Business leaders struggling to decide between raising debt vs. equity as the best path to growing their business need to stop and think about what they will do with the money once they get it — and what the actual need is. Is it a true working capital need?
Or something else?
Your hard-earned capital will almost always be spent in one of two buckets — working capital and everything else. Depending on your business model, however, you may find that your needs require a mix of both.
“People sometimes think that the greatest thing in the world is to go out and raise equity and take the money in,” says Roger N. Klarmann, senior vice president for Technology Banking & Capital Finance at Bridge Bank. “But that comes with a lot of pitfalls because you give away a piece of your company.”
Taking on debt allows you to retain control of your business, but it may not be enough to cover the resources you need to get your business to where you want it to be. And this factor many times necessitates raising equity. Used together, debt and equity can be a powerful tool to foster incredible growth.
“If you need to build a sales force, a work infrastructure, technology enhancements, and the like, that’s not a working capital problem,” Klarmann says. “That’s an equity problem.”
Smart Business spoke with Klarmann about how to make the right call for your growing business.
What are some common mistakes leaders make trying to grow their business?
When you go out to raise money, you’re going to be based against your performance. If the painted picture is too rosy and you don’t hit your projections, there are repercussions for not hitting those targets. A reasonably modest growth forecast is better than one that is too hard to reach.
Another common mistake is taking equity at all. There’s no sense giving away part of your company if you don’t need it. If you can get away with debt financing and that can get you to where you want to go, it’s a better way to go.
What is an example that illustrates the advantage of debt over equity?
Let’s say you’re in the digital media business and you do ad campaigns for some of the more notable brands and/or advertising agencies. At the end of the month, you bill your customer $100,000 for services performed in that month. The customer responds that you will be paid in 75 days.
So you spent all that money during the month on payroll, on vendors, etc. — and now you have to wait 75 days to get paid. You have a massive working capital need. Raised equity should not be used for this working capital dilemma. If you have that cash, it should be left on the side and used only for non-working capital issues.
What a bank can do is put together an accounts receivable facility where it will give you $80,000 of the $100,000 the day after you bill the customer. You can take that $80,000 and go on to the next project.
If you go the equity route, you might find a partner who can provide you with $1 million in cash. But they might take 30 percent of your company in return. If you follow the debt plan, you’re not giving away any part of your company and you’re getting all the money you need to complete the next month’s work, and some of your profit as well (in the above example).
What is some advice for a business owner who wants to raise equity and/or debt?
The critical factor here is to find people who know your business, can add value to your business, and are people who you feel you can work with.
Sometimes the ‘cheapest’ looking cost of capital can be the most expensive to take. You will hit bumps in the road for sure, and when bumps are hit what will your capital partners do and how will they react?
It’s always smart to ask for references. If it’s a bank, ask for companies where bumps were hit. Call those people and find out how those issues were handled, and in what fashion. Do the same with equity folks.
Don’t be afraid to ask questions or look for details on how the potential partner can help out your company. Make certain that your potential equity investor and banker know your space, and have history in it. That helps tremendously as they need to know your business and how it works. ●
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