Equity or loans: The entrepreneurs funding dilemma.

Every start-up requires funding. A business plan, no matter how good, without cash for implementation will remain a dream.

Most start-ups get off the mark with investment of one sort or another by the ‘3 F’s’: Family, Friends and Fools, supplemented by savings from the aspiring entrepreneur.

At some point, after proof of concept when the aspiring entrepreneur needs more cash to fund the growth, or scaling of their now successful SME, they must seek alternative sources. The choices are simple: give equity in exchange for the funds, borrow them from some financial institution, or use a combination of both.

There are pros and cons to be considered for each path, the answer that best suits every instance will be different, and subject to all sorts of caveats and variables.

Pros for Loan funds.

• • • The entrepreneur does not surrender any ownership and therefore control of the enterprise.
    • The entrepreneur gets to keep all the profits, assuming success. This assumes that the business is housed in a limited liability company, rather than on a personal basis, or even worse, a partnership.

Cons for Loan funds.

• • • A start-up may (probably will) have trouble getting a loan at a commercially viable interest rate, as there is no or very little trading history. Cash is the ultimate commodity, and institutions only lend money when they are comfortable, they will get their money back, and/or the interest rate is such that the risk is deemed acceptable.
    • There is a debt that must be paid back with interest, irrespective of the success or failure of the enterprise. Interest however, is tax deductable, assuming there are profits that incur a tax liability.
    • A lender will often place restriction on how capital is to be used, require reporting, and demand privileges that do not add value to the enterprise.

Pros for Equity.

• • • The entrepreneur does not have to pay back the capital, it is invested at the risk of the investor. The investor is absorbing the risk of failure into their equity calculations. If the business fails, they lose their money.
    • The absence of a schedule of repayments enables capital to be directed at the most productive uses
    • Those who provide equity are often in a position to offer more than just money. It is in their interests to leverage their networks and experience to benefit the enterprise in which they have invested. This advice can be of immense value, particularly to the young entrepreneur lacking the wisdom that comes with experience.

Cons for equity.

• • • Equity is just another word for ownership. If you give some level of ownership to another party, that entitles them to a share of the profits as a function of their equity, when and if they emerge.
    • When the business is sold, acquired, or floated, the equity holders share in the proceeds, it is their opportunity to generate a return on their investment above the dividends received.
    • Equity also entitles a say in management, strategy, and management of the entity. This can be agreed, but there are regulations and accepted practice around the power of an equity holder, and in the case of a listed company, the regulations are enforced by the Corporations Act.
    • If an investors circumstances change, and they need their money out of the business, there is not usually a ready market that will value and buy that equity. This will cause considerable distraction to the management of the enterprise if it happens.

Raising funds is nothing more or less than a marketing project. The entrepreneur has a ‘product’ to sell, the future profitability and potential capital gain from the enterprise. The investor/lender has the funds necessary to crystallise the entrepreneurs dream.

Both lenders and investors require common information, which they use differently. For a lender, it is the reassurance that the loan including principal and interest will be repaid over the life of the loan. Whether that repayment comes from the cash flow of the business, or in the event of failure, sale of the assets against which the loan is secured is largely irrelevant.

In the case of equity, the driving consideration is the potential for capital gain at some point, after the payment of dividends. Both rely on cash flow forecasts from the enterprise.

Agreeing the level of equity that will be exchanged for the investment is a really challenging process. The financial interests of the entrepreneur and the potential investor are directly opposed. The question is how much a point of equity is worth in cash terms. In almost every case, the better prepared party to that negotiation will win. However, it should not be seen as a binary negotiation just about the cash, as there are other variables at work, such as the networks of the potential investor, which as noted above can have significant value.

This process also must place a value on the ideas, and time of the entrepreneur, without which there would be no potential investment.

In short, you need to find a mutually acceptable valuation of forecasts of future cash flow from the ideas and commitment of the entrepreneur, and the value of cash and other factors the potential equity holder brings to the table from which to agree an equity split.

Header cartoon credit: once again Scott Adams and his mate Dilbert understand the dilema