Cost of Capital: Spend Money to Make Money
Oct 17, 2013 | By Chris Sluty
Once you have done the proper validation of your product offering, the next step is to grow the business. Marketing leads to sales, sales leads to growth, a pretty simple equation. ’You have to spend money, to make money’ is especially true in this rapid growth stage of your business. Your main options for financing are equity and debt, we will walk through the pros/cons of each.
The major benefit of debt financing for your business is that you do not give up any control of your company (unlike equity). If you are in the early stages of business, you may be able to use debt to finance receivables; but it is more likely the type of debt you have will be convertible to equity at a future date.
Interest payments are the main reason for someone issuing your company debt. The obviously disadvantage lies in the monthly interest expense, which will vary based on your interest rate. Fixed payments are beneficial for budgeting/forecasting and interest is tax deductible. The potential burden of interest payments is they are required to be made, regardless of the financial performance of your company.
Debt is the less costly form of financing for your business, it is also the quickest form of cash flow as it doesn’t require nearly the valuation extent that you would normally see with an equity arrangement. Debt is a good short term option for financing, but long term debt agreements can lower the flexiblity of your firm and excessive debt increases the risk of equity holders which leads to lower share prices.
Equity is the form of financing where you exchange a portion of your company, in the form of shares, for capital. This is the most attractive form of financing from an investor standpoint because of the future profit potential. Stockholders share in the profits of the company, based on ownership. On the other hand, shareholders also take on the risk of failure. You are more likely to find capital in the form of equity, due to the profit potential and certain investors appetite for risk.
There are several disadvantages of equity financing for your company. Ownership and control is given up with issuance of shares. Since there is more risk involved from an investor standpoint, a greater return is required, compared to debt financing alternatives. Also, the cost of issuance of shares is greater in time spent and money due to agreements needed to be made on valuation.
Debt vs. Equity
So what is the best form of financing? Each company’s priorities are different, if you in need a quick injection of cash to cover receivables or ramp up operations, a debt agreement may be your best option… depending on interest rates and potential covenants. Equity is the more common form of financing you see, especially in the venture capital world. Investors that believe in your business and vision, want to take part in your company’s potential success. Equity is a more attractive form of financing in this case, often strategic relationships can be made that will aid in the growth of your company. Each form of financing has costs associated with it, but that’s the cost of doing business. You must give up a little short term, to benefit in the future.