When you’re faced with an opportunity to grow your business, it’s a good idea to review the financing options available to fund your expansion. Whatever your opportunity entails— whether it’s adding a new location, buying more equipment, hiring additional personnel, moving into a new market, or acquiring a competitor— the same four basic financing options apply. Let’s review each of them and look at some of the benefits to each:
Debt may be the first option that comes to mind. Even though interest rates have increased, borrowing costs are still near historic lows, making debt an attractive option. Borrowing has the benefit of not diluting the business owner’s or acquirer’s ownership interest in the expanded enterprise. If the expansion succeeds in making a good return on investment, the borrower is a big winner.
The downside to borrowing is that if the debt cannot be serviced, the company is a greater risk of failure. In short, debt increases the potential for profit, but it also increases the risk of failure.
There’s a common phrase you may have heard: “debt is cheaper than equity.” This may seem like a confusing statement, but it comes down to the fact that creditors generally demand a lower return on their investment than equity owners. Once a loan has been paid off, the financial obligation between the borrower and lender is completed. Equity holders will be entitled to their share of the company’s earnings unless and until they are bought out in the future.
While borrowing should be cheaper than equity, it’s important to keep in mind that not all debt is created equally. The most affordable debt is secured by a lien on assets, such as real estate, equipment, securities, or receivables.
Hard money lenders are sometimes willing to finance deals that banks will not, but at a price. Along with other types of higher cost financing, such as accounts receivable or credit card receivables, factoring can result in a business falling into a debt trap.
Equity—in the form of cash injected by the owners or the addition of shares issued to new investors— is the safest form of financing. Equity owners accept the business risk of the enterprise. If the business does not do well or if it fails, they are owed nothing. If the business succeeds, however, they have a claim on all of the remaining cash flow of the business after taxes, employees, and creditors have been paid. Equity is golden, and growing businesses usually seek to retain some of their earnings to build more equity.
Equity is often a critical component of the financing mix. Having sufficient equity shows the commitment of the owners to the business, and contributes to obtaining the best terms for borrowing.
Convertible equity is offered by creditors who issue subordinated debt and may also have the option to convert their debt into equity. This can be thought of as a middle ground between borrowing and issuing equity only in the form of common shares. Existing equity holders/acquirers may be able to use this approach to maintain more control over the enterprises. Issuers of the subordinated debt enjoy a higher return than other secured creditors, and some protections if the business falters.
Sale leaseback financing
Sale leaseback financing can free the cash locked up in illiquid fixed assets. Many private equity groups prefer not to own fixed assets. Selling real estate and equipment and leasing it back can be an innovative financing alternative. Opportunities to liquidate assets are sometimes identified in a merger or acquisition deal, or they might just help finance business expansion and organic growth.
The right choice (or combination of choices) of financing will be different for each opportunity. Debt costs are still relatively low, and locking in today’s rates might be a long-term advantage. Short-term bridge loans can get a deal done more quickly, allowing time for a permanent financing structure to be established. Business owners should engage with qualified merger and acquisition consultants and CPAs for guidance.
Financing is available for well-managed businesses and sound acquisition deals. Low financing costs and economic growth should lead to more opportunities. If you have questions about any of these issues, or would like some guidance and perspective, by all means talk to your banker. They’ll be able to help you find the right financing option for your next big growth opportunity.