While there are many shades of gray between debt and equity financing, I’m going to take a stab and providing some of the more prominent distinctions most common between the two sources of business financing.
My motivation for writing typically comes from the discussions I’ve had during the week with clients, business people, lenders, and investors and this post follows the same basic source of inspiration.
Individuals looking for business financing are many times looking in the wrong places or asking for the wrong form of capital, most typically debt when they should be looking for equity.
A debt based lender is someone who is extending capital typically for a fixed interest rate and repayment term, where the actual interest rate and terms quoted are indicative of the level of risk associated with the use of funds and with the business as a whole. This means that the risk must be readily quantifiable in some way to place a cost to any money that gets borrowed.
With debt financing, there also needs to be a high probability of repayment of the debt in a timely fashion and if there is not, then there will be other actions the lender can take to reclaim what is owing to them.
Equity financing in many ways is the opposite of debt financing in that there many times is no set repayment term and the return on capital provided is a share of the future profits compared to a fixed rate of return.
As mentioned at the outset, there are infinite variations around either a debt or equity financing theme, but for the most part, if you don’t have a readily quantifiable risk with a clear means to repay the debt in one or more different ways, then you are looking for equity financing.
This is not to say that absolutely no one would provide you with a loan, confirming the notion that anything is possible…but not probable.
Regardless of the form of capital, if you don’t have something tangible or intangible to leverage, then its very unlikely you’re going to find much of either.
A well established cash flow is more likely to be able to acquire debt than a developing cash flow. And if a developing cash flow can acquire debt financing, its going to be at a higher price in accordance with the risk associated with growth and development.
In the debt financing world, regardless of the financing model, cash is basically king as loans need to be serviced and servicing comes from the cash flow generated from the business.
In the equity financing world, opportunity and cash are both very important, with proven opportunity capable of securing equity financing before cash flow is established.
The key point here is that “getting a loan” is not likely going to happen unless you can provide a lender with a high degree of confidence that they’re going to get their money back and their cost of money, in a timely fashion.
Securing equity can potentially be far more difficult to secure, but near impossible if you don’t have something of real value to leverage, in which case you would likely better off asking for neither.
When you’re in the process of trying to locate secure business financing, make sure that you’re prepared to get into the details related to your request right off the bat in order.
The reason is simple.
Because the business financing market can be fairly fragmented, its important to be spending your energy and time working with lenders or investors that can actually help you.
Too often, business owners will gloss over the details thinking that they may not be required to get the financing they are looking for.
Well here’s a news flash… the details are going to be required 95% of the time. And of the 5% of the time they aren’t required, most of the time you’re looking at some sort of financing scam that is more promise than substance.
When I speak of the details, I’m taking about full disclosure of what exactly you’re looking for and the credit and financial profile of your business.
Too often, little details will be missed on purpose because a business owner is trying to hit the warts of the business. But in the end, these items will come to the surface and can kill the deal after considerable time has been already spent.
This is also a problem when working with business financing consultants.
A business owner may gravitate to the financing consultant or broker that is asking for the least amount of information in the hope that he has some sort of special access to funds that can avoid having to do the Full Monty on business.
This is a tactic by some brokers to get you working with them. Later in the process, when you get annoyed with their false promises, you may likely just stick it out and go through the real process with them instead of starting over with someone new. And because business financing placements are usually one off transactions, the broker or financing consultant doesn’t have to worry about losing out on repeat business that likely wouldn’t happen anyway.
Banks and institutional lenders can also be guilty of asking you for bits of information at a time, pretending that they’re not going to ask for everything eventually in order to get you going with their application process.
And when I talk about asking for everything, I mean at least three years of completed accountant prepared financial statements, the current year interim statement supported by A/R, A/P, Inventory, and Equipment sub ledgers, transactional details to support margin levels, two to three years of financial projections, income tax statements, notices of assessment, government remittance histories, personal net worth and credit profile, and so on, and so on.
Even though its a bit of a pain to go through the details a number of times, its far more fruitful most of the time to sit down with someone and spend an hour providing a very detailed picture of what you want and what you have, so that they can provide you with more honest and immediate feedback as to the potential that they can help you or not.
Unfortunately, most business owners AND sources of financing do this onion peeling approach where the information is revealed bit by bit.
