Is Debt or Equity Financing Better for My Business?

Recently a client sent me a financing contract from a “hard money” lender. This lender was willing to lend my client $150,000 at an interest rate of over 20%. Upon the lender’s granting the loan, the loan principal would jump from $150,000 to $225,000. These loan terms were considered within the “normal” range for this type of high risk loan.

I often field questions from clients regarding business financing. Their needs for funds range from working capital (to sustain the company through a sales slump), to the purchase of key capital assets (to expand operations), to purchases of an owner’s interest (after a key event, such as retirement), to refinancing existing debt at a lower interest rate, to acquiring a competitor. Depending on the company’s stage of operations, existing collateral, timing and a host of other considerations, a company may want to pursue debt or equity financing or continue to “bootstrap” by utilizing funds from existing operations. The following matrix provides an overview of some considerations business owners need to make when determining whether to take on debt or issue equity to bring additional capital into the company:

 

FactorDebtEquity
Traditional LenderHard Money Lender
Credit UnionSmall Community BankBig National BankFriends and FamilyLow-level InvestorsAngel Investors
Does Borrower’s Credit Matter?YesYesYesNo

(made up for in interest rate)

NoNo (will discuss credit in due diligence)No (will discuss credit in due diligence)
Is Collateral Required?YesYesYesYesNoNoNo
Is a Personal Guarantee Required?YesYesYesYesNoNoNo
Range of Time to FundingMed-highMed-highMed-highLowLowLow-medLow-med
Range of Funds Desired by CompanyLow-medLow-medLow-highLow-highLowLow-medMed-high
Range of Control over Company by Lender or InvestorLowLowLowMed-high (after default)LowLow-medLow-high
Rate of Interest/Return RequiredLowLow-medLowHighLowLow-medMed-high
Friendliness and FlexibilityHighHighLowLowHighMed-highMed-high
Other Party’s Negotiating StrengthLow-medLow-medMed-highHighLowMed-highHigh
Other Party’s SophisticationLow-medLow-highMed-highHighLow-medMed-highHigh

As shown in the above matrix, friends and family equity financing is generally the most favorable type of financing if the company seeks a modest amount of funds. This holds true for debt financing from family and friends, who generally will not require (or even discuss) items that are crucial to other financiers, such as credit, collateral or personal guarantees. This option is limited by the caliber and quality of the company’s friends and family pool and the number of times the business owner(s) has tapped into this financing source. This method of funding is also potentially fraught with peril because personal relationships are potentially at risk.

Traditional lenders, especially credit unions and small community banks, tend to be the most user-friendly financing source after friends and family. Some companies and owners may shy away from traditional lenders because they are embarrassed by their low credit scores, think they do not have adequate collateral or are unwilling to provide a personal guarantee. However, most investors will also undertake similar due diligence as a lender and may (unlike a traditional lender) seek to exert a level of control over the company by joining the board of directors or becoming an officer.

Hard money lenders, like traditional lenders, will perform extensive due diligence, but, unlike traditional lenders, will likely take control of a company in the event of a default by exercising the stock pledge it received as collateral. Hard money lenders include the equivalent of business “payday loans” offered by credit card processors, who, rather than structure the lending transaction like a loan instead structure it as a purchase of a portion of the company’s future accounts receivable. This may be an attractive option for a startup company that has very little collateral beyond its accounts receivable and is having difficulty attracting investors or traditional lenders.

In general, the closer distance between a borrower and financing source, the better the lending terms and the working relationship if the company gets into financial troubles during the course of the relationship. This is because a company and owners that are familiar to a potential financing source translates into lower risk for the financier. In a future blog post I will discuss equity financing in more depth because equity financing arrangements, like lending relationships, come in a wide variety, including hybrid arrangements that straddle the divide between debt and equity.

 

This information is provided as general advice. For additional information and expertise when seeking business financing, consult one of Rudman Winchell’s qualified business attorneys.