“When Should Equity Financing Be Considered As A Source Of
Business Capital”
First of all, lets get clear as to what we mean by equity financing.
Equity financing occurs when ownership in a company is sold in exchange for an agreed upon purchase price.
The purchase price becomes new capital in the business and is recorded as such on the balance sheet.
In the business financing world, there are basically three general forms of financing…debt financing, equity financing, and some combination of debt and equity.
Equity financing, in many situations, occurs when a business or company can not qualify for debt financing.
Part of the reason for not being able to qualify for debt financing may be a lack of equity on the corporate balance sheet. Once this has been corrected through an equity investment, the business entity may immediately be eligible for different types of debt financing programs.
When a business is in a startup and development mode and has not generated revenues nor is cash flow positive on a monthly basis, then an equity investor is typically required to provide the cash flow necessary to complete the development process and get to a cash flow positive position.
Higher rate forms of asset based lending that provide financing debt to equity ratios higher than conventional lenders, will say that they are renting equity to the business due to the high level of debt and risk that the business is covering.
All things being equal, most business owners will prefer to debt finance their business needs as it comes at a lower cost than and equity investment in most cases, and the business owner retains ownership and control of the company.
That being said, debt financing can be difficult to manage, especially when you are working with more than one lender where the risk of being offside with some lender covenant is going to be that much higher. Debt financing sources can also demand repayment at times for no reason or wrong doing on the part of the business, potentially leaving the business owner or manager scrambling to manage cash flow.
Because equity financing is connected to ownership, its typically not always straightforward how an owner will be able to sell their shares and exit the business. Most corporations have shareholder’s agreements that outline this process, but it can still take considerable amount of time to exit and there is no guarantee that the initial investment will be reclaimed.
Equity financing in many cases is considered to be a more patient form of capital as its placement is usually connected to the future earnings potential of a given business versus existing financial returns.
The higher risk associated with speculating on future returns also demands a higher risk which is going to be expected by most any equity investor.
More and more often, we are seeing business financing solutions with both debt and equity elements where the investor/borrower is only looking to be in place for a period of three to five years, exit the business, and make a high rate of return on the capital provided upon exit.
For most start up business situations, the entrepreneur is first utilizing their own equity to get the business going, leverage debt to grow the business, and then use third party equity financing to scale out the business in order for it to reach it market potential.
So depending on where you are at in your business cycle, there can be different debt and/or equity financing solutions that are going to be more relevant to you.
The key point here is that each situation is unique and as a result most business financing solutions are customized towards available sources of debt and equity that are available and relevant at the time of need.
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“Asset Based Loans – When To Consider Them”
First of all, there can be many definitions of asset based loans.
For this discussion, we are referring to asset based loans in the context of a working capital facility that leverages the equity in accounts receivable at a minimum, but can also provide leverage on inventory, equipment, and even real estate.
The standard asset based loan or ABL type arrangement requires the borrower to open a joint account with the lender and that all funds paid to the business be deposited in this joint account.
The lender will, as they say, sweep the account every day and apply funds coming in to the balance outstanding on the loan. The borrower will request funds from the lender on a daily or weekly basis, depending on the requirements, to pay bills as they come due.
This is a highly simplified overview of how an asset based financing facility actually works from an operational stand point… each lender and financing scenario will have its own unique aspects.
Now back to the original question as to when ABL’s should be considered
There are two basic scenarios (with lots of variation within each one) where asset based loans can be considered to finance business operations.
The two scenarios include situations of growth and situations of financial distress…basically opposite ends of the lending spectrum.
In both cases, what is common is that the business requires high asset leverage to generate the cash needed to operate the business.
Under both these scenarios, conventional lending parameters may not provide sufficient leverage, causing the business to fail outright, or not be able to take advantage of growth opportunities immediately available to the business.
Most asset based loan facilities are born out of the inability of a conventional financing arrangement through a bank or institutional lender to provide the level of financing the business requires.
In highly stable companies with very strong balance sheets and cash flow, the ABL solution can be provided in house through the conventional lenders own asset based lending group. These institutional asset based lenders provide the higher leverage required at slightly higher rates than what their conventional business division would lend money out at. The large bank asset based lending programs are also only going to be available for growth and market development scenarios.
When a business cannot qualify for what we’ll call low cost institutional asset based loans, they turn to boutique lenders that provide ABL services at similar leverage, but at higher rates.
If a business is in distress, the asset based lender will provide higher leverage on assets and very tight cash management to give the business the best chance to turn things around or wind down the operations without destroying equity. Either way, this tends to be a short term solution until the business can once again qualify for a lower cost source of capital.
In situations of growth, the higher cost, traditional asset based lender will once again provide higher leverage at higher rates and serve as the senior lender until the business can qualify for a lower cost form of financing within a manageable range of leverage.
Unless a business is being funded by a low cost form of institutional ABL, the time period of business financing via an asset based loan is typically two or three years as the high cost of financing cannot be sustained over a long period of time in most cases.
Therefore, most traditional asset based loan providers are a form of bridge lender that does not expect to be financing the business into the long term.
Once again, there are many variations to these asset based loan programs, each with their own unique fit in the market place.
To better understand what type of asset based loan facility might be appropriate for your situation, you might consider utilizing the services of a business financing specialist that can help you navigate the landscape.
Click Here To Speak To Business Finance Specialist Brent Finlay For All You Business Financing Requirements