If you’re talking to the wrong source of financing, this can be death by a thousand cuts. If you’re talking to the right source, late disclosure of certain things can cause problems getting funding completed later on in the process.
The investment in time in the beginning of the process is a may me now or pay me later type of thing.
By investing time up front, the overall process is likely going to be more efficient because you’ll be working with the most relevant sources of business financing sooner versus starting the process over and over again with unsuitable dance partners.
The best approach to business financing growth is a short term vs long term type answer.
That is, do you focus on short term profitability or long term profitability or both?
If you have unlimited access to a cheap source of capital, then an optimal profit focus in the short term and the long term is going to be preferred with an emphasis on accurately managing margins to gain market share as fast as possible without eroding profits.
But most small to medium sized businesses in a growth period do not have an unlimited supply of cheap money, so there is a couple of different ways to look at the best approach to financing growth.
On the one hand, you could argue that its better to grow at the speed at which you’re low cost supply of money will allow you, even if this is not as fast as you could penetrate the market.
On the other hand, you could also argue that the cost of capital you’re prepared to pay should be dictated by the margin you generate in the market and that as long as you’re covering your cost and believe you can gain and keep share in the mid to longer term, that the speed more capital provides you is desirable as long as you can afford it.
This is where many SME’s struggle with using asset based lending compared to bank margining during a period of growth.
Bank financing is going to be cheaper on the surface, but may not be as cheap or as flexible as you may think.
For instance, if you’re talking about a margining facility in the millions of dollars, you’re going to have to provide audited financial statements on an annual basis and some pretty detailed monthly reporting and potentially third party measurement services as well. The incremental cost of these requirements can push up the effective rate considerably.
But the cost is the cost, and is bank margining is cheaper, then it should be used, provided that its also readily available and flexible enough to deal with your growth curve.
This is where bank or institutional margining in the short term can be very inefficient and costly to growth, even at a lower cost of borrowing plus the incremental administrative costs.
While many banks can be very cautious with extending credit limits, and sometimes even putting the brakes on their financing position, regardless of what their initial commitment may have indicated, asset based lender tend to follow more of a linear path and as long as you fall within their lending ratios and maintain the quality of assets, capital availability can growth at the right speed.
Once again, the key measuring stick is the collective profitability over both the short and long term.
The source of capital you use at any given point in your growth cycle should provide you with the capital required to growth the market as fast as you can manage at the least amount of cost, provided that you can cover the cost with the cash flow being generated.
This can also mean changing from one source of capital to another over time.
For instance, a business may start out with a bank or institutional working capital facility, move through one or more traditional asset based lenders as capital demands increase and then make a final transition to bank or institutional asset based lender that can provide the best rates versus leverage, but only tend to become interested when your monthly sales levels are at $5,000,000 or higher.
There can be tremendous challenges in figuring this out, but figure it out and stay ahead of the growth curve you must, otherwise you may loose momentum or be overtaken by someone else in the market that has figured out how to finance their growth.
Yesterday, the Bank of Canada announced that is overnight lending rate would stay put at 1%.
On the surface this would appear to be good news, but for whom?
If you’re a consumer with a variable interest rate mortgage, this is very good news as your mortgage rate is not likely going up.
If you’re a business owner that can qualify for low risk credit, your cost of going business isn’t going to increase due to more financing costs.
But for most sources of consumer or business financing, a change in the rate doesn’t really make a whole lot of difference which is where the perception issue comes in.
Because individuals read and hear about the low levels of the prime lending rate, they automatically believe in many cases that this represents the average cost of money or somehow reflects the cost of capital that would relate to them.
The prime lending rate posted by banks is basically a low risk lending rate where there is very little chance of the bank losing their money on a loan in the event of default.
If this is not the case, then the cost of money is appreciably higher to compensate for the relative risk.
So on the surface, a business owner may somehow feel entitled to a lower cost of financing than he or she can find on the market. But in reality, interest rate perception should be more about your cost of doing business and how to reduce it over time.
Let’s take credit cards.
While there are a wide range of credit cards on the market, most carry a pretty healthy, and some would even consider obscene interest rate. And while we all grumble about this, its pretty much accepted as the way things are and unless we are carrying balances month to month, it doesn’t really matter.
