As an aspiring entrepreneur, you may find yourself asking the question, "How do I raise funds for my business?" This is a crucial inquiry that arises when you are planning to start a new business, expand your existing one, or take your business to a new geographic location. Securing funds is essential for any business endeavor.
There are two primary ways to raise funds in business: debt and equity. Debt refers to taking out loans from institutions such as banks. While Non-Banking Financial Corporation (NBFCs) are not subject to the same regulations as banks, they also issue loans.
On the other hand, equity involves seeking partners and investors to invest in your company. These investors could be high net worth individuals, big fund houses, or those investing in Initial Public Offerings (IPOs).
Now, if you're wondering which option is best for your business, it's essential to understand the ten fundamental differences between debt and equity. By evaluating these differences, you'll be able to make an informed decision that is best suited for your business needs.
How likely is it that my cash flow will meet my expectations?
Determining the probability of cash flow in your business is a crucial aspect of financial planning. You must analyze whether your business generates consistent monthly returns or experiences delayed cash flows in the initial years, followed by sudden growth. If your business has a high probability of cash flow, obtaining debt financing can be a viable option. However, if your business experiences low or delayed cash flows, it is advisable to raise funds through equity financing. By carefully evaluating your cash flow probability, you can make informed decisions about the type of financing that best suits your business needs.
Factors that affect profitability
When considering whether to take on debt or equity for your business, it is important to take into account your company's profitability. If your business is generating high profit margins, then taking on debt may be a viable option. This is because high margins typically translate into strong cash flows that can facilitate debt repayment, even at high interest rates. That said, if your margins are low, taking on equity may be a more prudent choice. By sharing the risks with investors, you can alleviate the burden of interest and repayment, particularly in the event of cash flow delays. Ultimately, the decision between debt and equity financing should be based on a careful analysis of your business's financial health and goals.
True Cost of Borrowing
When it comes to raising funds for any venture, it's important to keep in mind that there will always be a cost associated with it. This cost refers to the returns that you will need to provide in exchange for the funds you borrow. It's worth noting that the cost of debt tends to be lower than the cost of equity. Therefore, it's crucial to determine whether you're looking to keep costs low or don't mind incurring a higher cost.
If you opt for equity financing, you'll need to be prepared to offer partnership in your venture. This means that you'll be giving up a stake in your business and making the investor your partner in your journey of growth. Consequently, the cost of equity tends to be higher than that of debt.
Alternatively, with debt financing, you need to provide a fixed return to the lender. Based on this fixed return, you can borrow the money and repay it without giving up any partnership in your venture. Consequently, the cost of debt tends to be lower than that of equity.
It's important to weigh the pros and cons of each option before deciding which one is best for your business. Ultimately, the decision should be based on your individual needs and the goals you wish to achieve.
In the realm of business financing, collateral refers to any plant, property, or equipment that a borrower pledges as security for a loan. The presence of collateral is a crucial factor for a bank to consider when deciding whether or not to grant a loan. In most cases, banks require collateral to mitigate the risk of default and ensure they have a means of recovering their investment in case the borrower is unable to repay the loan.
For instance, suppose you intend to borrow $1 million from a bank. In that case, the bank will likely require collateral worth $1.5-2 million to secure the loan. This ensures that the bank has adequate security in the event of a default.
However, without any collateral, it may be challenging to secure a loan from a bank based solely on your promise to repay. Nevertheless, there are other financing options available, such as equity-based funding. If an investor understands your business's growth plan or strategy, they may invest in your business in exchange for a percentage of ownership, without requiring any collateral. Ultimately, the type of financing you choose will depend on your business's needs and circumstances.
When it comes to investor risk, there are significant differences between debt and equity. In debt, the risk for an investor is relatively low because they have the option to recover their losses by selling the collateral. This collateral serves as security for the investor and minimizes their risk. However, in equity, the investor risk is much higher because they do not have any collateral to fall back on. Instead, they must rely solely on your promise, which can be risky if your business does not succeed. In such a scenario, the investor stands to lose along with you. It is important to note that the person taking the risk will inevitably bear more cost. Therefore, the cost of equity tends to be higher than the cost of debt. These factors should be carefully considered when making investment decisions.
