Debt and Equity Financing Q & A
The two questions most asked are, 1) which financing vehicle, debt or equity, is the best way to access capital, and 2) which would be best for my business? NWX has been asked these questions hundreds of times in initial client conversations, but the answer always is the same – it depends! And while that answer might sound evasive or non-committing, it is the right answer, without first understanding thoroughly our client’s current monetary needs and long term objectives, current debt or equity financing status, and the current financial condition of the business. In fact even with this information, the discussion has just begun.
For example, a client in upper New York state once asked if we could arrange about $ 20 million of debt financing to assist in building and expanding facilities for potential growth from Albany to Sarasota. Not even challenging the strategy, the limited geographic reach nor amount, the question was raised do you have any alternative means of financing this growth? The answer was no, but we have the ability to make debt service payments for the principal amount of roughly $20 million which we believe can cover all the estimated building and expansion costs! Have you gone to your bank? we asked. Yes, but our debt to equity ratios do not support the additional financing based upon our growth projections according to the bank, our client answered, however the bank would consider putting a transaction together if we provided at least $4 million or 20% as a down payment. Indeed, we replied banks tend to be a little conservative. How bad do you need this loan, we inquired. We were told that a national “chain” competitor was beginning to encroach on their long established territories, and that in order to re-establish a sizable market presence this expansion was critical. Okay, can we poke around for a couple days and get back to you, we responded.
After a day or two, we came back to our client with an obsolete inventory report that we created through help from his Information Technology department. This information was virtually unknown to anyone in the company. We provided documentation that the company had approximately $10 million of over 90 day inventory sitting in warehouses, manufacturing facilities, and retail stores. We contended that is was all obsolete because nobody was purchasing the retail products, the finished goods, and the raw materials. Here is your $4 million plus some, we advised, let’s just liquidate the $10 million by having the vendors take back most at full value or at a re-stocking discount, and re-sell the rest at an established break-even cost or at worst actual cost.
Long story short, our client had practically half of the amount of the expansion costs already in his company sitting as obsolete inventory. In the end, an extended family member financed the remainder of the expansion costs for a small equity position in just the expanded entities. Our client at first wanted a $20 million dollar bank loan for an expansion project, though ended up with zero debt for the full expansion amount. Also $20 million was a little high as well. With all the excessive inventories, vehicles, and equipment in the existing facilities that could be transported to the new facilities the figure was over $5 million less than originally planned. Therefore nobody (and we mean nobody) can correctly answer whether debt or equity financing is right, without first understanding all the basics then digging deeper, much deeper. It does help in understanding the basics in the advantages and disadvantages of both financing methods. The following is a short list:
What are the advantages of debt financing?
- The bank or financial institution has no say in the way a company is managed and has no ownership rights
- The business relationship ends once the debt is paid.
- The interest on the loan is tax deductible.
- Loans can be short or long term.
- Principal and interest are known figures that you can plan, provided that the loan is not adjustable.
What are the disadvantages to debt financing?
- The loan must be paid back within a fixed amount of time.
- If you have too much debt, or cash flow problems you will have difficulty paying back the loan.
- If you carry too much debt you will be seen as “high risk” by potential equity investors in the future.
- Debt financing can leave a business vulnerable during hard times.
- Debt can limit growth because of the burden of debt service.
- Assets of the business are held as security, and the owner (s) are often required to personally guarantee payment by pledging his/her personal assets.
What are the advantages to equity financing?
- Equity financing is generally less risky than a standard loan, because a business does not have to pay it back.
- You can tap into the investor’s network, which may help the business later.
- Investors take a long view and don’t expect an immediate return on their investment.
- Businesses will not have monthly debt service payments, thus having more cash flow.
- There is generally no repayment if the business fails.
What are the disadvantages to equity financing?
- Equity financing generally require higher rates of return than lenders.
- The investor will require ownership and possibly a percentage of the profits.
- The business owner will normally not have complete decision-making capabilities even for routine matters.
- It will take time and effort to find the right equity partner.
- Irreconcilable disagreements between the business owner and the investors may terminate the relationship and could perhaps terminate the business itself.
Should a business apply a mix of both debt and equity financing?
Yes! NWX contends that the advantages and disadvantages of both debt and equity financing are mutually beneficial if businesses opt for a blend of both to meet their needs. Both forms can work together to reduce the downsides of each method of financing, though deciding upon the correct mix can sometimes be a daunting endeavor. Of all five CSC Capital’s client services financing seems at the surface to be the most fundamental and basic to apply. Nothing could be further from the truth. In today’s world financing is one of the most complex business processes to be engaged, and careful attention must be given to each component of the process. Though to completely understand financing one must first grasp the object of corporate finance, which is the business or organization. CSC Capital’s financial roots are embedded with its ability to peer deeply in to the inner layers of a business to extract its fundamental core strengths and weaknesses, of which the success of all financing methods rest upon.