From credit cards and crowd funding to IPOs and VCs, there are a dizzying number of financial instruments that entrepreneurs can use to start up or grow their businesses. With such a vast array of options, it is more important than ever to choose the right instrument for the job. In the world of finance, this is referred to as structuring your business’s finances. Choose the wrong structure, and your business can sink into a bottomless pit of debt and despair. Choose the right structure, and you can build a business empire.
Debt or Equity?
Whether you need $5 or $5 million, there are truly only two forms of finance: debt, which is money that is borrowed, or equity, which involves giving up a portion of ownership in your company. The first step in financing your business is deciding whether to use debt, equity, or both. The choice typically depends upon your personal preference.
If you happen to like being in complete control, then debt is your best financing option. This will provide you with the funding you need without having to answer to anyone. However, it will also leave you deep in the hole right out of the gate; a situation that may be less than appealing.
If you have a company with heavy equipment or real estate that can be used as collateral and you would prefer to maintain full ownership, then debt financing is suitable for you. In such a situation, acquiring debt financing will not be a problem, because lenders like seeing these types of assets.
The leases and loans used in acquiring these assets are usually backed by the equipment itself. In fact, most equipment manufacturers provide built-in financing. However, traditional banks are also excellent sources for loans that are backed by these tangible assets. In either case, the loan or lease term should at least equal the lifespan of the asset that is backing it.
Conversely, obtaining financing through equity also provides businesses with major advantages. When you issue equity in your company, you reduce your stake in the company, but you improve your credit worthiness and do not over-extend yourself.
Equity financing can be obtained from many sources, such as venture capitalists, angel investors, or mezzanine investors. The latter involves the combination of equity and debt to fund business startups or growing businesses, which is a very common form of financing for growing businesses.
Using debt and equity together is essential in achieving maximum growth in your business. Equity provides assets, and banks look for assets when facilitating lending. Equity gives you added leverage, because banks can use the equity money itself as collateral and shareholders or business partners can use their credit scores for additional borrowing.
In Finance, Timing Is Everything
Purchasing a business is a long-term investment. Thus, most of the money raised for the purchase of the business should be long-term as well. This usually equates to the use of equity, because repayment to equity partners usually does need to take place until the business is liquidated or sold. However, long-term capital can also come in the form on long-term loans, which is the reason why a number of entrepreneurs finance the startup or growth of their companies with funds received from 30-year mortgages. For strictly commercial loans, businesses typically do not qualify for 30-year loan terms. Even with the involvement of real estate, loan terms of 15 to 20 years are the industry norm.
Of course, in many cases, long-term money is completely the wrong solution. If a growing business needs access to fast cash in order to meet payroll, purchase office equipment, or buy supplies, then taking out a 30-year mortgage makes absolutely no sense. For short-term capital needs, revolving credit lines, credit cards, short-term loans, peer to peer lending, and factoring are all better options.
Banks are often the best sources of revolving credit lines, short-term loans, and credit cards. However, with interest rates as low as 6% and 36 month terms, peer to peer lending is also an appealing option. Factoring provides a flexible financing option as well, and this is achieved through corporate finance companies and specialty lenders.
Regardless of where you seek out funds for your company, just remember the golden rule that short–term loans should be used to meet short-term needs and equity or long-term loans should be used for long-term needs.
Watch Your Numbers
Whether you acquire capital from giving up equity or using a credit line, all of the capital you raise comes with a price. Loans and credit accounts all have interest rates. Short-term loans and credit cards usually have the highest interest rates. On the other hand, long-term loans backed by collateral have the cheapest rates.
It’s difficult to calculate the cost of giving up equity, but even the most patient of investors will eventually want their money. At first equity may seem like the way to go, but since each investor receives a stake in the overall value of a company, it usually ends up being the most expensive financing option in the long run.
Regardless of the interest rate, it should always be lower than the expected return. Never invest money in any business project that will not generate enough profit to take care of the loan payments, including the interest. You want to compare the overall price of the loan or loans to the projected yearly profits, and also compare the monthly loan payments to the monthly cash flow.
Analyzing all of these factors will help you determine the viability of the business. In the end, you have to understand your numbers and know that you will still be able to afford the deal long after signing on the dotted line.