When a business manager concludes that a business should raise cash and has completed their analysis of the expected uses and outcomes of the cash, the next thing to consider is what structure is right for that business.
Broadly, capital can be raised using three alternative methods.
A business can sell part of itself in the form of equity. In an equity financing, the business issues ownership interests to an investor who then owns the portion of the business represented by that equity interest. Equity financing is usually heavily negotiated and may include terms governing dividend payments, voting rights, board membership, anti-dilution rights, etc.
Much “friends and family” financing is equity. “Taking on a partner” usually means the business is raising equity. If your mother will give you the money you need, and not demand very much, it can be an excellent way to raise cash. However, if you go to professional investors, prepare to have a partner (and quite possibly a very active one) for a long time.
Most equity investors seek an “exit strategy” which means a time when they will get their investment and the profits they earned out of the business – often through a sale of the business.
The second broad area of capital raising is borrowing or leasing. While borrowing and leasing are very different in their structures, we will combine them here under the concept of “credit.”
In these forms of financing, the business gets cash today (either in-hand or to buy a piece of equipment), in exchange for the promise to make set periodic payments until a set future date.
The aggregate amounts of the payments represent a combination of repayment of the amount the financing institution provided (the loan amount, or lease amount) plus interest charged for using the money.
Credit is one of the most common ways for businesses to raise cash. There are an almost limitless number of credit structures and types.
Most credit structures require collateral to secure the obligation and many require personal guarantees of repayment.
If the borrower or lessee does not make the required payments, then the creditor can foreclose on the collateral and attempt to execute any guarantees against the assets of the guarantors.
The interest charged on credit is usually pegged to the creditworthiness of the business borrower or lessee, and for small businesses, the creditor usually takes into consideration the creditworthiness of the owner. Interest rates vary widely, and many creditors also charge fees.
The third area of capital raising is asset sales.
Businesses can sell equipment they are no longer using, or contractual rights, inventory or real estate not essential to their businesses.
They can also sell accounts receivable through structures known as factoring.
They can also sell their future card receivables in the form of a merchant cash advance.
Most small businesses do not have unessential property, and if they do, often the market does not pay much.
The relative lack of hard assets in small businesses is one of the reasons financial institutions often look to the personal creditworthiness, guarantees of repayment and collateral of small business owners when looking to extend credit.
Factoring is an ancient financial technology, and involves selling an account receivable. If a business has extended credit to a customer and delivered the product or service, the resulting account receivable can be sold to a willing buyer – often at a substantial discount to its face value. The buyer, or “factor,” then collects the account receivable directly from the “account debtor” (the business or individual obligated to pay pays the factor rather than the business that delivered the product or service).
No form of capital raise is right for every business. However, some forms are wrong for some businesses – or their owners.
For instance, business owner “A” who is extremely independent, and would not work well with co-owners, might seek to avoid selling equity or taking on a partner.
Business owner “B” is in a highly cyclical industry and wants to avoid fixed payment dates and fixed payment amounts may wish to avoid a bank loan or lease with fixed payment schedules.
Business owner “C” may have easy access to loans or leases with low interest costs, with the excellent personal credit and lien-able collateral owned by the business often required by a bank or traditional finance company. They may also have plenty of time to do paperwork, and be unconcerned about fixed payment dates and fixed payment amounts.