Cash is the lifeblood of any business. Whether it’s a start-up company or one that has been in operation for years, cash is needed to meet daily operating expenses. Without it, employees can’t be hired, inventory and equipment can’t be purchased, and utilities, rent, taxes and insurance won’t get paid.
An entrepreneur’s dream or idea can’t be fulfilled without some sort of cash infusion into the business. For a start-up company, it usually starts with some investment from the stakeholders and can also include friends’ or family members’ money. As the business grows, ownership will need to turn to a third party for additional financing. This can take the form of debt or equity financing. Each option has its own advantages and disadvantages that must be considered while assessing the cash needs of the business for both their short and long-term goals.
For pre-revenue start-up companies, securing financing can be difficult because they don’t have the operating history lenders like to see and can be compounded if the stakeholders have a poor credit history. Having a good idea or business plan is not enough. Lenders want to see evidence of positive cash flow and business or personal assets to secure their loan. Even established companies must qualify after detailed due diligence on the company and their stakeholders. This due diligence will include credit reports on the company and stakeholders, UCC searches for secured lenders, evidence of tax payments, confirmation of business asset values, and a review of financial and projected operating results. The bank will want some level of comfort that the company can service its debt and that the loan will be repaid in full.
If the company doesn’t qualify for a traditional bank loan or SBA (US Small Business Administration) financing, alternative sources may be available. If management secured a purchase order (P.O.) from a customer, a P.O. lender can assist in the purchase of the inventory needed to complete the order. Additionally, trade receivables can be leveraged for working capital through a factor or asset-based lender. These sources can be used to bridge the cash needs of the company until they qualify for traditional bank financing. In any case, it’s best to use your judgment and use the financing available, rather than miss out on a new business opportunity and lose a potential or existing customer.
One of the biggest advantages of debt financing is that the stakeholders do not give up any ownership/equity in the company or any control in how the company is managed. The disadvantage is that the lender expects to be repaid with interest. Adding a debt payment to the company’s expenses assumes that the operating cash flow can service its debt. Management must prove the ability to manage the inflow and outflow of cash on a daily basis.
Equity financing comes from outside investors. These investors are typically venture capital or angel investors. They perform their due diligence with a team of lawyers, accountants, and investment advisors who take considerable time and money before committing. These investors are looking for niche businesses to place their money and they expect to see a return on their investment(s).
The advantage of equity financing is that there is no expectation to be repaid. The equity investors become part owners of the company because it’s their money at risk – just like the stakeholders – if the company should fail. They bring their management skills and connections to take the company to the next level. Additional financing is likely available to support the company as it grows. The disadvantage is that they have an ownership interest in the company that dilutes the stakeholders’ interest. They will also want to protect their investment by exerting some control on the management of the company and their decision-making process.
Additional Forms of Financing
There are other forms of financing that provide the benefits of both debt and equity financing. Subordinated debt from a third party can provide cash with no-payment or interest-only terms. Mezzanine financing may be available through a bank or third party. It will likely be at a higher interest rate, but will have the flexibility to convert to equity in the future. Terms that do not require the debt to be serviced over the short-term might offer some flexibility as well.
In conclusion, management should review the advantages and disadvantages of each source of financing when considering the short and long-term strategy for the company’s growth. It could be that a combination of each can best fit the financing needs of the business. Too much debt to be serviced can choke a business’s cash flow at a time it needs to grow and when there is a downturn in operations. Traditional banks take leverage into consideration when making loan decisions and often implement covenants as triggers on a loan’s creditworthiness. Management should also rely on its trusted advisors when making a final decision. These decisions should be considered months in advance before the need to assure that funds will be available when needed to take advantage of opportunities when they arise.