Ask 10 business owners if they want to grow their company and you can bet at least 9 will say, “Yes, of course!” After all, the alternative to growth is stagnation. Or worse, decline.
But growing a business just for the sake of “growth” can be as dangerous as not growing at all. Growth requires money — for marketing, employees, equipment, inventory, receivables, etc. — and money, as the old saying goes, doesn’t grow on trees.
Sources Of Financing
There are only two sources of cash owners can tap to grow a business: owner’s equity (usually retained earnings or personal funds) or outside funding. Since most businesses don’t have enough cash on hand to completely finance growth themselves, they usually turn to outside funding sources.
These sources fall into one of two main categories: debt and equity. It’s critical to understand the difference between the two before you go in search of growth capital.
The best example of debt is the traditional commercial bank loan. Banks loan money to businesses that meet their qualification criteria (usually including a pledge of collateral) and charge a rate of interest in return. The bank expects the money to be repaid with interest over a specific time period. Or there’s a line of credit, which enables a business to borrow up to a predetermined amount anytime and repay the money when it chooses, with certain restrictions.
Equity financing is quite different. In this case investors aren’t lending money to the business with the expectation of repayment. Instead, they’re providing capital in exchange for an ownership stake in the company. Such financing is often provided by private equity firms, venture capitalists or angel investors — wealthy individuals looking to invest in businesses or entrepreneurs they already know or in causes they want to support.
Pros And Cons
So which is better: debt or equity? Each has advantages and drawbacks. The biggest advantage of debt is that it enables you to retain 100 percent ownership of your company.
For most entrepreneurs, especially those building startup companies from scratch, the main benefit of ownership is the growth and appreciation of the business. No one knows the future value of each ownership share you part with in exchange for financing, but think about early-stage investors in companies like Amazon.com or Microsoft and what the value of a fraction of a percent of one of these companies is worth today.
On the flip side, there’s a short-term cost to debt financing: the interest charged. Lenders may also place restrictions on certain aspects of a business’s operations and most will require regular updates on the company’s financial condition and performance.
The “cost” of equity is more of a long-term cost but it can be substantial. Since there are hundreds, if not thousands, of strikeouts or singles for every Amazon or Microsoft home run, equity investors may demand a high percentage of ownership in your company. How high depends on many factors. Primarily on the level of risk investors perceive in the deal compared to the size of the potential reward.
Only you can decide which type of growth financing is right for your business. If you can qualify for a bank loan, most experts agree that this is usually preferable to equity, since it may cost you far less in the long run. However, if you’re a startup that’s short on cash and has little performance history for a bank to examine and/or little if any collateral to pledge, equity may be your only option.