Determining the price of the money will help you in raising money the right way.
By: Hitesh Khan/
Whether you need $10 or $10 million, there are only two kinds of money: debt, which is borrowed, and equity, which is traded for ownership of the company. The first step to raising the right kind of money is to decide between debt and equity. Usually, the choice depends on personal preference.
If you are running a company with real estate or heavy equipment, and if you would prefer to pay interest rather than give up ownership, then debt financing is the way to go. This is because lenders like to see those kinds of assets. Purchasing such assets usually involves leases and loans backed by the equipment itself. Many equipment manufacturers offer built-in financing.
Traditional lenders like banks are good sources for loans backed by hard assets. Either way, the term, or duration, of a lease or loan should more or less match the expected life span of the asset backing it.
On the other hand, raising money through equity offers serious advantages to businesses, in that if you issue equity, you reduce the amount of pie you own, but you potentially improve your creditworthiness.
Equity financing can come from individual angel investors, traditional venture capital or – most common for growing businesses – mezzanine financing.
Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in the company in case of default, generally after venture capital companies and other senior lenders are paid. Mezzanine financing tends to be completed with little due diligence on the part of the lender and little or no collateral on the part of the borrower. It is treated as equity on a company’s balance sheet.
And therein lies one key to achieving maximum growth for your company and in raising money: using equity and debt together. Equity provides an asset base that can facilitate bank borrowing, and with equity, you can leverage a little further.
Not only is the equity money itself an asset that a bank can use as collateral, but partners and shareholders may use their personal credit scores to enable additional borrowing, or in raising money.
For commercial loans, however, growing businesses don’t typically qualify for loans with long tenure. Even when real estate is involved, businesses are likely to find that 5 – 10 year terms are the norm. For most other business purposes, five years is considered long term.
Of course, there are plenty of times when long-term money is exactly the wrong solution. If a fast-growing business needs cash to meet payroll or simply wants to purchase office supplies, taking out a loans with long tenure does not make any sense.
Credit cards, short-term loans, revolving credit lines and factoring are all much better options for freeing up cash to meet short-term needs. Banks are often the best sources of credit cards and small or revolving credit lines.
For more flexible financing, specialty lenders like licensed moneylenders or corporate finance companies will fit the bill.
Wherever you go looking for money, remember the golden rule: short-term loans for short-term needs; long-term loans or equity for longer-term needs. At the end of the day, a key element is the price of the money, and in the case of a loan, the price is the interest rate.
Credit cards and other short-term loans with no collateral have the highest rates, so they are the most expensive way to borrow – which is another reason not to use them for long-term needs. Longer-term loans, particularly those backed by assets, will be cheaper.
Calculating the price of equity is tricky, but don’t forget that even patient investors want a payday eventually. Since each investor receives a percentage of the total value of the company, equity is usually the most expensive financing option.
Whether the price of raising money is 2 percent or 20 percent, it should always be lower than the return you expect from spending it. That is to say, don’t invest money in any project that won’t generate enough profit to more than cover the loan payments, including interest. To mix accurately the various loans into a recipe that preserves cash flow while keeping the average interest rate low is the trick.
No matter which flavors of money you choose to finance your deal, building a successful business will give you new options for financing. As you prove to the world that you can use money to make money – -and pay back what you borrowed – you will be able to negotiate from strength.
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