December 11, 2018
The Challenge of Capital: The Basics
Capital markets make our modern business world run. From Wall Street to Hong Kong, millions of professionals work in the business of matching money that wants a return with the companies that can earn it.
The workings of capital markets may be a foreign subject matter to many small to medium-sized business owners who have little formal business training. These are the business owners who had an idea or a skill and worked hard to turn into an enterprise — and no doubt that combination served them better at most junctures than any classroom instruction could. Even those who have a formal business education and remember quite a bit of material on capital markets, when it came to the lessons of how to actually access them, that subject was likely glossed over if covered at all.
Have a Great Idea, Get Funding — At Least in Theory
In classic western economic theory, we are led to believe that finding financing and investment is not a challenge and that a good idea or business plan can always find the funding it needs to grow (so long as the idea’s stewards are willing to be diligent enough and execute, of course). This kind of thinking takes root in the assumption that our global system of capital markets functions nearly perfectly and with nearly perfect information. But is that how it all really works?
For publicly listed companies, capital is indeed relatively easy to source, provided those businesses are credit-worthy. A call to an investment bank quickly facilitates a bond issue or the issue of new stock. However, for small and medium-sized businesses, the vast majority of today’s companies, this same process largely doesn’t exist. As such, raising capital can be one of the biggest obstacles to getting your business off the ground and nearly always an obstacle to growing it to its full potential.
What can you as a business owner do to raise money to start or grow your business? The answer depends on a variety of factors, but you do have options, options that, as it turns out, are growing every day.
Debt Versus Equity Funding
Before tackling how to access capital, first the questions of what kind of capital and why you need it must be answered. There are two basic ways for a business to raise money: debt and equity. Debt is the borrowing a fixed sum of money with the intent to repay it. Equity is capital raised by selling a percentage of your business and its future profits. Of the two, debt is a lower-risk, lower-reward situation for the person or company doing the lending.
Another way to look at this is that debt is temporary and equity is permanent. Debt carries a fixed cost and a fixed timeframe and, as such, is appropriate to utilize for fixed needs — such as an asset purchase or a block of future expenses that are known. Equity carries an unknown cost over time but little to none up front, and it has an unlimited timeframe, therefore equity is appropriate to utilize for situations that are less readily quantifiable, such as the development of a new product.
Many companies run perpetually with some sort of manageable level of debt, which is perfectly acceptable if the returns the company generates on that money are greater than the interest paid to borrow it. In this sense, debt can be a permanent line item for a company, though each individual debt contract should be designed to be temporary — one with a fixed payoff date.
Equity financing tends to me more long-term. You can, of course, potentially buy back the stock you sold at a later date, or buyout a partner, but such moves require either an advance agreement to do so or a willing seller, respectively. Too, unlike debt financing, in which those creditors can be discharged at any time by repaying the debt (therefore terminating the debt contract), equity partners cannot always be discharged.
So which type of financing is right for you? Let’s take a look at a few criteria to help you determine what makes sense.
You should look for debt financing if:
- The need for additional capital is temporary and/or you are looking to purchase an asset that will depreciate or have a limited useful life.
- You expect to have the ability to comfortably repay it.
- Your balance sheet and other financial statements support borrowing the amount you need.
- Your business is established and its track record will support this kind of investment from a creditor.
- You are unable or unwilling to sell or dilute your position in your business.
Equity financing would be a smart choice if:
- The need for additional capital is permanent or for an unknown period of time.
- You are looking for startup funding and cannot or don’t wish to use your personal credit to secure borrowings.
- The way in which you plan to utilize the capital will lead to substantial growth in the business (i.e., yield additional returns and profits).
- The investment that you are pursuing is too high-risk to fund with debt (uncertainty around the timing of returns or their sufficiency to repay).
- You are able and willing to sell shares or accept partners into your business.
- The need for or utility of the capital is great enough to justify taking on a potentially permanent partner.
This covers the basics of financing. In the next article, I’ll take a look at how to navigate certain situations that businesses face and which types of financing make sense to look at in those situations.
About the Author
Josh Fiorini is the former CEO of PTR Industries, Inc. He spent the first decade of his career in finance, holding positions as an equity analyst and portfolio manager before starting his own hedge fund. This experience, along with a deep background in manufacturing, banking and private equity, has made him a sought after contributor on numerous boards and discussion groups on political and economic issues for media outlets, corporations and community organizations. Fiorini currently invests his time and resources with non-profit initiatives and acts as a contributor and management consultant to various firms in the firearms industry as the founding and Managing Partner in the firm Narrow Gate Management.
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