Financing: Equity or Debt?By Fernando Padilla | Wed, 07/13/2022 - 13:00
There are two ways to raise capital for a company (besides the money injected by each of the owners). The first is through debt, which means "borrowing" from someone else, mainly financial institutions, or through equity, which basically means selling part of the company to a third party, which can even be friends and family. The second option is through an investment fund or crowdfunding that invests in the company, injecting resources in exchange for a shareholding in the company.
To understand these first two options, it is necessary to know the main differences between equity and debt, and when I talk about equity, it is more than just the money that each entrepreneur puts into the company, since the money in the company's portfolio always runs out, is more expensive and is always more complicated.
Sooner or later, there comes a time when a company must raise money from someone else to be able to maintain the pace of growth, plan an investment, face a moment of crisis, plan an acquisition, or anything else that may be needed. All companies constantly need to be funded in one way or another, in addition to revenue.
The money raised from investors is recorded in the balance sheet as shareholders' equity. This way, the investors, whether institutional, a fund, or personal, get a percentage of your company for their money. With that money that enters the company, they assume the risk of the company that will seek to gain through the profits generated at the end of each year or through the growth reflected in the valuation of the company; by increasing their investment they increase its value and, in a few years, after its sale, they will be able to obtain a profit.
Those are the two reasons for people to invest in equity. This type of investment carries more risk because it goes hand in hand with the risk that the founders or current partners of the company have (it may succeed or fail) and, for that reason, equity financing is always much more expensive than debt financing: by taking higher risk, investors expect higher returns (an institutional fund will look for returns in the range of 40x to 400x, or higher, while a family member or friend, will look for minimum returns above 20x). Investing this money often means obtaining higher returns, even if they don't charge you an interest rate. Given the higher risk, more often than not, they may be willing to participate in the decision-making process of the company, either by occupying an operational position or a seat on the board of directors.
You can raise capital through family and friends, private equity funds or venture capital, entrepreneur capital, seed capital, or equity crowdfunding platforms. Larger companies can go to the stock market to raise capital, but for most companies, the first sources of capital are those I have mentioned above.
When selling shares/equity of the company, it always becomes strategic, or at least it should become strategic: who do you want to have as a partner in your company? And that means that in your capital raising strategies you need to be very careful about who you want to partner with because you may be "marrying" for a long time, so your choice should become 100 percent strategic. Raising capital through equity, besides being strategic, always has to be thought about in the long term, that is to say, longer than five years. This means that the use of the money that comes in as capital has to be projected for the next five to 10 years of the company, not for the short term.
You need to understand that capital raising does not tend to be a fast process. It is slow because it requires a lot of research, a lot of analysis and you also have to be willing to knock on many doors. It is not easy to find someone who will invest at the first try; therefore, you have to be willing to knock on doors until you find someone who will invest in your company. There are always options and more and more are emerging every day.
When it comes to debt financing, there are many more options in the market, no matter what country you are in, and since there are many more options, it is relatively easier than equity financing. Credit or debt always involves an obligation in which you commit to repay the loan at the designated interest rate, which is the cost of the money.
Usually, debt financing for your company should be planned for slightly shorter periods, unlike equity financing. This means periods of less than five years (except for mortgage loans), and in those periods, no matter where you are financing from, the cost of debt financing is almost always much cheaper than equity financing because the process of granting a loan involves less risk than equity, therefore the cost of debt will always be cheaper.
So, when you include debt in your financing strategies, you generate a contract in which you are obligated to repay the loan but it does not mean "marrying" the lender; if you want to end the relationship you simply repay; when selling equity, you are partnering with an investor and ending a partnership with someone is complicated and usually requires a lot of negotiation.
Debt can be obtained mainly from financial institutions, banks, and non-bank financial institutions. In Mexico, the main players in the non-bank financial system are the SOFOMES (Sociedades Financieras de Objeto Múltiple) and crowdfunding, family and friends. Another popular financing method used by companies is asking for financing from their suppliers to give them a few days to pay, among other options, although these are the most widespread.
Now, which is the financial product of debt that suits you? Not all financial products and not all loans are the same; each one has its own characteristics and each one is used for different things. The first way to define which suits you best is by the intended use of the money. For example, for money needs of less than one year, that is called a short-term debt, and it is money that you plan to use quickly and pay in less than a year since the use that you will give it is also for a short-term need. The ideal products for the short term are as follows.
The first and most used is vendor financing, which involves negotiating with your supplier that you will pay, let's say in 30, 60, or 120 days. Sometimes it is possible, sometimes not, and this is a type of financing that is negotiated during the purchase of the goods needed for your business. This is the most used and it rarely has a direct financial cost (interest rate), although you may be sure that it is implicit in the sale price that they are giving you.
Revolving Credit Facility or Overdraft Facility
From the point of view of financial institutions, there are two ideal products for the short term. The first is a Revolving Credit Facility, which is like a credit card where you have an authorized credit line with the financial institution and you can use it and repay it as you go along. This is very convenient because you don't need to pay interest for the whole period, you are not committing yourself to a specific period; if you take it out one day and you pay it the next day, you pay one day of interest. It is meant to be used for short-term purposes; for example, to finance an unexpected expense due to your sales cycle, a late payment from a client, or because of poor cash flow planning. The idea of revolving credit is that your business does not stop because of cash flow. This type of credit must be handled very carefully, so you must not think that it is income; think of it as a buffer between sales and collection. You do not want to cover your losses or constant negative cash flow with credit. That requires another strategy. But be careful when using credit cards to finance a business. This type of financing is the most expensive there is. Credit cards serve mainly as a tool for managing expenses and at most to finance expenses up to 30 days, but not for anything else.
This is also a product that you will find in financial institutions, mainly in non-bank financial institutions, and consists of selling your invoices to a third party, called a factor. They can then collect payment from your customer when the agreed due date of the invoice arrives, which can be 30, 60 or 120 days. This helps you to increase the cash flow of your business while at the same time financing your customer.
Medium- and Long-Term Debt
When the intended use of money is for something that will have a medium- or long-term impact on your company, that is, more than one year; for instance, a loan to open a new branch, buying equipment or assets, to develop a marketing strategy, office renovation, investing in a project, and so forth. What you need is something that will impact your company for more than a year. The two main products you can use are simple credit and leasing.
Simple Loan or Credit
A simple loan is usually requested at a financial institution, either a bank or a non-bank. If you qualify, you will usually sign a contract and you will get the amount of money you requested, so you can use it for whatever you want. You will have to repay the loan monthly, along with the interest generated (amortization) until the defined term ends. Almost always this type of financing can be prepaid whenever you want (always check this in the conditions of your credit).
Simple credit is the most common financial product and you can find it in many forms, secured or unsecured, digital (fintech) or traditional (in person), mortgage, tooling, and from banks, SOFOMES, fintech, crowdfunding, Sofipos (other types of institutions or family and friends). It is the product that most players offer, so you should take your time to find and compare the best options, without forgetting that the most important thing is not the rate but who is willing to lend to you.
Leasing is the ideal product for when you need to buy equipment or machinery, such as cars, trucks, machines, computers or furniture. Leasing is a product created specifically for that purpose and not only helps you to finance yourself but also has fiscal advantages that help in the deductibility and payment of taxes. It is the ideal product to keep your assets up to date and for your company to always stay competitive, without the need for you to invest significant amounts of money, since you can keep your assets up to date, without the need to buy them, simply by leasing them.
The key when you are looking to finance is to compare. Whenever you are looking for financing, always look at at least three options (bank, non-bank financial institution, fintech) so you can really compare the different proposals being offered to you.
I hope these tips help you to better understand how to finance or how to capitalize your company to face the challenges that will come but above all, to help you decide how you can help your company grow in a better way. If you want me to discuss any specific topic, write to me on my blog or on any of my social networks. You can find me at capitalez.net.