Debt or Equity: Does It Make Any Difference?

By Beacon Staff

When entrepreneurs raise money to start and grow their businesses, this capital generally comes in three flavors: Grants, Debt and Equity. It is important that entrepreneurs understand each, especially the cost of these capital source alternatives.

Grants are great because no repayment is required and the source of the funds does not expect ownership in the company. Grants (or gifts) from Friends and Family are free…wow, what a country! Grants may also come from public, private or philanthropic agencies and many of these are also free – no obligations on the part of the recipient entrepreneur.

There are two types of grants from Federal agencies, such as the Department of Energy, the Department of Defense and the National Institute of Health: Granting agencies provide funding for new ventures to support their general mission (such as medical technologies for NIH), once you demonstrate that there’s a legitimate public need and a real market for the product. Contracting agencies, on the other hand, fund the development of very specific technologies to meet their internal needs and anticipate being the ultimate customer for the product. Government agencies do not expect the monies to be repaid nor do are they buying ownership in the startup company. These agencies are buying technology innovation and deliverables to these agencies vary, depending on the agreed upon contract.

Debt is a rather inexpensive source of capital for startups. Unfortunately, most entrepreneurs cannot qualify for bank loans (debt financing) because financial institutions require collateral that assure the bank will be repaid, in case of default by the borrower. For example, if an entrepreneur borrows money and agrees that the equity in his/her house can be used as collateral, then, if the entrepreneur cannot make the payments on the loan, the bank has the option of repossessing the house to sell and repay the loan. Most entrepreneurs do not have sufficient collateral available to borrow the amount of funds required to start their companies. But, often banks will accept a co-signer on loans for entrepreneurs. In this case, a person of means (parents, friends, family, investors, etc.) acceptable to the bank, agrees to repay the loan, should the entrepreneur be unable to do so.

The Small Business Administration (SBA), under certain conditions, guarantees loans by financial institutions to small businesses. For more information on SBA loans, see www.sba.gov or a local office of the SBA.

Loans from friends and family can be wonderful sources of capital for startup companies. Friends and family will likely require less collateral and provide funds at lower interest rates than commercial lenders. Just be sure to negotiate an agreement in writing with the lender stipulating the terms and conditions of these loan and their repayment. Don’t leave room for uncertainty that could create misunderstanding later.

You can find many stories of entrepreneurs who have used credit cards as debt financing to start companies. Credit cards can be great sources of startup capital but a word of caution: Credit cards can be a somewhat expensive source of capital with annualized interest rates of 20% or more in some cases, and if not repaid, will negatively impact the future borrowing power of you and your company. Understand and abide by the terms and conditions of all credit cards used in your company.

Equity is the most expensive capital for startup ventures, but often the only source available to entrepreneurs. Equity can come from Friends and Family, Angel Investors and Venture Capitalists. Selling equity means the capital source is purchasing an ownership interest in your company for the funding provided. For example, if Aunt Martha provides her nephew with $50,000 to start a new company, she will expect to own a small fraction of the company (perhaps 10%, in this example) for her cash investment. The good news is that no repayment is required as you are building the business. Aunt Martha expects repayment in one of two ways: (1) you eventually sell the business and, if so, Aunt Martha would deserve 10% of the selling price of the company, or (2) you and Aunt Martha come to an agreement at the outset that you will repurchase her 10% equity ownership at the appraised value of the company by an independent third party at some point in the future (say, five years hence). While Aunt Martha may be willing to sell her shares back to you or the company after some period of time, it would be unusual for angel investors or venture capitals to do so. Their exit strategy is usually to harvest their investment five to ten years after funding, when you sell your startup venture to a much larger company.

The cost of capital from grants, loans and equity investors varies widely. As was discussed above, grants are free, although some grants have deliverables to the sources of funds (a prototype widget, a report on the innovation, etc.). Grants are wonderful capital resources for startup ventures. Loans are generally inexpensive sources of startup funding. For example, a $100,000 loan, borrowed at 15%, interest-only for three years, all due at the end of three years, would cost the startup venture $145,000 to repay. (Sounds like a high rate of interest…but loaning to startups is risky business.) But, consider a $100,000 investment by Aunt Martha, purchasing 20% of the company: Assume you can sell the company for $3 million in five years. Aunt Martha’s share of ownership from the sale of the company would be $600,000. That is equivalent to an annual interest rate (internal rate of return) of 43%! Expensive indeed!

If you can scrape together enough capital to bootstrap the startup of a new company without raising money from outsiders, do it. Raising debt or equity capital is very time-consuming and sometimes quite frustrating. But, if you must raise capital, it is important to understand the cost of funding from lenders is always lower than from equity investors. Use debt, if you can forecast a debt repayment schedule within the expectations of the lender. If timely repayment is not feasible, then seek equity investors.

Columnist Bill Payne is an entrepreneur and angel investor. He may be reached by e-mail at bill@billpayne.com or see his website at www.billpayne.com where his book The Definitive Guide to Raising Money from Angels is available. This is the fourth in a series of monthly articles in the Entrepreneurs’ Corner written by Bill Payne for the Flathead Beacon.

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