ENTREPRENEUR RESOURCE CENTER
Capital Management (Debt vs. Equity)
Working capital is the money you will need to keep your business going
until you can cover your operating costs out of revenue. As a small business owner, it will be wise to have enough working
capital on hand to cover items such as the following during the first few months that you are in business:
|Replacing inventory and raw materials: you will need to
fund the purchase of inventory out of working capital until you start to see cash from sales, which could take months.|
|Paying employees: even the most loyal worker wants to get paid on
time, regardless of how much or how little cash your firm earns during its first months.|
|Paying yourself: unless you have made other arrangements, you will
need to withdraw some money to support yourself.|
|Debt payments: if you have borrowed money to get started, you probably
have to begin repaying it right away. Missing your first loan payments will not do your credit rating any good.|
|An emergency fund: you need some cash on hand to cover unforeseen
shortfalls that may result from any number of factors such as delays in getting your space ready, a slow paying client, or
The five most common sources of short-term working capital financing
|Equity: If your business is in its first year of operation
and has not yet become profitable, then you might have to rely on equity funds for short-term working capital needs. These
funds might be injected from your own personal resources or from a family member, friend or third-party investor. |
|Trade Creditors: If you have a particularly good relationship established
with your trade creditors, you might be able to solicit their help in providing short-term working capital. If you have paid
on time in the past, a trade creditor may be willing to extend terms to enable you to meet a big order. For instance, if you
receive a big order that you can fulfill, ship out and collect in 60 days, you could obtain 60-day terms from your supplier
if 30-day terms are normally given. The trade creditor will want proof of the order and may want to file a lien on it as security,
but if it enables you to proceed, that should not be a problem.|
|Factoring: Factoring is another resource for short-term working capital
financing. Once you have filled an order, a factoring company buys your account receivable and then handles the collection.
This type of financing is more expensive than conventional bank financing but is often used by new businesses.|
|Line of credit: Lines of credit are not often given by banks to new
businesses. However, if your new business is well-capitalized by equity and you have good collateral, your business might
qualify for one. A line of credit allows you to borrow funds for short-term needs when they arise. The funds are repaid once
you collect the accounts receivable that resulted from the short-term sales peak. Lines of credit typically are made for one
year at a time and are expected to be paid off for 30 to 60 consecutive days sometime during the year to ensure that the funds
are used for short-term needs only.|
|Short-term loan: While your new business may not qualify for a line
of credit from a bank, you might have success in obtaining a one-time short-term loan (less than a year) to finance your temporary
working capital needs. If you have established a good banking relationship with a banker, he or she might be willing to provide
a short-term note for one order or for a seasonal inventory and/or accounts receivable buildup.|
The two most common sources for long-term working capital financing
|Bonds: These debt securities are promises made by the
issuing company to pay the principal when due and to make timely interest payments on the unpaid balance.|
|Long-term loan: Commercial banks make loans to borrowers who can repay
the principal with interest, and they will often require collateral for upwards of 85 - 90 percent of the loan value. You
will need to demonstrate a track record of sales revenues to justify your ability to make periodic installments. Unfortunately,
as a small business or start up, your fledgling business idea probably doesn't have either the sufficient assets or customer
base to warrant serious consideration for a bank loan.|
Debt vs Equity Assessments
It is essential that you assess the relative merits of each form of
funding for your specific business.
|Take on Creditors
||Take on Partners |
|Low Expected Return
||High Expected Return |
|Smaller Funding Amounts
||Larger Funding Amount |
||No Short-Term Payments|
||Open-Ended " Exit" Date |
Whoever provides your firm with funding will, to some degree, become
part of your management team. An equity partner will have direct input into decision making while a lender does not have this
Equity partners will likely expect your venture to generate after-tax
annual profits of 35 to 45 percent on the equity they invested. Creditors are only concerned with your ability to generate
pre-tax cash flow to cover periodic interest expenses on the debt.
Equity partners can provide your firm with more up-front capital to
allow you to fund all the projects necessary to achieve your growth objective. What a lender can fund is based solely on your
ability to make loan installments, and that will likely be quite small early on in the life of your business.
Equity does not get "paid back" each month or each quarter--it represents
partners in the firm. But lenders will expect loan repayment to begin the month after you close escrow on the loan.
Equity partners have no guarantees on when they may get their funds
plus a (hefty) return out of your business. It could be after an acquisition, a subsequent round of funding or the IPO. Creditors,
however, are removed from the balance sheet at a set date upon the final payment on the loan.
Both funding types can require contractual terms that limit your use
of funds and the types of policies implemented, but lenders often have much more restrictive loan provisions than do equity
ADVANTAGES OF USING DEBT
|DISADVANTAGES OF USING DEBT|
|Debt is not an ownership interest in the business. Creditors generally do not
have voting power.
||Unpaid debt is a liability of the business. If it is not paid then the creditors
can legally claim the assets of the firm. This action can result in liquidation or reorganization.|
|The payment of interest on debt is considered a cost of doing business and is
fully tax deductible.
||Your business must earn at least enough money to cover for the interest expense,
otherwise you may not be able to pay you interest which may lead to default (financial distress). |
|The creditors will only be concerned that the business will be able to generate
cash flow to cover interest expenses.
|ADVANTAGES OF USING EQUITY
||DISADVANTAGES OF USING EQUITY|
|Unlike obligation of debt, your business will not have any contractual obligation
to pay for equity dividend.
||Equity is an ownership of the business. So an equity partner will have a direct
say about your business. |
|Equity financing also allows your business to obtain funds without incurring
debt, or without having to repay a specific amount of money at a particular time.
You must examine each of these trade-offs in detail before deciding
which is best for your firm. Then you can establish a set of funding priorities to guide you in your negotiations with potential
equity or debt funding sources.
Working capital has a direct impact on cash flow in a business. Since
cash flow is the name of the game for all business owners, a good understanding of working capital is imperative to make any
For more information on Debt or Equity Financing, please refer to: