Business Funding Options: Equity Financing

Hello and welcome to FYI.

This week, we bring you the fourth installment of a five-part series on business finance. It’s about equity financing as an external source of funding and continues from previous posts on bootstrapping and debt finance.

So what is equity financing?

Simply put, equity is a stake in a business; a claim to both profits and losses. Equity financing therefore translates to raising money by trading a slice of the business in exchange for financial investment. These investors agree to a permanent partnership that can only be liquidated by the sale of their stake to the original owners or other new investors. As such, equity funds are not repayable and do not attract interest payments.

What are the sources of equity financing?

During the start-up process, family and friends in some instances would want a share of ownership as opposed to granting a loan. The fund received under these terms is classified as equity finance because they inevitably become shareholders in the business. It is important to note though, that once again the absence of drawn agreements and shareholding structure has led to lots of problems with equity investments from family, especially during future refinancing stages of the business.

The second source of equity financing is Angel Investors. These are usually business-savvy, wealthy individuals who bring networking opportunities in addition to interest-free leverage in exchange for a part of the business. They are the most sought-after type of investors and can come in during the early stages of the business life cycle. They not only share risk but also increase the probability of success through their personal experiences and relationships. They are however difficult to find and demand considerably higher stakes than family and friends.

A third source of equity financing is Venture Capitalists. These are the big-money investors that fund high-growth businesses in a bid to sell off or go public. They also bring networking opportunities, interest-free leverage, and a wealth of industry knowledge in exchange for a part of the business. They base their decisions on the competitiveness of the management team and sometimes insist on installing theirs. They also usually require an exit strategy that is achievable in not more than 5 years.

Another source of equity finance is Government Grants. These are highly competitive funds that are sponsored by Federal or State Governments in exchange for small stakes in the business. They usually carry single obligor limits and are directed towards growing small and medium enterprises in strategic sectors of the economy. A typical example of an equity grant is the type available to entrepreneurs under the YOUWIN program in Nigeria.

For businesses that become highly successful brands with established profitability, stable management, and growing public demand for goods and services, Initial Public Offerings (IPOs) provide further equity financing opportunities. These are however guided by Government regulations and are in most cases very expensive. It is also an important part of the exit strategy for other private equity financiers such as Venture Capitalists and Angel Investors.

And how do you decide on equity financing or the source to pick?

Any decision on equity finance must be based on the understanding that while traded equity provides leverage that doesn’t carry the weight of interests nor needs to be repaid, it slows down the decision-making process, and reduces your control of the business and share of profits in the long run. It is for this reason that equity finance is considered by some to be more expensive than debt in the long run. However, entrepreneurs in fast-growth industries, where economies of scale are crucial, understand that total ownership of a small business will not compare to a smaller slice of a larger one. For example, a 100% stake of N1million compared to a 25% stake of N100million.

For investors, the high risk of incurring losses means investments will only be tempting if the possibility of high returns exists. Businesses seeking equity finance must therefore prepare comprehensive business plans that show rapid profitability and feasible exit strategies. These strategies can range from buyouts from existing shareholders of the company to mergers and acquisitions that target other businesses, IPOs that target the general public, and even liquidation. Venture capitalists and Angel Investors particularly pay close attention to this aspect of the business.

If you haven’t considered these exit scenarios and the other funding options discussed are not favorable for your business, we still have one last part of the series to go. So just follow our social media page(s) and get notified.

In what other ways have you used equity to finance your business so far?

Editor’s Note: A version of this article first appeared in The Business Hub on 13th August 2014.

Business Funding Options: Debt Financing

Hello and welcome to FYI.

This week, we bring you the third installment of a five-part series on business finance. It’s about debt financing as an external source of funding and continues from our last post on bootstrapping.

So what is debt financing?

Simply put, it means the injection of borrowed money into a business with the promise of paying back at a predetermined future date. Depending on the source of debt, the repayment may also include an agreed interest component and the pledge of collateral for the duration of the loan. However, once repayment is completed, the business has no further commitment to the lender, and the collateral pledged must be returned.

And what are these sources?

