The Difference Between Working Capital and Equity Financing

It's not uncommon for business owners suffering through a cash flow crunch to think that bringing on an equity partner or investor, such as a venture capitalist or angel investor, will solve all of their problems. Unfortunately, during my many years in the alternative business finance industry, I've seen many businesses fail due to this kind of thinking.

Specifically, these business owners didn't understand the difference between working capital and equity financing. I've seen good, profitable businesses blow themselves up because of cash flow problems, and entrepreneurs lose ownership and control of their companies before they had a chance to succeed. A lot of this grief could have been prevented had the business owners opened their minds and taken the time to seriously look at all of the financing options available to them.

Often, what's really needed is simply a boost in or access to more working capital. "There is a big difference between increasing working capital and bringing on an equity partner," says Davis Vaitkunas, an investment banker and president of Bond Capital in Vancouver, British Columbia.

"While owners suffering from cash flow problems may think their only solution is a large injection of cash from an equity investor, that could very well be the worst possible thing to do," Vaitkunas says. "In fact, the math will demonstrate that the owner who funds 100% of his or her working capital with equity earns a lower return on owner's equity."

Working capital vs. equity financing

At this point it might be helpful to clarify some terms. For starters, working capital is the money used to pay your business bills until the cash from sales (or accounts receivable) has actually been received. Terms for sales vary among industries, but normally a business can expect to wait somewhere between 30 and 60 days to be paid. Therefore, as a general rule, your business should retain double its monthly sales in the form of working capital. You can increase the amount of available working capital by retaining profits, improving supplier credit, or using alternative financing vehicles.

Equity financing, meanwhile, is money a business acquires by selling some of the ownership shares in the business. In many cases, this can also involve giving up control in some or all of the most important business decisions. This can be a good thing if the investor brings in some unique expertise or synergy to the relationship. However, the terms of an equity investment can be complicated, so it's important to completely understand them and have good legal counsel. Think of it as a business marriage.

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• Fast Small Business Funding: The Best Ways to Get Cash Quickly
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According to Vaitkunas, "Businesses should use equity to finance long-term assets and working capital to finance short-term assets. You want to apply the matching principle and match the length of the asset life to the length of liability life." A long-term asset takes more than one 12-month business cycle to repay, while a short-term asset will normally be repaid in less than 12 months.

When to dilute equity

"Equity is a precious commodity," Vaitkunas says. "It should only be sold when there is no other option. The equity partner should bring experience and/or contacts that cannot be found elsewhere."

The best strategy is to secure equity financing at a time when you can negotiate and preferably dictate some of the terms. Ideally, absolute control should remain with the business owner.

Timing is everything when it comes to equity financing, Vaitkunas says. "Sometimes it's best to simply take your time and wait for the best value proposition. While you're waiting, you can grow within your means using short-term liabilities."

It's usually not a good idea to look for equity when a business is new, struggling to earn a profit, or suffering from a setback. Unfortunately this is exactly the time when many business owners start thinking they need to "find an investor." This process can take a lot of time and consume a lot of energy—time and energy that should go toward the business—and this can have an aggravating and compounding effect on the business's existing problems.

As a rule of thumb, equity partners should only be sought once a company has a proven track record of sales and profitability and there's an identifiable and specific need for the money. Then, it's important to show how an injection of capital will create even greater profits and higher sales. A business that has a proven level of profitability, some historical sales growth, and even more future sales growth potential is a much more attractive investment to potential equity partners.

Financing working capital

Working capital shortages are a short-term problem that can be financed with senior debt or mezzanine debt. Short-term financing is also available from factoring or accounts receivable financing providers that look to certain accounts receivable and inventory assets as collateral. A combination of these types of alternative strategies can boost available working capital to the point where the need for an equity partner disappears.

So how do you decide which financing tool to use for the job?

"If you are tempted to consider an equity injection to resolve growing pains, you must also consider possible partnership risk along the way and the true cost that equity can bring down the road," Vaitkunas says. The best working capital solution may be an accounts receivable line of credit, which costs less than equity and does not introduce partnership risk.

The bottom line

There are many alternative options available to businesses in need of a cash infusion other than taking on a partner or shareholder. It's important for every business owner to know and understand all of the options—and when it's best to use which one—before making such an important decision.

RELATED: The Difference Between Factoring and Accounts Receivable Financing

About the Author

Tom Klausen is president at True Viking Finance, which provides creative financing solutions to small and mid-size businesses across Canada. Klausen has worked in the alternative lending industry for more than 25 years and consults with businesses struggling to obtain traditional financing.