For most entrepreneurs, starting their own business is a labor of love. The time, energy, and money they spend help bring their dream of being the boss to life. However, after pumping in personal assets and money from family and friends to get their enterprise off the ground, a small business owner may be reluctant to take on debt to expand. Of course, the alternative—equity—has its own cost. Which type of financing will best serve the needs of a small business?
“Equity investors have a completely different set of goals than organizations that provide debt,” notes Daniel Feiman, author of The Book on Business from A to Z and managing director of Build it Backwards, a global management consulting and training services firm based in Redondo Beach, California. Because of the higher risk they assume, equity investors usually expect to play a larger role in the decision-making and that can cause problems. “An investor’s growth ideas may be different than yours,” points out Feiman. “You may even be forced out if the investor doesn’t think you’re driving the company in the right direction.”
Therefore, small business owners must be prepared to give up some control when taking on investors. That may be a bitter pill to swallow after putting so much personal effort into creating a business. “If you bring other people in with lots of money and expertise, your business will be bigger and you’ll probably be richer, but you’re likely to have a much smaller piece of a larger pie,” says Mitchell Weiss, who spent two decades in the commercial lending industry before becoming a consultant, author, and professor at the University of Hartford. “If you want control, you’ll have the whole pie, but a much smaller one.”
Think long-term (costs)
With debt, a small business owner is beholden only to a lender for the principal and interest of a loan over a set period (with set payments). “Debt is higher risk but less expensive because you’re paying a small fixed charge and you know exactly what it is,” points out David Worrell, author of The Colors of Money and principal at Rock Solid Finance based in Charlotte, North Carolina. “Some debt is good for business because it helps free up cash to expand and that helps you grow faster.”
Another consideration: Over time, equity ends up being more expensive than debt. “Equity investors demand a premium to debt investors,” explains Weiss. “If you can’t generate enough profits to make a sizable return, then you should look at debt.” Because equity investors take a greater risk, he notes that when your business does generate profits, investors expect a bigger and bigger share for as long as they invest.
Get only what your business needs
Venture capitalists and angel investors tend to only lend large amounts, typically millions of dollars. For small businesses in fast-growing industries—such as tech and biotech—that need a large cash infusion to keep up with growth, an equity investment may be the way to go. But for companies looking for a much smaller amount to smooth out cash flow or purchase property, equipment, or inventory, debt financing makes more sense. “If you’re like most businesses, you’re going to take much longer to grow and to collect cash and receivables,” notes Feiman. “Your business will not be best served by having equity as the primary source of financing.”
For a startup that has yet to make a profit, a business loan can be hard to come by unless significant collateral, such as real estate or equipment, is pledged. After using his personal savings to develop “Incredible Greens”—a condensed vegetable powder made up of 35 different greens, grasses, and probiotics—and launch Health Kismet, Jonathan Bechtel took out a three-year $15,000 personal loan to develop a new berry-flavored powder and introduce different packaging sizes. “You have more control over the lending amount,” notes Bechtel. “I didn’t need a huge amount, as the cost of manufacturing in the supplement industry has decreased.”
For Bechtel, seeking out investors would have served as more of a distraction. “If I had spent three or four months looking for investors, I wouldn’t have been able to focus on the daily workings of my business, which probably would have killed it before it started,” says Bechtel.
Although Health Kismet is now cash-flow positive, having reached its first five-digit month in gross sales after just a year in business, Bechtel prefers to keep as much cash as possible available “in case the unknown happens,” he says.
In the red, in the black
When Michelle Furyaka joined NPD Global as an executive VP in 2010, the small IT staffing and recruitment firm was looking to expand after weathering the worst of the recession. “If we were going to stick to the business plan we devised and meet our goals to grow in a certain way, then we had to borrow money,” says Furyaka. She and her partner were able to secure a loan for their company through a small business program offered by one of the big brokerage houses.
While it was not cash flow positive at the time, NPD Global already had some established clients. The loan helped finance their move from New Jersey into Manhattan to be closer to their clients, which include some large finance and insurance companies. After signing a few new customers and turning a profit, the company was able to turn to debt financing again—this time for a revolving line of credit—to cover the lag between getting paid by their customers and paying their employees. “Sometimes we’re waiting 40 to 60 days to get paid,” notes Furyaka. “[The line of credit is] like an insurance policy we can dip into and then immediately pay back.” Since 2010, NPD Global has expanded from five to 40 employees and grown 300 percent, with another doubling of growth projected for this year.
Before taking on debt, small business owners must consider both business and personal risks. “You are taking on the full burden of that money personally,” says Worrell. “Almost every SBO must give a personal guarantee when taking out a loan.” Personal credit history is weighed along with the health and growth prospects of your business. So if you default and your business assets don’t cover the full cost of the loan, the bank can come after your personal assets.
Before approaching any lending institution, it’s also important to be prepared. “You must have not only a solid business plan, but also a good story for the bank that supports profitability in the future,” Worrell points out. “You have to prove to the bank that you’re mature enough to handle your money, your company’s money, and their money.”
Along with gathering all the necessary financial, legal, and tax documents, entrepreneurs must determine the right amount and appropriate structure for their loan. “Your profits will tell you the maximum amount of financing you can afford,” notes Feiman. “You need enough cushion in case of surprises, and there are always surprises.”
“Any money that comes into a company has to have a way out,” says Weiss. “Equity and debt are the same in that there’s a price to be paid for each and each has to be returned at some point.” For those small business owners whose dream it is to nurture their business over many seasons, taking on a manageable level of debt may be just what’s needed to help their business bloom.
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