Equity and debt capital: The 2 basic sources of capital for your business

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By Will Lucas, senior associate, Azalea Capital 

A common challenge many business owners and entrepreneurs face is raising capital to support an expanding enterprise or selling a portion of their ownership interest to diversify their net worth. This process can be frustrating and time-consuming as entrepreneurs are more familiar with operating their businesses than with raising capital. Armed with the right knowledge and support, however, this process can be a win-win for the business owner and his prospective financial partner.

Know your options

Several key factors should guide your fundraising process. Company size, stage, and sector are starting points for determining what form of outside capital is appropriate. For example, most startups will pursue capital from friends, family, and angel groups. Certain new businesses may qualify for a microloan program. Businesses with a track record of financial performance will generally have access to more options and cheaper sources of capital, which come in two basic forms: equity and debt capital. Each source of capital has unique characteristics that offer certain advantages and disadvantages depending on your ultimate objectives.

Debt financing 

Debt financing can provide a low cost of capital depending on the interest rate and repayment terms, while interest expense is typically deductible for tax purposes. But debt also comes with restrictions in terms of financial covenants, liens on company assets, and often a personal guarantee from the owner.

Equity capital 

Equity capital is a higher, all-in cost of funds that may provide value-added intangibles, such as more patience, flexibility, and long-term value to owners. By selling company stock, owners trade a degree of control for cash, outside expertise, and relationships that may positively impact a business far beyond what a loan may provide.

While valuation and terms certainly matter, selecting the right partner with the right chemistry is imperative. Unlike debt, equity does not come with personal guarantees and debt repayment. Instead, investors will often require a seat at the table for strategic decisions such as capital investment, major hires, budgeting, and acquisitions. Investors will perform “due diligence” or verification of the facts about a business, which owners should do as well on potential investors. Understanding and being comfortable with the character, style, and reputation of the firm should guide your decision when choosing an equity partner.

Many business owners think bringing on an equity partner essentially means selling their business. While selling 100 percent of your business is always an option, a partial sale (often called a recapitalization) can be a way for owners to achieve three objectives. First, you inject additional liquidity into your business. Second, you diversify your net worth while retaining a meaningful ownership stake in the company alongside an experienced investor and hopefully value-adding equity partner. This retained ownership stake has the potential to significantly increase in value as the company grows. Third, you can remain actively involved in operating your business and preserve the legacy of the company you’ve built.

Set clear goals 

When seeking capital, it is important to have clear objectives that align with the amount and type of capital you are seeking. Are you raising an appropriate amount of capital relative to your growth, succession, or estate plans? Raising too much or too little capital could negatively affect the long-term prospects of your business and its future value.

Oftentimes, business owners want to raise as much capital as possible because it will provide abundant resources and perhaps increase the likelihood of future success. This instinct is understandable, but the unintended consequences must be considered. Excess debt capital can mean high debt service or restrictions, while too much equity may overly dilute your ownership interest in the business. An excessive inflow of either type can lead to poor capital allocation decisions, such as hiring too quickly and spending too liberally. Raising an appropriate amount of capital brings a healthy discipline to the business, just like living on a budget does for many households.

Summary

There are several options for owners looking to raise capital in their businesses. As each option has advantages and disadvantages, choosing the right path is critically important for the future success of the business and your personal aspirations. Seeking input and counsel from your circle of advisors (your attorney or accountant, for example) is a good first step to help identify your objectives and options. After a careful assessment of your goals, reaching out to banks or equity investors for feedback can also provide helpful insights and begin the process of identifying the right financial partner.

Will Lucas is a senior associate at Azalea Capital. His responsibilities include identifying and evaluating investment opportunities, supporting transaction due diligence, and working with management teams to implement growth strategies.

 

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