How to decide if you need debt or equity financing for your business
Feb. 26, 2018
8 minutes to read
Opinions expressed by Contractor the contributors are theirs.
For small businesses, 2018 seems like a great time to grow. Corporate tax rates have been significantly reduced, accelerated depreciation rules encourage capital investment, and the economy is showing signs of continued strength.
The first question homeowners should ask themselves is whether to use debt or equity to meet their capital needs. Let’s start by looking at some common debt options: conventional bank debt, SBA guaranteed debt (my favorite, but not the best in all cases), and factoring and other forms of non-bank lending.
Conventional debt for proven companies
Getting the right kind of financing starts with an honest assessment of the Five Cs: capital, collateral, terms, creditworthiness, and cash flow. These are the factors that banks use to determine whether the business qualifies for bank debt.
Capital city refers to the ratio of owner’s equity to total liabilities (or leverage) of the business. While there are exceptions for some industries, in most cases a business should not have more than $ 3-4 in liabilities (mostly debts and accounts payable) for every dollar of equity to be eligible for financing. conventional.
Collateral designates the assets that will secure the loan. Banks typically use a percentage of the current market value or cost of assets (called mark-ups) to determine how much they can lend in a conventional manner. For example, a bank may cap its term loan offers at 75% to 80% of new real estate and equipment, and 50% of used equipment; and cap its lines of credit at 70% to 80% of current accounts receivable and 30% to 50% of finished product inventories.
Terms & Conditions are market and industry conditions. If the business is very cyclical or seasonal, or subject to significant regulation, it is generally riskier than other businesses and may have difficulty obtaining conventional loans.
Solvency This is how the company and its owners demonstrate a long-term desire to pay their creditors on time. This is usually documented by credit reports.
Cash flow is perhaps the most important of the five Cs; it is generally based on the historical profits of the company, before reductions for depreciation, amortization, interest expense or taxes but after mandatory distributions and required maintenance capital expenditure. This cash flow is then compared to the proposed debt payments. Cash flow must be at least 1.2 times the amount of debt service required to qualify for conventional financing.
For established businesses that demonstrate strength in each of these five Cs, a conventional bank loan can be a great option. These loans offer attractive rates and the lowest overall cost of borrowing.
SBA loans for businesses that need more
Businesses that are strong in most of the Five Cs, but need to overcome a collateral weakness, need longer term to be able to pay payments, or grow beyond capacity Their company’s history of collecting debt, will fare better by applying for a loan backed by the US Small Business Administration. SBA loans provide banks with the flexibility to approve loans with no collateral and offer terms of up to 10 years in most cases (conventional loans are typically three to five years), so Cash flow calculations are often improved. SBA-back loans can also help a bank say “yes” to a business in a riskier industry or with a busy past.
If the business is seeking SBA funding to grow its business, or will be relying on projected cash flow for repayment, it is essential that the business has a solid business plan showing how the funds will be used and how he plans to generate the cash flow needed to repay the loan.
Companies that do not have such plans can seek help from Small Business Development Centers and SCORE Association chapters. These plans begin with three years of detailed financial projections and should discuss the assumptions that were made when creating the projections. If the company’s financial data is different from industry standards (i.e., shows a lower cost of goods sold or operating expenses), the plan should explain why the company can realize its projection. Business plans should also include detailed explanations of anything unusual in the business’s past, such as one-time expenses or unusual circumstances.
Getting the right loan is also made easier by going to a bank that knows your particular industry. A banker familiar with hospitality or construction businesses, for example, is more likely to understand the unique needs of your business than someone who has never taken on debt for those industries.
Factoring and other debt options
For companies with good debts but weaknesses in other Cs, factoring may be an option – sell the company’s accounts receivable to a third party at a discount. Factoring is high cost debt, but can make sense when a high growth business needs financing to grow its business quickly and the new business opportunity is profitable enough to generate cash flow to pay off the debt. . The factors generally relate to two things: 1) the validity and enforceability of claims; and 2) the strength and ability of the company’s customers to pay when due.
Related: 4 ways to finance your business
Some small businesses that do not qualify for loans can still get into debt. One option is micro-lenders, which are non-bank, often non-profit lenders themselves who mix public and private funding to lend to startups, very early-stage or growing businesses. They can lend anywhere from $ 1,000 to $ 1 million, charging higher rates and requiring collateral in most cases, but not all. Businesses can also use personal credit to obtain auto loans and leases; credit card debt (an option better reserved for amounts of $ 10,000 or less); a home equity line of credit; or take out a loan secured by other income (perhaps a spouse’s salary or a guarantee from another family member).
Equity for fast-growing companies
Like debt, taking various types of equity is also influenced by the stage of growth of the business and its cash flow. Equity can come from family and friends, angel investors, venture capitalists, private investors or a strategic partner.
Friends and family can be great investors when the business is in its infancy and will not qualify for a loan, and is unlikely to attract professional investors.
Early stage businesses, such as a proven restaurant that is expanding into a fast growing chain model, or a business that has developed a product, has proven to be marketable and now wants to hire a sales team to profit. of a market opportunity, may be able to attract equity capital. Angel investors offer equity injections, typically $ 50,000 to $ 500,000, and look for businesses that have a chance to grow quickly. They usually stick to specific industry niches that they are familiar with and that can be found through local angel investor networks. The SBA is also supporting its own public / private early stage capital investment program, the Small business investment company, which has supported companies like Apple, You’re here and whole foods.
Traditional venture capitalists are useful for fast growing companies that need an injection of $ 5 million or more to bring in new money quickly. Technology or a product in the market, but with insufficient historical cash flow to secure a loan of this size. The company may even generate losses as it drives growth, but it has a short-term path to high returns for investors. Venture capitalists favor sectors such as technology and healthcare and plan to sell their stake in three to five years, either through a buyout from a larger firm or through an initial public offering. They require substantial control over the companies they invest in, often significantly dilute previous owners, and typically strive for 10x or better returns.
Private Equity (“PE”) investors seek to acquire a stake in companies that are generally more established. Private equity investors prefer to target companies looking to grow by acquiring other companies and hope to increase their profits by capturing the resulting efficiency gains. This could be a medical practice expanding to become a regional system, or a distribution and logistics company looking to acquire other companies.
Like VCs, PE investors want to sell their investment, typically in three to seven years, for multiples of their initial investment. Both are looking for a return that is significantly higher than that demanded by the banks.
For relatively mature companies that are growing at a more down-to-earth pace, selling shares to a strategic partner may be a better option. This could be the sale of part or all of the business to the business’s primary customer or supplier – a business that is invested in the success of the business.
With economic conditions suggesting that 2018 will be an overwhelmingly positive year for small businesses, deciding whether to borrow or sell stocks, and finding the right source, is an important first step in making expansion plans a reality.