Debt vs Equity: How Much Will You Give Up To Get What You Want?

Let’s say you know how to turn a $20 million business into a $50 million business.

You need $5 million more to make it happen. Your couch has $0.82 under the cushions. What now? Where does the rest of the money come from?

Most of the time, you’ve got three options: Bootstrapping, by either increasing your personal investment or using your business’s retained earnings, obtaining a bank loan, or selling a portion of the company.

You have a fourth option for raising millions, but first you have to date Tiger Woods.

The Empty Piggy-Bank
You’ve probably already invested just about everything that you can in your company. Maybe even more. Increasing your own personal investment may not be an option for you. Your company needs to retain earnings, too.  It needs cash reserves to see it through the lean times when checks from your customers get “lost in the mail.”

That leaves banks and outside investors. That’s right—you’re going to trust the future of your business to bankers and strangers.

Before looking for money, ask yourself these questions: How much of your business do you want to own? Do you plan to sell and get out altogether? How much control are you prepared to give up in order to grow your business? How much time do you want to spend with your family? Just kidding about that last one—you  own a small business. Your kids believe you exist like they believe in the Tooth Fairy.

Keeping Your Company
There are pros and cons with each source of capital. Both hope to make money from doing business with you. Bank loans  allow you to keep complete control of your business, but they also add liabilities to your balance sheet. Conversely, private investors don’t need to be paid back each month, but they will own part of your business and they’ll expect to have some say in how you spend their money.

For any loan, the lender wants to know that your business is generating enough money to repay the principal and interest. They will also look at the assets owned by your company to make sure that, if you default, they can sell off your company’s assets to recover their money. If you can’t satisfy those two criteria, you won’t get very far with an institutional lender.

However, by using a loan to grow, you won’t dilute the share of ownership enjoyed by each owner—the bank doesn’t become a stake-holder, it becomes a creditor to be repaid. The bank isn’t the mob. The mob is more polite. Even if you run into cash-flow problems, or lose a valuable customer, the bank will want its payment. But you do get to maintain everything the way you want, without interference from a banker who probably doesn’t know anything about your business.

If you decide to use bank loan to grow your business, Mitch Jacobs, founder and CEO of On Deck Capital, Inc., of New York, warns that you should “expect to have a lien on the entire business. A lender is likely to name specific assets that they will also have a lien on, and that becomes backing for their loan.”

You should also expect conditions, or covenants, as part of your loan package which might include guarantees about “income levels, net income levels, revenue levels. There might be certain balance sheet covenants like the book value of the business.” Jacobs said.

More Money, Less Ownership
So what if you don’t want to go to a bank, or if your cash-flow or assets can’t support the kind of investment you need? Banks are not to be interested in your great idea. Banks are interested in what your accounts have looked like in the past, right up until the moment they cut you a check. They want to bet on proven success. If your business is younger, or is high risk/high reward, you might need to find a venture capital group or an angel investor.

Richard Upton, General Partner at Harbor Light Capital Partners in Keene, NH, said that “most venture capital firms evaluate over 100 opportunities for each investment consummated.” To put that in perspective—you have, at best, a 1 in 100 chance of securing venture capital if you apply for it.  According to the National Safety Council, the odds of you meeting your maker in a motor-vehicle accident are 1 in 85.  You do the math.

Venture capital groups will expect to own part of your business for a specific length of time. That portion is related to the value of your business. If your business is worth $20 million, and you secure a $5 million investment, then the investor will own $5 million of $25 million, or 20 percent of the company. As your company grows to $50 million, the investor still owns 20 percent, or $10 million, while you own the remaining 80 percent, valued at $40 million. You can leverage your $40 million share to buy the $10 million share owned by your investor.

Angel investors operate in a similar way to venture capitalists, and there is probably an angel investment network in your region. While venture capital groups often manage large funds for multiple investors, angels are usually wealthy  individuals. Angels usually demand a higher return on their investment and a bigger share of the company. Venture capital managers don’t always have more business experience than angel investors, but angels may feel more emotionally involved with your business—for better or worse.

As long as the investor has an ownership stake of your company, they might expect a seat in your board room, or veto power over spending above a specified amount. If an outside investor put money into your company, it’s because they see an exceptional growth potential for their money, and you can expect a degree of pressure to achieve that return. After all, if your business fails, it’s their money that you’re losing, too—and unlike a bank your private investor can’t sell your assets to recover their losses.

How you choose to grow your business is up to you.  If you can secure financing that suits your needs, the question becomes whether you’re going to go to the couch or an outside investor to get the change you’re looking for.

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