Financing versus Equity Financing
Banks, Lenders, and Investors (oh my!) all exist because we
fellow businesses need them. They sometimes can be the fine line between
succeeding and closing the doors for good. Each of these entities, holders of
large sums of money, provide capital.
In order to
build new wineries, buy new equipment, develop new products, and upgrade
information technology, businesses have to have money.
Banks, Lenders and Investors each have different financial structures and costs associated with using their money – also known as their “cost of doing business”. The beginning of the year is a popular time for companies to seek out financing assistance due to restructuring or restrategizing operations. No matter the goal, preparation and knowledge is the key to success.
Money Comes with a Price
Money is what we use to buy goods and services. There are many forms of monies in the world but here in the US we use the US Dollar. Not every dollar is treated equal. As a matter of fact every dollar, depending on where it comes from has its own price tag.
The cost of capital refers to your cost of making a specific investment and what you make in return. The basic formula for Cost of Capital is:
the amount of money (cost) and capital (cash) or another infusion of equity into your business
your businesses expenses and how much you pay for it
Generally, business owners will not invest in new projects unless the return on the capital investment is greater than the cost of the capital. The cost of capital is key to all business decisions.
Continue to read up on the two most common ways a business can acquire money; Financing versus Equity Financing.
Equity in business is the portion of the company’s assets that belong to the owners or stockholders. If a company uses funds provided by investors, then the cost of capital is known as the cost of equity.
Investors, angel funds, venture capitalists etc., all fall under the equity financing umbrella. In summary a business gives up a piece of their company’s equity to purchase cash to expand business and operations, essentially giving up a portion of ownership stake. These investors don’t actively participate in the daily management of the company, but they are active in strategic planning in order to reduce risks and maximize profits.
A popular example is the hit television series Shark Tank. Startup and established businesses alike come on the show seeking financial help, and are willing to negotiate a percentage stake of their business for a monetary investment from the “Sharks.” This is actually the most expensive form of financing. Here is an example why.
Let’s use John’s Packaging, a startup product packaging business. John needs about $100,000 for additional equipment and expenses to really get his business going. John finds an investor willing to provide the $100,000 in return for 20% stake in the company. Let’s fast forward five years, and John’s Packaging is a success valued at $5 million dollars. The 20% stake has grown to a value of 1 million dollars. That is a 1000% return on investment, great for the investor, not so great for John. In conclusion, John received all of the money he needed initially but later down the road realized the true value of what he had given up early on in the game.
Equity Financing is a top choice for a startup who is not necessarily pulling in monthly income quite yet and needs financial assistance to get operations up and running.
Referring to the cost of capital, Financing is known as cost of debt in the financing world. The word debt gets a bad rap, but it really shouldn’t always be considered a negative. Debt is when the borrower is required to repay the balance by a certain date. Good debt is an investment that will grow in value and generate long term income.
Equipment Financing and Leasing, Working Capital Loans, Cash Advances, and Invoice Factoring are the main products under the financing umbrella.
Financing is provided by lenders and banks. The cost of debt is the interest rate paid by the company on the financing amount. Interest rates are determined by a combination of elements; the current state of the market, how long a business has been operating, risk factors, credit scores, bank history and amount needed. An advantage is the fact that interest rate expenses are tax deductible and therefore more tax-efficient than equity financing. This form of financing is also able to provide services to a broader range of businesses across all industries with a variety of financial histories.
Financing differs from equity financing in that a business may acquire capital without giving away any portion of the business and essentially is utilizing a line of credit. Financing programs are structured to have fixed monthly payments over a 2 or 5 year horizon. You always know going in what your cost is going to be.
John’s Packaging, an 8 year old company needs capital to pay for replacement equipment costing $100,000. John qualifies for an Equipment Financing Program from a Private Lender, whom will provide all $100,000. In return John makes monthly payments for 24 months (also known as the terms) until the $100,000 is paid off. At the end of the term John owns the equipment and still owns 100% of his business.
Financing is a top choice for businesses who are in operation and can make the monthly payments.
Partnering up with an investor is expensive, however investors can also provide invaluable industry expertise that may not be available from other resources.
Financing on the other hand is a shorter term investment to help boost business without restructuring or including more hands in the profit share.
The take away is for each and every business to spend time evaluating its true needs, and the potential cost of bringing an investor into the mix or taking out a line of credit.
Innovative Lease Services is a commercial lender and provider of custom Financing Programs. Visit www.ilslease.com or call 800-438-1470 for more information.