Pros and Cons of Equity Financing
for Your Business
New and growing businesses may need funding to launch or develop to the next level. Starting a business may be the fun part…securing the financing to get it off the ground and really grow it, maybe more challenging. In this two part blog series, we are talking about funding options for your business start-up or growth. There are two basic forms of financing for business start-up/expansion – debt financing or equity financing. Last blog dealt with the details of debt financing a business. Now we turn our attention to equity financing.
To recap, debt financing refers to borrowing money that will be paid back over time and usually includes interest. With this type of financing the lender does not retain any ownership in the business, it is strictly funds now to be paid back as the business is making money. For smaller businesses, there will likely be a need for personal guarantees, in the form of collateral. If the business does not make it, the lender has the safety net of the business owner’s house or other valuable asset to offset the loan.
Equity Financing describes an arrangement whereby the lender takes a share of the business as part of the exchange for the money put to business start-up or development. With equity financing the business owner does not incur debt, but sacrifices some aspect of ownership or control over the business. The major disadvantage to equity financing is the dilution of your ownership interests and the possible loss of control that may accompany a sharing of ownership with additional investors. That said, there are many different types of equity financing arrangements, with various terms and agreements.
There are many different avenues to get equity, such as friends and family, angel financing, a private placement, or private equity. You may need to find a broker/dealer to assist you in raising funds, but wherever you go, make sure you check out the individual, group or organization, and be careful to assure you are dealing with reputable sources, such as R & F Commercial Debt and Equity. You should be able to ask for references and check out those references.
Debt and equity financing provide different opportunities for raising funds, and a commercially acceptable ratio between debt and equity financing should be maintained. From the lender’s perspective, the debt-to-equity ratio measures the amount of available assets or “cushion” available for repayment of a debt in the case of default. Excessive debt financing may impair your credit rating and your ability to raise more money in the future. If you have too much debt, your business may be considered overextended and risky and an unsafe investment. In addition, you may be unable to weather unanticipated business downturns, credit shortages, or an interest rate increase if your loan’s interest rate floats.
Conversely, too much equity financing can indicate that you are not making the most productive use of your capital; the capital is not being used advantageously as leverage for obtaining cash. Too little equity may suggest the owners are not committed to their own business.
Lenders will consider the debt-to-equity ratio in assessing whether the company is being operated in a sensible, creditworthy manner. Generally speaking, a local community bank will consider an acceptable debt-to-equity ratio to be between 1:2 and 1:1. For startup businesses in particular, the owners need to guard against cash flow shortages that can force the business to take on excess debt, thereby impairing the business’s ability to subsequently obtain needed capital for growth.
At R&F Commercial Debt and Equity, we work with creative and non-traditional business financing. In contrast to debt financing where the terms may be variable but still fairly simple, equity financing may be quite complex. We are experienced and skilled at developing the perfect funding dynamic for all involved. With offices in Florida and Washington DC, we have connections in many critical markets. Contact us for a consultation.