But from a business owner’s point of view, certain credit cards charge the vendor a fee for processing their customer transactions, which is a big part of the their profit stream. And this cost isn’t cheap. It can range from 1.5% to upwards of 3.0% of the value of the transaction.
If customers expect to use certain credit cards that charge a vendor fee, then its a cost of doing business which either needs to be built into the price, or paid from the existing margin. If you can’t do that, then you can’t provide the option to the customer.
Similar with asset based financing, most notably factoring, or invoice discounting, where the business can be paying anywhere from 1% to 3% a month on invoices they finance in order to generate more working capital to purchase inventory, pay supplier bills and so on.
If the cost of financing can’t be reduced by some combination of early payments to suppliers, purchase discounts, price increases, then its a permanent cost of doing business that either can or can’t be covered by your margins.
Over time, as your business builds financial strength, cheaper forms of money will likely come available, at which time your cost of doing business will go down.
The key for any business owner is to understand the relative cost of financing for his or her business and then decide whether or not they can compete in the market place with that cost and grow to a size and level of efficiency that can qualify for cheaper credit.
The cost of money is a true barrier to entry as well as business killer if you don’t understand it properly and manage it well.
If the prime rate is relevant to your business, then pay attention to it. If its not, don’t waste valuable time chasing something that you’re not going to be able to get a hold of in the near term.
The prime rate being low is good for the economy as a whole which is likely going to be at least an indirect benefit to most businesses. But that doesn’t mean it going to reflect your personal cost of capital.
Not too long ago, most of the major lenders still worked under a regional financial model where the bank manager had a significant amount of lending authority and decision making.
Overtime, this proved to be a very dangerous way to operate as individual bias and relationships could skew the decision making process and could ultimately lead to loans being made that were not in the best interest of the lender and the lender’s owners or shareholders.
Similar to most major companies, there is now a clear separation of duties in the organizational and decision making hierarchy of the marketing/sales group, and finance/underwriting group.
Taking it even one step further, while marketing and sales can recommend loans, only underwriting can actually approve or put them forward for approval if a board or higher level of signing authority is required.
Yet, despite this well defined operating structure that has been the standard for close to ten years in the lending world, most business owners still think that their local branch or even regional manager can pull a few strings and get their application approved.
Sorry folks, but that’s not going to happen.
What’s even more confusing to anyone looking for a business loan or business financing facility is that the people you speak to at the bank (marketing and sales folks) will almost always be very interested in speaking with you about your requirements and are prepared to spend time collecting your information, even if there is very little hope of the deal ever getting funded.
Sometimes this is a function of the front line sales team not keeping up to date with what the underwriters are approving, sometimes this due to too much turnover at the sales position where you’re almost always dealing with someone new or fairly green, and sometimes its because the sales force has an incentive to collect applications, regardless of how irrelevant they may be.
So how’s this relevant to today’s post?
As a business owner, you need to be more well aware of the financial parameters of a given lending institution. You may not be able to know exactly what they’re approving at any given time, but its not to hard to get a grasp of their basic lending criteria that is always in place.
Taking any amount of time to “sell” a deal to lender where the fundamentals of the deal do not fit their lending criteria is going to be a waste of time 99% of the time.
Its easy to get caught up in a false reality of who can help you when everyone you come in contact with at a given lending organization appears to be very interested in your deal. But lets not forget, the front line folks can’t lend you money. In fact, its not uncommon that during a business financing application process that the applicant never meets or even speaks to the real decision maker or makers.
And spending too much time barking up the wrong tree can take months and months of time before you realize nothing is likely going to happen, which is another problem in the lending world and that’s a failure to get to “NO” quickly.
When seeking business financing, its important to thoroughly understand the fundamentals of your business financing request and then making your application for financing to a lending source that’s going to be able to lend against those fundamentals.
Spending too much time trying to convince front line individuals how great your planned use of funds is when they work for lenders that aren’t likely to be interested is likely going to be a waste of time.
Since the start of the 2008 recession, business acquisition financing dynamics have changed considerably and will likely remain in their current state for the foreseeable future.
What state is that you ask?
The ability to close an acquisition requires a greater reliance on cash and higher cost bridge financing, especially for company purchases where a market discount is obtained.
