There are two types of capital that are raised: Equity or debt
Equity
This refers to capital that participates (to the extent of shareholding) in the profits or losses. Equity in many times is looked at capital that is priced at least 15-20% returns per annum
Debt
This refers to capital that asks for a fixed return independent of the profits of the business. Lower the interest rate, the more stringent the terms that come with it and more the collateral that is demanded. If the entrepreneur is very confident of a positive outcome for his project, and if the project’s forecasted cash flows show that debt is serviceable then debt can be taken. There are several innovative forms of raising debt – Working Capital finance, Sale and Lease back, Vehicle Finance, Trade Finance, Term Loan, etc.
1. When raising capital, the choice for a company is usually to raise some form of equity capital or debt capital. From an entrepreneur’s perspective, equity is the costliest source of capital, but it provides the most flexibility. Debt is cheaper in cost, but it can be very risky since regular cash payments have to be made for interest and principal repayment. Cost in this context means how much is the effective return that will be charged for that type of financing.
2. Risk
If the entrepreneur is very confident of a positive outcome for his project, and if the project’s forecasted cash flows show that debt is serviceable then debt can be taken. There are several different forms of raising debt – Working Capital finance, Sale and Lease back, Vehicle Finance, Trade Finance, Term Loan, etc.
From the perspective of the entrepreneur and the company, debt is the riskiest source of capital and equity is the safest. This is because if the future performance does not go as per plan then the company and the entrepreneur can lose the company’s assets as well as personal assets in the case of debt. In the case of equity, profits and losses are shared with the investor.
However, from the perspective of the investor, debt is the safest form of capital to invest in while equity is the riskiest. This is because a debt instrument gives the investor seniority in the rights over cash flows of the company as well as in the case of liquidation of the company.
3. Considerations for raising equity
If an entrepreneur decides to raise equity, he or she must decide what stake they are comfortable with selling in the business. A lot of entrepreneurs question whether they should sell any equity stake at all. The reason why equity sale (also called ‘dilution’) works is that the entrepreneur may land up generating larger wealth by owning a smaller stake in a larger company rather than by owning 100% in a smaller company. Larger companies have higher chances of surviving and monetizing equity stake through a company sale.
However, entrepreneurs must remember that when an equity investor invests in a company, the investor asks usually for significant rights including approving the strategy of the company, asking for a committed path to exit, non-compete provisions, etc. The larger the stake that an investor gets in a company the more rights that investor gets.
In some industries that have ‘winner take all’ characteristics, and this is particularly the case in consumer internet industries, it is essential to raise capital to try and take significant market share as soon as possible. In these industries, the entrepreneur has little choice but to raise lot of equity capital and get diluted very soon thereby being left with minority stake. In some industries, raising so much capital is not as essential. In such industries, an entrepreneur can choose to not get diluted but grow gradually and slowly.
4. Considerations for raising debt
Debt is not available to all industries. It is usually available only to companies that have steady business models, cash generating business structures, hard assets, and other forms of collateral. This is because debt investors invest only in companies that can regularly pay interest and where there is collateral available.
There are different metrics to track debt affordability for a company. While things vary from business to business, some guidelines are below.
a. Debt to EBITDA ratio should not exceed 4
b. Total debt to total equity ratio should not exceed 1
c. Interest servicing ability as indicated by DSCR should exceed 1
Some businesses are viable only if they get debt. For example, some businesses such as power plants, roads, real estate projects are usually financially viable only if debt is available. In such businesses, careful planning of cash flows has to be done.
In other businesses, debt may not be a necessity. In these businesses, debt can be used to enhance returns for the shareholders. However, if debt servicing is not planned for appropriately, then it can lead to value destruction for shareholders.
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