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What Kind Of Capital Is Appropriate For Your Business?
By Dee Power And Brian Hill

There are two kinds of capital: debt and equity. Both kinds are
typically used by a company during its lifetime. Lenders have
different objectives than investors and therefore look at
different factors about a company when deciding whether or not
to invest or make a loan.

Debt
Debt is money borrowed, which must be repaid at a set time
period and generates income for the lender over that time
period. Lending sources include not only banks, but also leasing
companies, factoring companies and even individuals.

Lending sources look primarily at two factors: how risky the
loan is; and whether the company can generate sufficient cash to
pay the interest and repay the principal. The growth potential
of the company is secondary; the primary considerations are the
track record and asset base of the company. Usually the debt
must be secured against the assets of the company and very
commonly must also be secured against the assets of the owner of
the company, also called a personal
guarantee.

Assets of the company are not usually given full book value in
securing a loan. In other words, if your inventory has a book
value of $50,000 (or it cost you $50,000 to produce that
inventory) a lending source will only give you 50% to 75% of
that value. The reason being is that the lending source is not
in your business and would have to quickly liquidate the
inventory, rather than selling it at market prices.

Accounts receivable, or money that is owed to you from
customers who have previously purchased your product but not
paid for it yet, are also discounted. Using the same example,
$50,000 worth of accounts receivable may only be worth 60% to
70% of that value to the lending source. Customers may not pay
the full amount owed, or feel they have to pay for the product
at all, if an outside lending source is demanding payment. And
so on…with equipment, land, buildings, furniture, fixtures and
what ever other assets the company has, the same general rule
applies.

The lender often requests that the personal assets of the owner
of the company are pledged as a contingency and as a gesture of
faith by the owner. Obviously, if the owner of the company does
not believe in his/her own company's ability to repay the loan,
why should the lending source?

Equity
Equity capital is money given for a share of ownership of the
company. Equity can be provided by individual investors,
sometimes known as "angels", venture capital companies, joint
venture partners, and the sweat equity and capital contribution
of the founders of the company. Equity providers are more
interested in the growth potential of the company. Their
objective is to invest an amount now and reap the rewards of a 5
to 1, or even 10 to 1, payoff in three to five years. In other
words $100,000 now will be worth $1,000,000 in three years if
invested in the right company.

Since the objectives of investors are different from lenders,
the factors they evaluate in determining whether to invest are
different from lending sources. Investors like to put money in
companies that have the potential for rapid growth. Growth
potential is based on the quality of management of the company,
product brand strength, barriers of entry to competitors and
size of the market for the product.

So Debt Or Equity Capital?
The answer is dependent on the answers to several questions:
Why does the company require additional capital? What stage is
the company at? What is the financial condition of the company?
How much capital is required? What constraints will the
financing source put on the day-to-day operations of the
company? And finally, what impact will the financing source have
on the ownership of the company?

Why Does The Company Require Additional Capital?
The reasons funds are required, or how they will be put to use,
may lend themselves more to debt than to equity or vice versa.
Debt is often a source of funds for the day-to-day operations of
the company or to refinance a current loan. Expansion capital
can be debt or equity. Start up funds most often come from
equity sources. A turnaround situation, refinancing a delinquent
loan, covering a deficit in revenues, could be either, but in
these cases the financing will come with a high price.

What Stage Is The Company At?
Companies grow through several different stages: seed,
start-up, first stage, and second stage. The stage of the
company can be an indicator of the risk involved. While neither
debt nor equity would be prohibited at any stage, the older and
more established the company is, usually the less risky it is.

Seed Stage--the idea for a product or company is in the mind of
the founder, but there is still substantial research and
development necessary to determine whether the idea is viable.

Start-up--the company has a business plan, a defined product,
and basic structure, but little or no revenues are being
generated. The product may still be just a prototype.

First Stage--the product is either ready for market, or is
generating some revenues. The structure of the company is in
place.

Second Stage--full scale production. The company's product has
been selling and accepted by the marketplace. The company is
ready for a major national introduction of the product or
introduction of a second product.

Established--the company has been operating successfully for at
least three years.

Turnaround-- the company has been operating for a number of
years but is underperforming. A hard turnaround refers to a
company that is not only underperforming, but has been in a cash
deficit position with little hope of returning to a positive
position without major restructuring.