For small businesses in the start-up phase, the major external source of finance is family and friends. While being a one-time source, it is the cheapest form of leverage and usually requires no collateral and minimum agreements if any. And because of the personal relationship with the funding source, the appraisal is not always based on a convincing business plan or market realities. Rather, it is an investment in the business owner. It is important to note though, that the absence of drawn agreements and a defined repayment plan has resulted in lots of problems with family loans, especially during future refinancing stages of the business.

The second and most popular source of debt finance is a bank loan. For starters, banks are sustained by the income they make from the money they lend. They therefore require proof of capacity to repay the principal and in most cases, an interest component. They may also require the pledge of collateral as a second way out and are likely to base lending decisions on the proven character and integrity of the principal officers. As such, business history or realistic and provable financial projections are necessary. It is for these reasons that bank loans are very difficult to obtain during the start-up phase but get progressively easier as the business grows. But that’s not a bad thing. These demands serve to make businesses better by exposing details of feasibility, profitability, and most importantly, cash flow; which ultimately determines if the business will succeed or not.

Another source of debt finance is private companies. These are usually unofficial, short-term and high-interest lenders that provide quick access to funds and do not demand some of the conditions provided by banks. They however require personal guarantees and are based on referrals from trusted existing or former customers.

So how do you decide on debt financing or the source to pick?

Any decision on debt finance must be based on what is to be financed, cash flow realities, interest rates offered, and the availability of collateral. Loans from family and friends are usually finite and one-off. As such, they finance the early stages. They also allow extra cash to run the business by eliminating interest payments and the need for collateral.

Bank loans on the other hand are dependent on an appraisal of cash flow, prevailing interest rates, and collateral. Cash flow depends on terms of payments between you, your supplies, and buyers. The most favorable terms of payment should allow you to get supplies and pay later while also collecting money from your buyers in advance; the least, being a situation where you pay suppliers in advance and sell on credit. These situations will determine your capacity to make timely loan repayments and will affect the bank’s decision to lend. Even if these are satisfactory, an understanding of the part of the business to be financed is critical to the successful repayment of loans.

Care must be taken to understand the difference between financing for fixed assets/costs and variable ones. For example, a loan to construct a warehouse, or factory or purchase furniture will not be the same as one to run daily activities such as shortfalls in fuelling costs, or raw materials. While the former will finance a process during which the business does not generate any extra money, the latter can start being recouped from daily operations. The basic rule of thumb is to finance fixed costs with long-term loans that allow moratoriums where possible, and finance variable costs with lines of credit. However other types of loans may even provide extra flexibility.

Okay, Okay! What is a moratorium? A moratorium is a period when loan repayments are suspended to allow for the construction or installation of an asset to be completed. In some cases, moratoriums are granted on principal only. For example, a loan of one million naira may still have a one million naira principal component after 6 months while interest on the one million is charged each month. In other cases, both principal and interest are capitalized for the period of the moratorium. In this case, a loan of one million naira will, based on a six-month moratorium, start charging repayments on a principal component of say one million and one hundred thousand naira (principal of one million plus six-month interest of one hundred thousand naira) in the seventh month.

A line of credit (e.g. an overdraft) is an amount that can be drawn on an account when it is unfunded but attracts interest on only the specific amount used. For example, if a business with a million naira line of credit uses two hundred thousand in March, repays, and then uses one hundred thousand in April, interest will only be charged on two hundred thousand in March and on one hundred thousand in April. Moratoriums and lines of credit allow for reduced burdens on repayment obligations while freeing cash to run the business, but an understanding of your cash flow and terms of payment is critical to the source of debt financing you choose.

Fundamentally, debt allows you to retain full ownership of the business and schedule expenses based on a defined repayment plan, with the added benefit that the lender’s claim expires once the loan is fully repaid. The key is however to remember that it has to be repaid, with interest, which may erode cash flow, and the ability to grow and result in the loss of assets pledged as collateral. But don’t fret! Even if these aren’t favorable to your business, other funding options exist and will be discussed in the next two posts. So just follow our social media page(s) and get notified.

Care to share how you have used debt to fund your business so far?

Editor’s Note: A version of this article first appeared in The Business Hub on 6th August 2014.