Last week we introduced the various uses to which funds are put into a business. We made it clear that the use to which funds will be put into, must have bearing on the type of finance, as well as its source. Let us assume you need N20 million for a minor capacity expansion programme. Let us also say that out of the said amount, N10m is needed to purchase equipment that will last for 10 years and the other N10m will be used to procure more raw materials that will be processed into final products to be sold in cycles of three months each. So, even though the two amounts are the same, but because the purposes (uses) are different, consequently the “recovery rates” will be different, hence the type of finance for each use should be different.
Generally speaking, there are two types of funds: equity and debt.
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Equity financing: At the point you start, you may own 100 percent of your business. However, if you want to inject more capital into the business, you can sell a certain percentage of it to the investor(s) through offering of shares at an agreed price. Individuals and organisations can invest in your company if you can convince them of the proposition and the possible benefits accruable to them. By buying shares, the investors become equity holders in and part-owners of your company.
More often than not, equity investors would provide cash for the shares sold to them. But it is also possible for investors to provide other assets such as real estate, raw materials, equipment, etc. in return for the agreed stake.
There are at least a few types of equity investments that can be made. Irrespective of its type, equity financing is generally long-term, and its owners are not paid interest or other obligations as may be paid lenders. Equity financing, therefore, places the least financial burden on an organisation but is riskier than debt from the investors’ perspective. For instance, in the event that the business has to be wound up for whatever reason, the owners of the equity will be last to be paid after creditors and other liabilities are settled. Notwithstanding, equity owners expect performance and reasonable returns on their investment through dividend payout, as well as capital growth over time.
Debt financing: This means an external source such as a bank is lending you money with an obligation on your part to pay back the amount at an agreed interest rate and period.
There are different types of debts. Some are interest-bearing, while others are not or may only be interest-bearing on certain conditions. A bank loan is a straight interest-bearing debt. But with developments in non-interesting bearing financing models, institutions now also lend to fund transactions on a profit sharing basis. Regardless, neither ownership stake nor control is surrendered by the business owner(s) to the lender. However, lenders can insist on taking a charge on some assets of the business and may also put in conditions and restrictions on the activities the business may do or how it may do it.
Other liabilities that help run your business include trade credit in which raw materials’ suppliers may give you goods on credit and you are to make payment at pre-agreed price at some time in the future. Some trade suppliers will put in an interest clause such that if you fail to pay within the agreed period, you will begin to pay interest at a rate on the amount outstanding.
Prudent and wise use of debt can help create more wealth by making it possible for a company to seize opportunities that would otherwise be passed. If your business hits hard times or does not grow as fast as expected, however, debt can become really burdensome on the operations of the company.
Furthermore, if you fail to pay your debt, your lender can foreclose on not just your business assets pledged, but also your personal assets if you have given your personal guarantee for the loans extended.
Debt-equity mix: In real life, most businesses have a mix of debt and equity financing. As the owner of the business, you need to be alert to your business gearing and your debt-equity ratios. Your business gearing refers to the amount of loans funding your business. If you have too much debt, you are said to be highly geared. If you have too much debt in comparison to the equity in the business, you are said to have a high debt-equity ratio. Lenders will always look out for your gearing and debt-equity ratios whenever they are considering giving you a loan you applied for. An optimum mix of debt-equity combinations is what you have to continuously strive to maintain. Different industries tend to have different gearing levels and debt-equity mix. Regardless though, an entrepreneur must be alert to their debt-equity dynamics and the implications it has on business risks, results and reputation.
Last week and this week, we covered the uses to which funds are put in a business and the two major types of finances for a business. Next week we will take up sources of funds for your business, still on Entrepreneurship: Funding Your Business (III).
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