What Is The Financial Condition Of The Company?
In certain situations the company's financial condition will
suggest one kind of capital over the other. If the company needs
all its cash to fund its growth, then a loan is not feasible,
because the company could not afford interest and principal
payments. If the company just needs a line of credit to fund a
cyclical increase in orders, then it doesn't make sense to bring
in an equity investor.

A lender looks at the asset base to secure a loan, and the cash
that has been generated to pay the interest. They also look at
what other debt or liabilities the company has and very often
the debts and liabilities of the owner(s). The old adage that
it's easiest to get a loan when you don't need one is close to
the truth. A strong balance sheet, top heavy on cash, and light
on the side of liabilities is easier to finance.

Investors look at how healthy the company is by reviewing
trends in the operating statements and the balance sheet. A
company that has demonstrated a positive trend in the past is
looked upon favorably. However, the future outlook for the
company's product and market is just as important to an investor
as the past performance. A company with a somewhat shaky past in
a currently booming industry is probably preferable to an equity
investor than a great performance in the past in an industry
that's on the downslide.

But what if your company is a start-up and doesn't have much,
if any, history? Then other factors will be reviewed such as:

How much money the owners contributed to the company.

How strong is the management team.

How dedicated to success is the management team.

What other proprietary assets might be available such as
patents, trademarks, goodwill, etc.

What barriers to entry to the marketplace are there?

While both debt and equity come at a price, the company must
generate enough cash to repay the principal of the loan and the
ongoing interest expense. Equity does not have to be repaid
according to a fixed schedule. Equity investors are seeking
long-term returns.

How Much Capital Is Required?
A small amount of capital required for a short time is not
often an attractive situation to either traditional debt or
equity sources. Lenders are not interested in loans that cost
them as much in processing as in the income that can be
generated. Investors feel that the due diligence required to
fund a small amount of capital is nearly the same as that to
fund a much larger amount.

On the other hand a very large amount of capital may only be
obtainable if broken into stages that are funded based on
achieving performance levels. For example: you have an idea for
a diagnostic test that would be a medical breakthrough and
revolutionize the treatment of all disease as we now know it.
But you need $3.5 million to get the product ready to market.
The initial funding may be as little as $50,000 to perform a
literature and patent search to see if anyone else is working on
the same idea and to determine the size of the market demand for
the product. If the search shows that no one else is working on
the idea, and the market is every doctor's office worldwide, the
second stage of $500,000 could be available to acquire lab
equipment, hire lab technicians for six months, and hire
consultants to develop a business and marketing plan. If the lab
technicians develop a prototype test apparatus by the end of the
six months, then $1,000,000 more could be available to develop a
working prototype and patent it. When the working prototype is
patented then $750,000 would be available to obtain FDA approval
and independent tests.

What Constraints Will The Financing Source Put On The
Day-To-Day Operations Of The Company?

You must consider how the financing source may limit the
company's operations. Loan covenants often restrict what the
company can do with excess cash. They can also put limits on how
much the company can spend, and on what type of expenditures, as
well as demanding that the company maintain certain balances in
their accounts, collect their receivable within certain limits,
even determine the credit policies that the company extends to
its customers. The company may not be able to take advantage of
some opportunities because of these restrictions.

Equity investors can demand the same restrictions and in
addition require that they have veto power in certain instances,
or expenditure approval, even if they are in a minority
ownership position.

What Impact Will The Financing Have On The Ownership Position?

The last issue and probably the most important one is, how will
the owners react to having their ownership and management
control diluted. An investor can often contribute experience and
management expertise, as well as money, and has a vested
interest in the success of your company. A lending source has no
impact on the company (other than any loan covenants discussed
above); its primary objective is to be repaid.

So Debt Or Equity? The choice is yours.

About the Author: Brian Hill and Dee Power can be reached
through http://www.capital-connection.com They are the authors
of "Business Plan Basics," "Inside Secrets To Venture Capital,"
"Attracting Capital From Angels," and the novel "Over Time"
Money,Love, and Football, all the important things in life.

Source: http://www.isnare.com

Permanent Link: http://www.isnare.com/?aid=49675&ca=Business

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