Funding Mechanisms For Businesses - Debt Or Equity? The Big Question

If your company needs money to start or to grow, you have two choices. Debt or equity. There is a third one, less known which I call: financing without capital, that I will cover in another article.

In order to finance a company, the general idea is to acquire the necessary money to satisfy the acquired obligations before money is needed. In other words, it is hoped to be able to pay what is needed to acquire or to use (this includes salaries or fees of consultants or workers).

Financing for equity generates a reward to those who place THEIR money in the company and therefore acquire a part of the company. Debt financing implies an obligation of repayment to those who do NOT get the benefit of being owners of the company. Financing without money it is also called guerrilla financing or financing without capital. This refers to the use of resources without paying for them (in other words, it has not counted upon capital neither from equity nor with debt).

Equity and debt are different things but not in opposition to each other. Equity is costly, debt is consistent. Equity requires delegating certain control over the management of the company, debt requires payment security.

While a company gets more solid and has more history, the relation between debt and equity increases, until reaching equilibrium a little less than the amount of capital that comes from debt is getting closer to the amount of property (equity). A healthy relationship between debt and equity depends on many factors, but above all in these two: assets value, when they can be sold and the amount of money that will be generated by those assets.

The company owners must know how to balance between debt and estate. While the company grows, the amount of debt could increase and also the amount of estate, but for different reasons.

Debt increases because the company requires more capital and it can be financing. When a company is subject to financing for debt it is said that it is "bankable". Not having debt is impractical. A healthy debt implies that it can be paid and raise the profitability of the investment in ownership.

Equity increases because the company is generating profits. These profits are distributed among the company owners in the form of dividends or can be accumulated, increasing the equity.
Let's see the other side of the balance: the assets. In its beginning it's unlikely that a company can get a loan unless it has assets that can be liquidated.

A company that has assets with a relatively known liquidation value, as construction, machinery or equipment has more possibilities of getting debt financing, than a company which has assets with an unknown liquidation value, like a patent or a trademark. The value of the assets can be built. For example, every single trademark has been built. When the companies are going to be selling or purchasing, the value of the trademark, the group of established clients or the process can be high. However, this is not considered assets for the case of debt.

As a basic rule, it is always better debt than equity for two reasons: it is cheaper and you keep control over your company.

Remember that in exchange for capital from debt you must give:
o Interests payments.
o Principal repayment (loaned capital).

Use debt when you can prove that you have the means to backup more than double a believable, and short time income in order to pay the interest.

Remember that in exchange for capital from equity you must give:
o Part of the company.
o Future dividends.
o Control over strategic decisions.

Use equity when you can convince an investor to place his money in your company because it is going to be more profitable than any other choice, and because he can make decisions that improve the management of the company.

If you cannot access debt financing, or equity financing, use financing without capital. To finance without capital choose others who might get benefits from your activities and invite them to share or finance your expenses. In that case, your company does NOT use capital but the resources. For example, perform barters, use a rented office, do cross promotion, talk with your suppliers and maybe they could give you days of credit, or expand your term.

I remember one of the entertaining classes with Jeffry Timmons, which referred to your own funds as an essential need to opt for more money. Your own funds, he said, come from the 3F's: Family, friends and fools. And truly the third F refers to the founding members. Remember that if you cannot prove you are taking risks, the chances of capturing the formal interest of an investor is going to be very low.