Take a Loan or Share Ownership?
In my August 2006 column, we considered the choice between self-funding and using Other People's Money (OPM), and, in the June 2006 column, we discussed the use of Other People's Resources (OPR) as an alternative to the traditional approaches to raising capital. This month we will take a closer look at two specific options: debt financing versus equity financing.
Debt financing -- taking out a loan or selling "bonds" to raise capital -- involves paying a fee (interest) to a lender for the use of the lender's money. Equity entails selling an ownership interest (equity) in your company.
Finding a source
Is it easier to find lenders or equity investors? It depends. The amount of money that you are seeking is typically a factor in finding a source. The amount sought may be too large for some lenders (although this also involves the issue of investment criteria -- you may not "qualify" for a loan of that size). That same amount may be beyond the means of some potential equity investors (such as friends and family) or insufficient to get the attention of others (professional investors such as venture capitalists).
Debt financing does, however, have a clear advantage in one area. You can always make a "cold call" to a bank. Because of securities laws, that is not necessarily the case with respect to potential equity investors (or non-institutional lenders).
Is it easier to meet the criteria for obtaining a loan or the criteria applied by equity investors? Again, it depends. Investment criteria vary all across the board. Professional investors (such as venture capitalists and sophisticated "angels") and financial institutions tend to apply stringent, relatively inflexible investment criteria. On the other hand, friends and family (who may be either lenders or equity investors), often invest in "YOU" as much as--or more than--your business.
Some professional investors tend to concentrate their investments in specific industries in which they have acquired some expertise. They also typically have very specific criteria with respect to such things as how much return they will receive on their investment, and when they will receive the return, and demonstratively sustainable competitive advantage. Many also require that a business be developed beyond a certain point before they are willing to invest in it. Some professional investors are simply not interested in start--up companies, as they are looking for a much quicker return.
The primary distinction between equity investors and institutional lenders is the willingness to assume risk. Most institutional lenders use creditworthiness--net worth, past payment history and the availability of collateral for security--as the primary criteria for deciding whether or not to lend money to a business. They typically will not make a loan unless they are relatively certain that they will be repaid the principal with interest.
Equity investors are more willing to assume the risk (in return for participation in any "success"). Of course, there is a significant element of risk inherent in most start-ups.
The cost of OPM has both short-term and long-term aspects, and both monetary and non-monetary (e.g. control) aspects. The cost of debt financing is typically finite, and you gain the benefit of 100% of any appreciation in the value of your business. However, in the short-term, repayment of the loan can place constraints on cash flow--you will have to repay the principal and pay interest--and as a general proposition, repayment is required whether your company is a success or not. It can be tough to manage cash flow when you have to make periodic payments to service debt. There also can be strings attached to debt, such as a requirement not to exceed a specific debt to equity ratio, that can tie your hands with regard to future financing activities.
Equity financing, on the other hand, gives you much more flexibility with respect to cash flow issues. There are typically no short-term repayment requirements, and it lets you share the risk with your equity investors. Of course, you also will be sharing the benefit of any appreciation in the value of your business. And, while you can separate "profit interests" from governance and control (through appropriate agreements), any time you add equity investors, there is some loss of independence, and a real potential for a loss of control.
The bottom line is that in the short term, debt financing can be problematic with respect to cash flow, but ultimately the loan is paid off, and you retain full control of your business.
On the other hand, "equity investors are forever." If your venture is successful over the long term, equity financing can be much more expensive than debt in more ways than just monetary.
Deciding between the two means weighing your personal tolerance for the risks inherent in each type of financing.