Equity or Debt?
Aug 21 2012, 14:14 | By SME Mentor
Every entrepreneur needs money to start and grow his business. But the mode of funding differs from company to company. You can go in for debt or equity and even for a mix of both, depending upon your requirement and ability to raise the money. There is also a third option which we shall delve on later in this report, that can augment funds without exposing you to debt or equity.
Understanding Equity and Debt
Debt, as you would know by now, stands for a loan. Which means you could raise a loan to finance your business venture. Equity, on the other hand, means shares. i.e. selling part of your company's ownership to other parties in exchange of money. Both have its plus and minuses.
You can raise funds through - direct finance, bill finance, refinance, government subsidy schemes, international finance and micro finance. You can raise money from institutional investors, financial investors and your existing customers. Most of these funds would come under either debt or equity category of funding.
Debt, in detail
"Companies with predictable or sustainable cash flows can go in for debt as they can service the interest payment. This way the promoter's stake will not get diluted," opines Vinod Keni, CFO & Director, Aavishkaar Venture Capital.
However, the downside of this option is dealing with the liability when the business doesn't work. At that point your assets may be seized and sold to recover part or the entire debt.
What do banks or financial institutions look for?
One of the most important things that the persons or institutions contemplating giving your business a loan looks out for is - Are you (the promoter) capable enough and trustworthy to get funding? They may perhaps look at your personal finance track record to establish that and/or even speak to former colleagues or your bank to understand you own credit record. Among the other aspects they will examine are: Your business idea and its unique selling point, the scalability of your company, and the management expertise your and the other promoters have to execute the plan and deliver it. Not to forget, you would also need to have a sustainable business model.
So, for example, if your personal forte lies in computers and you propose to set up a restaurant business, you getting funds for the idea are remote simply because you do not have any kind of management expertise to run a food business.
Equity is expensive
For many promoters raising funds through debt is a difficulty as the startups do not have any assets to pledge.
If your project is of a long gestation or incubation period also, you can go in for equity. It is not that you will find equity investors easily. Early investors buy it very cheap and you should be prepared to part stake at that price. Equity is a very expensive option.
"The individual who gives you money could sometimes turn out to be a hindrance rather than a help. You have to get into the detailed expectations of the investor before accepting money," says says Anjana Vivek, founder VentureBean Consulting.
You need to be very careful before opting for equity.
"You may run into issues if you do not do enough due diligence before deciding on the investor. You must understand from whom you are taking money. The comfort level with the investor is also important," says Vivek.
The third option
There is even a third option: Your capital expenditure (buying of goods, materials, etc) requirement can be taken care of through a revenue sharing arrangement with suppliers, vendors and others. So you don't need to worry about raising capital upfront but will be required to give up a small share of your profits, as and when they start coming in, with these parties.
"This is a third innovative option. Your business model may be able to help you get you money without raising debt or selling equity. For example, one can try to make payments through a revenue sharing formula. The payment could be linked to the amount of cash coming in," explains Vivek.
Eg: You can have an "understanding" with your landlord for your real estate requirement, where the entrepreneur pays a percentage of the sales revenue towards rent rather than paying a fixed rental every month. "This also has the added advantage of converting the landlord into your business partner who works with you to increase the revenue from your business," adds Vivek.
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