What to consider when bringing on outside capital to fund a business

Companies typically need to look for outside funding to fuel the growth of their business. In these situations, they could turn to equity, debt or working capital facilities to expand products or services, enter new markets, repair or replace facilities, add equipment or acquire another business.

However, which type of funding to get, and when, can be a tricky question. For Wesley Gillespie, regional president, Northeast Ohio, at ERIEBANK, answering that question in a way that benefits the business is a matter of perspective.

“When businesses take a more expedient approach to solving their funding issues, it can be problematic,” says Gillespie. “What works to solve only today’s problem misses the bigger picture and can put the company in a tough situation later on.”

Smart Business spoke with Gillespie about what to consider when bringing on outside capital to fund a business. 

What issues tend to affect how businesses decide on the method of funding? 

Most often, companies are choosing between getting a loan or a working capital facility to fund some type of growth initiative. A term loan is the better choice of debt when a company is making long-term investments with a long-term payback, such as expanding a plant or adding capital equipment. Banks typically require collateral with a useful life to match the term of the debt. A plant expansion or equipment improvements should generate a return throughout their productive life, and through or beyond the term of the loan. 

Lines of credit fund short-term debts, providing working capital to cover, for instance, any gaps that might exist between payables and receivables. With a working line of credit, banks look for conversion of that asset to cash in 60 to 90 days.

Equity is typically used for riskier gambits, such as entering new markets or acquiring companies to accelerate growth or diversify. These investments might not have an immediate return, making them the higher risk, and a more expensive option.

What flaws tend to exist with how companies approach the question of funding?

Companies don’t always consider the timing of the funding — whether it’s the best time for equity or debt, which has to do with the cost of each. A good time to take on debt is when interest rates are low. A good time to take on equity is when a company’s valuation is high. A company’s life cycle stage should also be considered. Earlier-stage companies that aren’t yet revenue-positive more often use equity to grow, while revenue-stage companies tend to fund through debt.

Companies can also outgrow capital, which creates risk. Companies that don’t have enough capital might not be able to service their customers. Conversely, companies that carry too much debt too early can stifle both their ability to service debt and, in an equity situation, could have too little equity available for new investors to show interest. 

It’s best that business owners and executives step back and consider the bigger picture when making a funding decision. Get a diversity of opinions on matters of funding from a team of advisers consisting of a commercial banker, an attorney and a CPA firm. Such a team can provide an objective look at the whole picture and help make the best funding decision for the business. 

How does timing play into the funding decision? 

It’s important to consider the mix of debt and equity at the moment a funding decision is being considered. If the company is stable and profitable, it could be prudent to take on more debt, potentially buy out some investors to buy back a greater percentage of ownership and secure more profits. 

Companies that have high debt compared to earnings, and are either seeing their profitability suffer or are having trouble covering interest payments as a result might look to diversify and bring equity into the company to get their debt retired. 

There are many ways to acquire capital to fund a business, especially in this environment, which still has favorable interest rates and investors with capital that are looking to put it to work. Ultimately, making the best funding choice is about regularly assessing the funding mix on the balance sheet, asking questions about what’s best for the business and considering the bigger picture.

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