Ownership is a crucial aspect that needs to be considered when seeking investment opportunities for your business. As a business owner, it is important to understand whether the investor will have any ownership in your business or not.
If you are borrowing money against collateral and are paying monthly EMIs to repay the amount after 3-5 years, then you need not give any ownership to the investor. This is because there is no equity involved in such a scenario, and the investor is merely acting as a lender.
On the other hand, if you are seeking investment based on your growth plans or strategies, then the investor will have a stake in your business. This means that the investor should have some ownership in your business so that they can take data from you. In this case, the investor will take shares of your company and position in your directors, thereby becoming a part-owner of your business.
Therefore, it is important to note that investors get ownership in equity, and it is essential to understand the terms of the investment before agreeing to any deal. By understanding ownership and equity, you can make informed decisions about the investment opportunities available to you and ensure the success of your business in the long run.
When it comes to loans, it's important to note that the returns are typically fixed based on the current market rates. As a borrower, you won't be able to receive returns that exceed these rates, as the lender is operating within the confines of this established framework. The interest rates are generally non-negotiable, as they're based on broader market trends and are set accordingly. However, when it comes to equity, things can be a bit more variable. Returns in this realm can range from very high to no return at all, depending on a variety of factors. It's important to keep this in mind when considering your investment options and deciding where to allocate your funds.
Upside for the Investors
When seeking investment for your company, it is important to understand the concept of upside. Essentially, upside refers to the potential growth that the investor may receive from their investment. If you opt for debt financing, there is no upside growth. This is because the debtor or bank will provide you with a fixed amount and fixed returns, regardless of how your business performs. Therefore, you need not share your business growth with them. Equity financing, on the other hand, offers much higher upside potential. You may have come across companies whose share prices have multiplied two or three times over the course of one or two years. Some companies that were established 10-20 years ago have even paid out yearly returns of 35-40% to their investors. It is important to consider these factors when deciding which financing option is best for your company's growth and success.
Growth Can Capital
When it comes to capital for business growth, there are two main options: debt and equity. Debt capital may seem like a quick and easy solution, but it can actually hinder your growth in the long run. This is because debt requires you to pay monthly interest and a final payment, which can eat into your profits and limit your ability to reinvest in the business.
On the other hand, equity capital offers a more flexible and potentially lucrative option. With equity, you don't have to pay any interest or make any payments until the investor exits the investment. This means you can use the money you receive from equity investors to comfortably grow your business for 2-3 years without the pressure of immediate repayments.
Furthermore, as your company grows and its value increases, it becomes more attractive to investors. This can lead to more investors coming on board, which can provide additional capital for growth. The first investor may even choose to exit the investment, which can free up more equity for you to use as needed. Overall, equity capital offers a more sustainable and potentially profitable path to business growth.
Capacity to Raise Capital
As a business owner, you need to be aware of your company's capacity to raise capital. Every business has a limit to the amount of money it can borrow, beyond which it cannot sustainably pay back. For instance, if your business is earning $100K per month, it cannot afford to pay $200K per month as interest. This means that the amount of loan a company can take is limited by its income.
When a bank evaluates a company's income before giving out a loan, it checks that the company can only use 50-60% of its income to repay the loan. If a company reaches this level, no new bank will give it a loan. However, if your company has growth potential, then you can raise equity multiple times and use the capital obtained to expand your business. In this case, when your equity base increases, banks become more comfortable and start giving you loans.
Equity is not the only way to raise capital, as there are other sources of funding. For instance, customers can be a great source of investment. If you have a business model that allows you to get cash flow from customers through pre-bookings, you should raise money from them as their money is the best and the cheapest.
It's important to evaluate your business based on the above 10 pointers whenever you want to raise capital for business expansion. This will help you decide whether you need debt or equity to move forward. By using these tips and frameworks to evaluate your business, you can determine which method suits your business model best.