Next to start up financing, major bank or secondary institutional financing for a business acquisition is the most difficult form of financing to secure.
This has only increased over the last three years as banks and other institutional lenders increase their requirements and take their time before issuing any prime plus debt obligations.
The result is that businesses for sale that are well set up for meeting all the lending requirements of cheaper money are typically not in a hurry and are going to command a premium.
If you are looking for value in the market, then a motivated seller is going to be required where things on the inside of the business may be a bit ragged and hard to leverage or gain the confidence of a primary debt provider.
So to go after value in the market without having to pay a premium, the buyer needs to either have the cash in hand to do the deal, or be prepared to access higher cost forms of asset based lending, bridge financing, or short term equity investments to complete the acquisition, improve the performance and transition to cheaper capital in the future.
The leveraged buyout scenario is a difficult game these days due to the amount of time and money it can take to get the deal done. And if there is a market for the play, it may be difficult to keep other suitors at bay before a potential path to closing is laid down.
With the beginning of the last recession three years behind us, there are a growing number of opportunities to be had in the market as companies that have tried to hang on are still going to run out of time, high dollar parity putting other less efficient operators out of business, and baby boomer retirement plans pushing the need to sell.
But the prospects for business financing from the buyer’s point of view has gone the other way in recent years causing a real quandary in the market… more buying opportunity, but hard to finance.
Or at least hard to finance in terms of more recent approaches.
The traditional approach of trying to highly leverage what you’re trying to buy with cheap money is not working in many case, but business owners still are not getting this for the most part.
But the smart ones are.
In fact, for the financially astute, if you can get enough of a purchasing discount, and have enough money to afford higher priced acquisition capital as well as the funds to improve the financial performance of the assets acquired, the economics can still work out in your favor.
It just requires taking a different approach to solve the problem … which very simply is to get cheaper money in place post acquisition and then have it available for a long time through solid business management.
Once again, this may mean max leveraging existing assets, using cash reserves, or utilizing higher cost debt or equity to complete the purchase.
This may not always be the best approach, but its something that should be considered more often these days.
For the most part I try to keep my comments to strictly financial and financing topics and I will today, sort of, although I plan to go on a bit of tangent.
Even thought the dollar is 5 points above parity today, it should actually be higher right now as the U.S. currency continues to depreciate against all other major currencies at a faster rate.
Why should the Loonie be even higher?
Because the potential outcome of the May 2, 2011 federal election is making the rest of the world nervous, present company included.
Anything less than a conservative majority will likely have some negative impact on the dollar and will also increase the bank of Canada’s intervention with monetary policy to offset the expected increase in fiscal spending if any type of alliance forms among the NDP, Liberals, and Bloc.
Here’s some additional information on the topic as well http://business.financialpost.com/2011/04/28/ndp-gains-might-sink-loonie-or-not/
When we are talking about monetary policy, the only real lever the bank of Canada has is interest rates, and they will be pulling it much harder if required to maintain the status of the currency.
The result will be higher than expected business financing rates.
Any scenario where the NDP would come into power would as the article I’ve linked to states …”could cause the dollar to Wobble”.
The NDP had some well documented disasters trying to run the provincial governments of B.C. and Ontario, and to think they have the expertise available to manage the fiscal policies of the entire country is laughable.
I understand that everyone may not like how the conservatives go about their business and I don’t agree with all the things they do or say either.
But this is the only party capable right now of keeping us going in the right direction.
Hopefully people can see through all the pie in the sky promises that political parties make to try and get into power.
If not, and we get a Conservative minority, or heaven forbid, a NDP minority government, then we are turning the ship into the financial abyss that most of the rest of the world is in right now.
Selecting governance should not be a popularity contest where the unqualified get to be contestants.
Canada is currently held up as one of the strongest economies in the world, period.
Let’s not do anything next week that is going to jeopardize that status, regardless of what you think about Mr. Harper and some of his soldiers.
I’m all for change … if there is a better option. But there’s not.
We can continue to stay ahead of the financial cloud of dust darkening most countries these days, or we can fall back into it like everyone else.
It is a choice and now is the time to pick the party that has the best chance to keep the country on a solid economic track.
