Equity Financing Can Be
Critical To Your Business
Whether you realize it or not, your
business is employing equity financing to some
degree. How effectively you’re utilizing it may be a
whole different matter.
By definition, equity based financing
represents the owner’s share of net assets in a
business. The amount of equity that exists at any
particular time will impact the balance sheet ratios
that can be critical to securing debt financing.
When dealing with most banks, the debt to equity ratio
will need to fall between 2:1 and 4:1, depending on the
bank. So, if you’re a start up company, you will need to
have a minimum equity investment of between 20% and 33%
to be considered for most forms of financing. Depending
on the industry, the equity requirement can be as high
as 1:1 or 50%.
But regardless of your industry or sector it’s likely
that some equity is required. Why? Because 100%
financing is deemed to be too risky for most lenders
regardless of the level of security and this has been
proven over and over again by loan failure statistics.
Equity financing represents your stake in the business
and the more you have to lose of your own money, the
less chance you’re going to forgo paying back money
you’ve borrowed.
Therefore, it’s important to always understand the
financial ratios on your balance sheet when planning for
future financing or trying to locate immediate
financing.
Lower Levels of Equity Financing Can Still Facilitate
Growth
When you look at asset based lending, the type of asset
and the ability to liquidate it can result in higher
debt to equity ratios.
Also, operating leases, which by definition are a source
of “off balance sheet financing”, are not represented on
the balance sheet as a debt against an asset because the
underlying asset is owned by the lease company.
Capital leases on the other hand are no different from a
conventional loan with respect to the balance sheet due
to the fact that the underlying asset associated with
the capital lease will be purchased at the end of the
lease term.
But even more aggressive asset based lenders offering
loans, leases, or mortgages will still have their limits
and will want to see more equity financing in place in
order to lend you more money.
Sources of Equity Financing
In most asset purchases, the primary source of equity is
good old fashion cash. Too often people will try
unsuccessfully to use debt from one source to serve as
the down payment for another purchase. In this case, the
down payment is just more debt, therefore, the purchaser
is trying to work with 100% financing.
Now the one key exception to this scenario is leveraging
existing equity. Let’s take the previous example and
utilize a home equity line of credit for the down
payment. This doesn’t always work, but in many cases
it’s an acceptable way to come up with the equity
investment required for the purchase without liquidating
the underlying asset, which in this case would be your
house.
Another non-source of equity is a personal loan from a
friend or relative to cover off some or all of a down
payment requirement. If the loan is expected to be
repaid, then it’s more debt. If the personal funds are a
gift with no springs, then it can be considered as an
equity contribution.
Basically, equity is the net worth of the owner or
owners. At times you can utilize your personal equity
(like the home line of credit example) to secure
business and personal debt financing where the lender is
providing all or close to all the available funds.
Equity is build over time through earnings that are
retained in the business. As the equity level increases,
so does the debt borrowing capacity.
If none of these approaches can create the amount of
equity required, then you need to turn to external
parties to provide equity financing.
In some cases, a guarantor can be put into place to
guarantee repayment of your debt financing through the
guarantor leveraging their own personal equity, net
worth, or established cash flow. This is a common
practice of parents providing financial support to their
children and spouses where one spouse holds the title of
an asset and the other spouse has an established cash
flow.
The remaining source of equity comes from asset
investments made by additional ownership. For a defined
ownership share of the business, a new owner will
provide an investment which in turn increases the
overall equity position.
This is typically the hardest form of equity to secure
and it also represents the most expensive form of
capital due to the inherent risks of ownership. The
ownership dilution can impact control and profit sharing
for the original owner(s).
When all available sources of debt financing are being
utilized, business owners will seek out investors to buy
part of the business in exchange for an equity infusion
that can also be used to secure additional debt
financing.
Unfortunately, most searches for additional investors
are an act of desperation versus a planned capital
financing strategy. As a result, interested investors
tend to hold most of the bargaining power and will tend
to demand a disproportional ownership share in relation
to the equity investment being considered.
As a small to medium sized privately held company,
finding the right equity investor that fits into your
particular business model at a particular point of time
can be very difficult, and in may cases impossible, to
accomplish.
Why?
Largely because there is a lack of a formalized market
place for smaller equity placements due to the amount of
work and cost involved.
There is a market for private equity placements and most
people have heard of
venture capital financing and
angel investor financing.
But there is always a
far greater demand for equity financing than there is
supply. As a result, investors have the ability to be
incredibly selective with their investment choices,
ruling out the vast majority of potential suitors in the
process.
In many cases, potential new investors already have
knowledge of the business and potentially have some
relationship with the current owners.
The funds that are available will gravitate more to
proven management teams and proven business models than
those business models in development or distress.
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