Companies requiring funds can categorize all their requirements essentially into two buckets, debt financing and equity financing. Typically, debt financing involves borrowing funds from a bank or from the general public by issuing bonds. Equity financing includes selling shares of stock or taking on additional owners.
The one common mistake entrepreneurs make is thinking that these two financing options are interchangeable. It is not uncommon for businesses to think that they can fund their working capital and operating expenses through equity financing. Both these forms of financing should be used as required by any company and both these financing options should be used for different purposes. Entrepreneurs using equity for working capital requirements will lose control before even having a chance to succeed.
Businesses should use equity to finance long-term assets and working capital to finance short-term assets. One has to match the length of the asset life to the length of liability life. A long-term asset takes more than one 12-month business cycle to repay, while a short-term asset will normally be repaid in less than 12 months. There is no point in burning equity for a short-term requirement. Companies that use equity monies for the working capital requirement will always earn a lower return on owner’s equity.
“It is suicidal using equity funding for working capital and capex,” says Hari Menon, Co-founder and CEO, BigBasket.
“Short-term capital for requirements such as raw material, day-to-day running of operations should either come from cash flows or from debt. Equity funding is primarily growth capital, which includes consumer acquisition, marketing spends, and expansion plans.” says Rahul Khanna, Managing Partner, Trifecta Capital.
Traditionally, companies would use bank loans and overdraft accounts for the working capital requirement. Working capital is the money used to pay your business bills until the cash from sales (or accounts receivable) has actually been received. But normally businesses have a credit period to pay to their suppliers and vendors. Therefore, it is expected that a business should retain double its monthly sales in the form of working capital before it has to pay its suppliers and vendors. Since the cash from sales is expected to come in, for any short-term requirements it is better to always take debt and manage the cash requirement than to burn your highly valuable equity.
Traditionally, most companies only used to get debt financing from NBFCs (non-banking financial companies) and banks basis only solid assets like plants, machinery, and cash flows, which most technology-driven startups do not have. And therefore, these startups, especially in early-mid stage, used to rely heavily on venture capital. But, this trend is now changing with a global infusion of venture debt.
Venture debt is very much like a bank loan, which needs to be paid back in a definite time frame. The loan amount is typically based on the projected run rate the company shows, and its revenue projections. The interest rate is generally 15 to 24 percent, which is higher as compared with traditional bank loans as the risk involved is greater. While bank loans typically require collateral, often times venture debt comes with riders like debt conversion to equity in case of defaults. Several startups also seek venture debt as an extra runway between two rounds of equity funding.
4 Other Reasons for debt over equity
- Debt induces discipline
- Paying interest on debt reduces the tax burden, reducing your cost of capital
- Cost of capital from equity can be more than the cost of capital from debt because of immediate costs (tax, etc.) involved in cashing equity
- Debt is usually less expensive than giving up equity (of your high growth company)
In summary, there are many options available for the entrepreneur today to finance various needs of his business. Each of these options was designed for a specific category of use at a certain stage of the business. Entrepreneurs should understand and use them as recommended than unnecessarily using equity for all requirements.
Also, please refer my blog post working capital funding for retail businesses for details on working capital funding in India.
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