I wrote last week about the fact that over 50% of all business financing does not come from banks in direct contradiction to popular belief.
Business financing has more to do with the creativity and ingenuity of the entrepreneur and business owner seeking out sources of financing that can get value above and beyond an interest rate on a loan.
And guess what?
Banks also fall into this category.
There is virtually no bank or lending institution out there that wants to just make loans to you. Their objective in giving you a loan is to help maintain the investments, insurance, and services they have with you which tend to be far more lucrative than any potential loan profits.
But by saying that business financing comes from non bank sources, I’m continually asked for more examples of this.
Here’s an article the talks about one additional source of capital for business which has been coined “crowd funding”. http://www.theglobeandmail.com/report-on-business/your-business/start/financing/need-financing-join-the-crowd/article1974748/&/
Crowd funding is an off shoot of the social network movement where entrepreneurs and business owners can ask for “donations” to fund a very specific project outline.
All proceeds provided to the business are done through donation to stay within the requirements for investing governed by the securities and exchange commissions in different geographies.
In order to entice donations, an applicant for funding can provide other non monetary rewards such as fresh baking, acknowlegement of contribution on a product, etc.
The donation amounts can range from a couple of dollars to hundreds and thousands of dollars.
The growing success of this type of funding method has a lot to do with the donator getting hooked on the business owner’s story and wanting to be a part of it.
All that being said, there are also those in crowd funding that do want a monetary return.
For these individuals, territory licensing agreements are just one example of what they are receiving for the money they may put in.
While this is not likely going to be able to raise $100,000’s of dollar for a project, in many cases people are looking for $5,000 to $50,000 which can’t be secured from any type of bank financing option.
I’ll pass more real world examples of non bank funding as I come across them.
As I’ve mentioned several times in the past, only a fraction of the capital that is provided to small and medium sized businesses actually comes from banks and other institutional lenders.
Depending on who’s numbers you want to believe, I personally peg the amount somewhere around 40%.
So where does the rest of the money come from?
Boutique lenders, angels, venture capital groups, joint ventures, licensing agreements, and so on.
One of the sources that is getting some press these days are peer to peer lenders where businesses with case are basically providing loans to other businesses that qualify under certain criteria.
Here’s an article that goes into more detail of peer to peer networks in the U.S.
For me, this type of lending makes a great deal of sense for a number of reasons of which I’ll name a few.
First, if you’re a business with excesss cash and nothing internally to invest it in, what are you going to do with it?
Why not put your cash into businesses that are in your industry or a similar industry whereby you know how to qualify their business plans and monitor their performance and manage your risk?
If the loan goes bad, perhaps you’ve just acquired some assets that are very useful to yourself for pennies on the dollar, or you end up taking on partner that can add greater value to you in the long run.
There’s lots of other potential reasons for being a peer lender, but I’ll leave the rest for another day.
Business financing should always be about creating economic value from capital being utilized, regardless of the purpose. Period
As a business owner seeking capital, the more valuable your intended economic benefits are to more people with money, the sooner you’re going to find the capital you’re looking for
A market wire news release came out this week about BMO’s 2010 business financing lending.
Here is an excerpt from the article…
BMO Study Finds 80 per cent of Small Business Owners in Ontario Consider Access to Credit as an Important Determinant Choosing Their Bank
BMO to Add 150 New Small Business Banking Experts Across Canada in 2011.
Here’s a link to the full article …http://www.marketwire.com/press-release/BMO-Small-Business-Lending-in-Ontario-Reached-More-Than-11-Billion-in-2010-TSX-BMO-1423285.htm
The first point is more than a bit obvious. I don’t need a survey to tell me that at least 80% of small business owners may want access to credit at some point from their bank.
The second point is more interesting and telling.
During the recession, the major banks and other institutional lenders were laying people off and coming up with new and creative ways to decline requests for business financing.
Now BMO is telling us about all the money they lent out last year, survey results that speak to businesses looking for capital, and an announcement that they are going to hire a bunch of new people to work on business financing requests.
I’d say this is definitely a strong signal that the business lending market is getting back to what we may consider more normal operations in the Canadian market.
That being said, I still believe that the major lenders’ credit policies are going to still be tighter than they were a couple of years ago, but at least they are actually getting back to lending money.