Which Form Of Financing Is Best For Your Company

Debt and equity are the two primary forms of financing available. Throughout its existence, a company will likely employ both types. When selecting whether or not to invest or provide a loan, lenders' priorities will be different from those of investors.

Borrowed funds that accrue interest for the lender until they are repaid are called "debt." Banks aren't the only ones who lend money; leasing corporations, factoring firms, and even private individuals can do it as well.

Lenders are primarily concerned with two things: how risky the loan is and whether or not the company can create enough cash flow to pay the interest and return the debt. Prioritizing the company's track record and asset base over its potential for growth is important. The loan is typically collateralized by the company's assets and, in many cases, the owner's personal assets as well (this is termed a personal guarantee).

The company's assets are typically not valued at their full book value when used to secure a loan. In other words, a financing source might only provide you with 50% to 75% of the value of your inventory if it has a book value of $50,000 (or if it cost you $50,000 to produce that inventory). The reason for this is that the funding source has no vested interest in your company and would have to quickly liquidate the goods at below-market prices.

Accounts receivable, or money that is owed to you from consumers who have already purchased your product but have not paid for it yet, are likewise discounted. The same $50,000 in accounts receivable may only be worth $40,000 to $60,000 to the lender. If a customer owes money to a third-party lender, they may be reluctant to pay the whole amount due or perhaps make any payment at all. After that, the same rule of thumb applies to the company's equipment, land, buildings, furnishings, and fixtures.

Lenders frequently require business owners to put up their own money as collateral in case the business fails to pay back a loan. If the business owner has little faith in the company's ability to repay the debt, the lender has no reason to do so either.

Equity

Investment funds are received in exchange for equity stakes. Sweat equity and cash contributions from the company's founders also count as equity, as do investments from venture capital firms, joint venture partners, and individual investors (also called "angels"). Investors care more about a company's prospects for expansion. Their hope is that, in three to five years from now, their initial investment will yield a return of five to one, or even ten to one. In other words, if you invest $100,000 now in the correct company, you'll have $1,000,000 in three years.

Since investors' goals differ from lenders', investors use distinct criteria when deciding whether or not to make an investment. Companies with strong prospects for expansion attract the most funding. The strength of the company's management, the popularity of the product's brand, the ease with which new competitors can enter the market, and the total size of the market all contribute to the company's growth potential.

Should You Invest In Debt Or Equity

Several questions must be answered first before a conclusion can be drawn: For what reasons does the firm need extra funding? At what point does the company stand? What is the company's current financial status? How much money do we need? How will the company's day-to-day operations be affected by the financing source? Finally, how will the company's ownership structure change as a result of the financing source?

For what reason does the firm need extra funding

Some situations are better suited to debt financing, while others are better suited to equity financing. Debt is a common way for businesses to raise operating capital or pay off existing debt. Debt or equity might be used for growth funding. Equity financing is a common source for new venture capital. Either one, although the cost of financing will be higher if the company needs to make a quick turnaround, pay off a late loan, or make up for a revenue shortfall,

Where does this company currently stand

Seed, startup, first stage, and second stage are four distinct phases in a company's life cycle. The degree of danger may be proportional to the development level of the organization. Neither debt nor equity investments are off-limits at any time, but the less hazardous they tend to be, the longer a company has been around.

The seed stage is when an entrepreneur has a concept for a business or product but hasn't done enough research and development to know if it will succeed.

Startups have a business model, a clear product, and some basic infrastructure in place, but they have yet to generate any significant revenue. It's possible that this is only a test run of the product.

The product is either commercially available or producing revenue, marking the end of the first stage. The foundation of the business has been laid.

Full-scale production is the next step. The market has been receptive to and supportive of the company's offering. The time has come for the corporation to launch the product nationally or launch a second product.

Established after at least three years of profitable operation

The company has been established for a while, but its performance has been lackluster. To undertake a hard turnaround, a company must not only be failing but also be in a cash-loss situation, with little possibility of turning that around without significant reorganization.

What Is The Financial Condition Of The Company?

Depending on the company's current financial standing, one type of capital may be more appropriate than another. If the business requires all of its capital for expansion, it is not a good candidate for a loan since it would be unable to make the required interest and principal payments. It would be counterproductive to bring in an equity investor if all the company needs is a line of credit to cover a cyclical uptick in orders.

Lenders consider both the collateral offered by the borrower's assets and the interest payments made regularly. Additionally, they consider the obligations and liabilities of the company's owner(s), if any. The proverb goes something like, "It's easier to get a loan when you don't need one." It's easier to get financing for a company with a solid balance sheet that's high on cash and short on liabilities.

Trends in the company's income statement and balance sheet are used by investors to assess the firm's health. A corporation with a history of growth is more likely to succeed. An investor cares not just about the company's previous performance but also about the product's and market's potential going forward. An equity investor is more likely to back a company with a problematic background in a booming industry than one with a stellar track record in a declining one.

But what if your business is a start-up and has little to no background? Then, we'll have a look at some additional variables, like:

How much capital the owners put into the business.
How competent is the executive team?
How committed is the leadership group to the company's success?
What other forms of intellectual property, such as patents, trademarks, goodwill, etc., could be made available?

How difficult is it to break into this industry?

Both debt and equity carry costs, and the business must be profitable enough to pay back its loans and their associated interest. A repayment schedule is not required for equity. Returns over the long term are what equity investors care about.

How Much Money Is Needed?

Traditional lending and equity sources are typically not interested in providing funding for a short-term, low-dollar need. No lender is going to approve a loan if the processing fees equal or exceed the interest payments. Investors believe the level of scrutiny needed to commit even a modest sum of capital is comparable to that needed to commit a much greater sum.

However, it may be necessary to raise a massive sum of money in phases, with each one being funded dependent on meeting predetermined benchmarks of success. You, for instance, may have a concept for a diagnostic test that would represent a major advancement in medicine and completely alter the way we currently approach the diagnosis and treatment of illness.

However, you'll need to spend $3.5 million to get the product to market readiness. As little as $50,000 could be used to check for similar projects and assess the size of the market for the product through a literature and patent search. In the second step, $500,000 might be made available to buy lab equipment, hire lab staff for six months, and pay consultants to design a business and marketing plan if the search shows that no one else is working on the idea and the market is every doctor's office worldwide. If the lab personnel are able to create a prototype testing apparatus by the end of the six months, then an additional $1,000,000 could be made available to complete the project and secure a patent. In order to get FDA approval and conduct independent tests after the functioning prototype has been patented, a sum of $750,000 would be needed.

What Constraints Will The Financing Source Put On The Day-To-Day Operations Of The Company?

It's important to think about how finance could affect the business. The use of surplus funds may be constrained by loan covenants. In addition to dictating spending caps and prohibited purchases, creditors can require that a company keep a minimum balance in its accounts, collect its receivables within specified parameters, and set its own credit terms for its customers. Because of these limitations, the organization can miss out on some chances.

Even if they hold a minority stake, equity investors can nevertheless want the ability to exercise veto power over particular expenditures or other similar rights.

How will the financing affect the current share of ownership?

Finally, how will the owners respond to having their authority over the business and its management reduced? An investor has a keen interest in the success of your business and can contribute not only financial resources but also experience and management know-how. Except for the loan stipulations already stated, a lender's only interest is in getting repaid.