How to Decide Whether You Need Debt or Equity Financing for …

February 26, 2018

8 min read

Opinions expressed by Entrepreneur contributors are their own.

For small businesses, 2018 looks like a great time to expand. Corporate tax rates have been cut significantly, accelerated depreciation rules are encouraging capital investment, and the economy is showing signs of sustained strength.

The first question owners should ask is whether to use debt or equity to meet their capital needs. Let’s start by looking at some common debt options: Conventional bank debt, SBA-guaranteed debt (my personal favorite, but not the best fit in every case), and factoring and other forms of non-bank lending.

Related: Entrepreneurs Don’t See Business Financing the Way Lenders Do and It’s Costing Them

Conventional debt for proven businesses

Getting the right type of financing begins with an honest assessment of the five C’s: capital, collateral, conditions, creditworthiness and cash flow. These are the factors that banks use to determine if the business qualifies for bank debt.

Capital refers to the ratio of owner’s equity to the firm’s total liabilities (or leverage). While there are exceptions for certain industries, in most cases a business should have no more than $3 or $4 in liabilities (mostly debts and payables) for every dollar in equity to qualify for conventional financing.

Collateral refers to the assets that will secure the loan. Banks typically use a percentage of the current market value or cost of the assets (known as margin rates) to determine how much they can lend conventionally. For example, a bank may cap its term loan offerings to 75 percent to 80 percent of real estate and new equipment, and 50 percent of used equipment; and cap its lines of credit to 70 percent to 80 percent of current accounts receivable and 30 percent to 50 percent of finished goods inventory.

Conditions are market and industry conditions. If the company is highly cyclical or seasonal, or subject to significant regulations, it is generally more risky than other businesses and may have difficulty obtaining conventional loans.

Related: 3 Financing Keys for Aspiring Entrepreneurs

Creditworthiness is how the business and its owners demonstrate long-term willingness to pay their creditors on time. This is typically documented through credit reports.

Cash flow is possibly the most important of the five C’s; it’s typically based on the business’s historic earnings, prior to reductions for depreciation, amortization, interest expense or taxes but after mandatory distributions and required maintenance capital expenditures. This cash flow is then compared to the proposed debt payments. The cash flow should be at least 1.2 times the amount of required debt service to qualify for conventional financing.

For established firms that demonstrate strength in each of these five C’s, a conventional bank loan can be a great option. These loans offer attractive rates and the lowest overall cost of borrowing.

SBA loans for businesses that need more

Firms that are strong in most of the five C’s, but need to overcome a weakness in collateral, need a longer term to be able to afford the payments, or are expanding beyond their business’s historic ability to cash flow the debt, will fare better by applying for a U.S. Small Business Administration-backed loan. SBA loans offer banks the ability to approve loans with a collateral shortfall, and offer terms up to 10 years for most purposes (conventional loans typically are three- to five-year terms), so cash flow calculations are often improved. SBA-back loans can also help a bank say “yes” to a business in a riskier industry or with a storied past.

Related: 3 Strategies for Getting Into Lending Shape

If the business is seeking SBA financing to expand its business, or will rely on projected cash flows for repayment, it is critical for the business to have a strong business plan showing how the funds will be used and how it plans to generate the cash flow needed to repay the loan.

Businesses without such plans can seek help from Small Business Development Centers and SCORE Association chapters. Those plans start with three years of detailed financial projections and should discuss the assumptions that were made when creating the projections. If the business financials are different than industry norms (i.e. they report lower cost of goods sold or operating expenses), the plan should detail why the business can achieve its projection. Business plans should also include detailed explanations of anything unusual in the firm’s past, like one-time expenses or unusual circumstances.

Getting the right loan is also helped by going to a bank that is familiar with your particular industry. A banker fully versed in hospitality or construction companies, for example, is more likely to understand the particular needs of your business than someone that has never underwritten debt for those sectors.

Factoring and other debt options

For companies with good receivables but weaknesses in the other C’s, factoring may be an option — selling the firm’s accounts receivable to a third party at a discount. Factoring is high-cost debt but can make sense when a high-growth business needs the financing to grow the business quickly and the new business opportunity is profitable enough to create cash flow to repay the debt. Factors are typically concerned with two things: 1) validity and enforceability of the receivables; and 2) the business’s clients’ strength and ability to pay when due.

Related: 4 Ways to Finance Your Business

Some smaller businesses that don’t qualify for any loans can still take on debt. One option is micro-lenders, which are non-bank lenders, often themselves non-profits that mix public and private funding to lend to startups, very early or aggressively expanding businesses. They can lend $1,000 to $1 million, charging higher rates and requiring collateral in most cases, but not all. Businesses can also use personal credit to obtain auto loans and leases; credit card debt (an option best reserved for amounts of $10,000 or less); a home equity line of credit; or take a loan guaranteed by other income (perhaps the salary of a spouse or a guarantee from another family member).

Equity for fast-growing companies

Like debt, taking on various types of equity is also informed by the business stage of growth and its cash flow. Equity can come from family and friends, angel investors, venture capital, private equity investors or from a strategic partner.

Friends and family may make great investors when the business is in its infancy and won’t qualify for a loan, and is unlikely to attract professional investors.

Early stage companies, such as a proven restaurant expanding into a fast-growth chain model, or a company that has developed a product, proven it is marketable, and now wants to hire a sales team to take advantage of a market opportunity, may be able to attract equity. Angel investors offer equity infusions, typically from $50,000 to $500,000, and are looking for businesses that have a shot at rapid growth. They typically stick to specific industry niches that they know well, and can be found through local angel investor networks. The SBA also backs its own public/private early stage equity investment program, the Small Business Investment Company, which has backed such companies as Apple, Tesla and Whole Foods.

Related: Debt vs. Equity Financing: Which Way Should Your Business Go?

Traditional venture capital investors are useful for fast-growing businesses that need an infusion of $5 million or more to quickly bring an exciting new technology or product to market but have insufficient historic cash flow to secure a loan of that size. The company may even be generating losses as it drives growth, but it has a near-term path to high returns for the investors. VCs favor such sectors as tech and health care and expect to sell their stake in three to five years, either through a buyout from a larger firm or an initial public offering. They require substantial control of the companies they invest in, will often dilute prior owners significantly and are usually looking for returns of 10 times or greater.

Private equity (“PE”) investors look to take a stake in companies that are typically more established. PE investors prefer to target companies that are seeking to expand by acquiring other companies and expect to boost profits by capturing the resulting efficiencies. That could be a medical practice expanding to become a regional system, or a distribution and logistics company that wants to acquire other companies.

Like VCs, PE investors want to sell on their investment, usually in three to seven years, for multiples of their initial investment. Both seek a significantly higher return than banks demand.

For relatively mature companies that are growing at a more earth-bound pace, selling equity to a strategic partner may be a better option. That could be selling some or all of the firm to the company’s main customer or vendor — a firm that is invested in the company’s success.

With economic conditions suggesting that 2018 will be an extremely positive year for small businesses, deciding whether to take on debt or to sell equity, and finding the right source, is a great first step in turning expansion plans into reality.