looking for Business Financing?
[button color="225F97" size="xl" link="http://www.lendio.com/sign_up?mission=lending"]Create a Free Lendio Account[/button]