Financing Your Business-What’s The Difference Between Debt And Equity?

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There are two kinds of capital: debt and equity. Both kinds are typically used by a company during its lifetime. Lenders have different objectives than investors and therefore look at different factors about a company when deciding whether or not to invest or make a loan.

Debt

Debt is money borrowed, which must be repaid at a set time period and generates income for the lender over that time period. Lending sources include not only banks, but also leasing companies, factoring companies and even individuals.

Lending sources look primarily at two factors: how risky the loan is; and whether the company can generate sufficient cash to pay the interest and repay the principal. The growth potential of the company is secondary; the primary considerations are the track record and asset base of the company. Usually the debt must be secured against the assets of the company and very commonly must also be secured against the assets of the owner of the company, also called a personal guarantee.

Assets of the company are not usually given full book value in securing a loan. In other words, if your inventory has a book value of $50,000 (or it cost you $50,000 to produce that inventory) a lending source will only give you 50% to 75% of that value. The reason is that the lending source is not in your business and would have to quickly liquidate the inventory, rather than selling it at market prices.

Accounts receivable, or money that is owed to you from customers who have previously purchased your product but not paid for it yet, are also discounted. Using the same example, $50,000 worth of accounts receivable may only be worth 60% to 70% of that value to the lending source. Customers may not pay the full amount owed, or feel they have to pay for the product at all, if an outside lending source is demanding payment. And so on….with equipment, land, buildings, furniture, fixtures and what ever other assets the company has, the same general rule applies.

The lender often requests that the personal assets of the owner of the company are pledged as a contingency and as a gesture of faith by the owner. Obviously, if the owner of the company does not believe in his/her own company’s ability to repay the loan, why should the lending source?

Equity

Equity capital is money given for a share of ownership of the company. Equity can be provided by individual investors, sometimes known as “angels”, venture capital companies, joint venture partners, and the sweat equity and capital contribution of the founders of the company. Equity providers are more interested in the growth potential of the company. Their objective is to invest an amount now and reap the rewards of a 5 to 1, or even 10 to 1, payoff in three to five years. In other words $100,000 now will be worth $1,000,000 in three years if invested in the right company.

Since the objectives of investors are different from lenders, the factors they evaluate in determining whether to invest are different from lending sources. Investors like to put money in companies that have the potential for rapid growth. Growth potential is based on the quality of management of the company, product brand strength, barriers of entry to competitors and size of the market for the product.

Source by Dee Power

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