You don’t need financial training to know that capital is needed to start a new business or grow an existing company. Debt and Equity Capital are the two most common routes for acquiring needed cash; however, many entrepreneurs and business leaders lack understanding of which option to choose and the implications of each.
Let’s Define the Debt and Equity Capital
Debt capital is borrowed money. Its advantages are: 1) it’s relatively inexpensive if the interest rate is low, 2) the process of acquiring it is quick and easy—there are banks everywhere, and 3) it’s temporary—when paid back you owe nothing more to the bank. The disadvantage of debt capital is that it must be paid back with interest. This can become problematic when a company takes on too much debt.
Equity capital is money paid-in by investors to acquire shares of stock in a company. Its major advantage is that the company does not have to pay it back. If shareholders want their money back, the shares must be sold to another buyer. This is easy for public companies whose shares trade on the stock exchanges, but is more difficult for private corporations because the seller is required to find a buyer. The disadvantages of equity capital are: 1) it’s difficult to find equity investors, 2) selling shares means you must give partial ownership of the company to the equity capital provider, and 3) equity investors expected greater return and tend to exert more control over company strategy and activities than lenders.
Which is More Expensive—Debt or Equity Capital?
Many mistakenly believe that debt capital is more expensive because it must be repaid with interest, but the opposite is true—equity capital costs more. As mentioned above, loans are inexpensive, especially when interest rates are relatively low, as in recent years. But, new businesses often have difficulty getting loans because lenders do not like to take many risks and don’t provide lending unless they are sure of repayment. Lenders usually ameliorate even the minimal risk taken by requiring collateral equal to the principal amount of the loan.
What this means is that you are not likely to obtain much debt capital for a risky start-up venture. That is the purpose of equity capital. Equity capital providers take more risk because they have no promise to be repaid. Equity capital is more expensive because of this increased risk. Shareholders put pressure on company management to produce revenue, profit, and cash flow significant enough to increase the value of their shares, so they can be sold at a substantial profit. Shareholders may also expect annual dividends. Dividends are quite different from interest on a loan. Interest retires when the loan is paid off. Dividends do not retire. Large companies organized as C-corporations are not required to pay dividends, but stopping paying them is usually viewed as a bad sign by investors. Smaller Sub-S corporations must distribute all earnings to its shareholders each year, so all equity investors receive annual dividends by percentage of ownership of shares. If you own shares in a company that pays dividends, you will receive dividends until those shares are sold and then the new buyer will receive them.
If your company is established and you have substantial assets to use as collateral, borrowing is the best way to raise capital.
Start-ups are more reliant on equity capital. Even equity capital has different levels of risk. The riskiest capital is usually referred to as seed funding. This is truly start-up money and is a highly risky investment. This money is typically provided by the entrepreneur, friends, family members, or angel investors who have a high tolerance for risk and believe strongly in the entrepreneur’s idea.
After seed funding helps a company prove its viability, further stages of equity funding are usually provided by venture capital firms as the business grows. Despite the risk, equity capital, unlike loan capital, has a large upside.
Your company needs $1,000,000 of capital. If that amount is borrowed at 4% simple interest, the lender will receive $40,000 in interest the first year. Now imagine your company goes bankrupt and cannot repay. The lender loses $1,000,000. Imagine how many successful loans the lender will have to make to repay that amount of loss. That’s why lenders secure loans with collateral and do not take much risk. If you’ve provided collateral, this will be lost to the lender.
An equity investor applies different financial training and awareness. An equity investor will most likely invest only 100,000 of your requested amount, meaning you will need to find nine other equity partners. Equity investors know that each investment is highly risky. With a million dollars to invest, they are likely to spread this money over 10 smaller investments, knowing that some will fail, others will break-even or have small successes and maybe one of the ten will be a huge success and return multiples of the original million dollars invested. Equity investors understand and can tolerate the inherent risks of venture capital. If your company acquires a million dollars of equity capital from 10 investors and goes bankrupt, each party will be disappointed and possibly upset by the loss. Each investor will have some likely of recouping the loss through another investment.
Take it From Tesla
An innovative alternative way to acquire capital that does not involve loans or equity funding has recently been demonstrated by the electric car company, Tesla. The company has designed and developed a new and mid-priced car, which it plans to begin selling in 2018. It needed the funding to manufacture this new model. The company has become quite well known and was aware that hundreds of thousands of people are interested in purchasing this car when it is ready for sale. People were invited to make a $1,000 deposit to ensure they are in line to buy the car. Over 300,000 people have acted on this offer, which has provided hundreds of millions in capital to Tesla to cover upfront manufacturing costs. Tesla pays no interest and gives away no stock for this capital. The requirements here were a trusted entrepreneur, Elon Musk, a respected company, Tesla, and a glamorous product.
Crowdfunding has also become a way to get startup capital. This money is essentially gifted to a company and usually provided by people who want to support the social mission and benefits to humanity represented by the success of the recipient company.
Choosing the best way to obtain needed cash is an important decision for every company. The things to consider are:
- Stage of the company operations—start-up, early development, mature operation
- Collateral available
- Proof of concept—revenues generated versus new idea
- Willingness of owners to part with ownership to grow
- Current debt to equity structure of the company
Interested in Learning More About Debt and Equity Capital?
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