Cash is the lifeblood of every business. Cash inflows, like oxygenated blood, fuel strength and growth, while cash outflows are the necessary expenditures of that growth effort.What options are available to a company looking to grow or grow even faster? Well… there’s one way. And then there’s another. Then there are the legal options.There are two sources of capital: internal and external. Internal capital, money raised through company savings, personal savings or personal debt, is pretty straightforward and I won’t spend much time on it here. Instead, I’ll be focusing on external capital.More often than not, a company’s growth requires a larger investment than can be achieved via credit cards, organic cash flows or savings. The company must exchange something of value for a large lump sum cash inflow from an external source. The key thing is that the estimated return on the project must meet or exceed the cost of the external capital; otherwise the project is not worth undertaking.External capital sources come in three flavors: debt, equity and alternatives.EQUITYEquity is a cash investment in exchange for a percentage ownership of the company. The amount of the ownership percentage depends on the amount of the investment relative to the of the company. I could go all day on the specifics, but I just want to provide an overview But there are a couple key features of equity that are important to point out:
Selling equity is usually the first external capital a company raises because at a company’s early stage, equity is all it has to offer potential investors. It is not uncommon for a company to raise equity investments even before it has finished stocking its shelves or building a prototype or made a first sale.
As such, equity investors are usually taking the most risk by giving your company money. The investor owns x% of the company’s equity value, and if things go south and the equity value goes to $0; the investor owns x% of $0. Also, equity investors usually only see a return on their investment if the company is acquired or IPOs.
To offset taking these risks, the upside for an equity investment is literally infinite. Also, equity investors may try to mitigate the downside risk by asking for board seats and very strict corporate control provisions. It is also common for equity investors to receive the first money out of any exit scenario.
Equity investments are taking the most risk, but receive the highest return (cost to the company) in exchange.
Common forms of equity investment are friends and family, angel investors and venture capital. Friends and Family investments can range in size from a few hundred or thousand dollars to several hundred thousand dollars and from informal to formally, legally documented. Angel investments generally refer to contributions of $1M or less and are labeled ‘seed’ investments while venture capital investments are generally labeled as ‘Series A’ and are $2.5M or greater. Additional resources on angel groups and venture capital firms are available here and here.
Most people are familiar with debt, whether it’s from credit cards, student loans or a home mortgage. Generally, personal debt has a negative connotation because the common perception is that it indicates a consumer’s inability to pay the full amount now for something they are trying to buy.
I’ll save you the long sundry list of theories on capital structure, but generally for a business, debt is a good thing. It’s almost always cheaper than equity and with U.S. tax code, the interest payments are tax deductible.
Long-term debt, or a ‘term loan’, is probably the most familiar, and is a lump-sum commitment in exchange for fixed monthly, quarterly or annual repayments of principal plus interest. The other most common form of corporate debt is a revolving line of credit. These facilities work like a credit card – you have a limited amount of money you can draw from, and you only pay interest on what you’ve drawn and the balance you keep.
Retail banks and institutional investment funds are the most common providers of corporate debt. As mentioned, debt, particularly term debt, is usually the cheapest form of external financing a company can obtain. The cost of the loan is determined by the underwriter’s assessment of the credit risk of the company – how likely it is to repay the obligation.
The biggest downside to traditional debt is that it is harder to qualify for, especially in today’s post-financial crisis environment, often requiring at least two years of consistent profitability and going forward the company must maintain and abide by strict financial ratios and covenants. Also, it’s not uncommon for a bank to require the owner to sign a personal guarantee or pledge personal assets (your house) as collateral.
Debt and equity are the two most common and well-known methods for funding a company externally. Look for the future installment on financing options which will cover the growing area of alternative options to debt and equity.