Capital to Meet Your Needs
Hi, it’s Thursday, I’m Jason, and welcome back to Intro to Finance where we make understanding finance easy. Thus far, we’ve spent a fair amount of time exploring the differences in cost between debt and equity. But this isn’t the only or most important reason to choose one over the other. Which brings us to today’s topic:
“Why would I use debt over equity?”
If the comparison of debt vs equity was purely based on cost, you’d be crazy to not take debt every time. However, your need for capital should be the driver for why you use one over the other. A lot of companies understand that they need cash, but they don’t have a great understanding of why.
As an individual, you wouldn’t use a credit card to purchase a house or take on a mortgage to buy your weekly groceries. Similarly, each financing product has its time and place for a business. That’s right, despite all of the one-size-fits-all marketing that seems to surround Venture Capital, every type of funding is purposefully built to meet a need. This week we’re going to explain some common funding needs you might have, and give some examples of funding options.
Seasonality
The ups and downs of sales due to seasonality can present natural funding needs. For a young, growing company, it can be hard to know where seasonality is in your business. The growth of a great product can disguise seasonal fluctuation. Use your historical data or industry peers to understand what peaks and valleys you should expect. For some, that could mean small changes in sales performance from month to month. For others, it could mean 50% or more of sales happening in just a few months a year.
The surge of demand after a lull can require more resources, such as staffing and/or inventory. Having flexibility to match the funding amount and timing can be extremely important, because the seasonal high isn’t expected to last forever. Lines of Credit are a great way to meet this need.
A Line of Credit is a loan that allows the company to borrow up to a certain amount, but the company has the option of when and how much they want to borrow. If you’re in your slow period, you don’t have to borrow anything, but you have capital available to you to finance operations between seasons and/or gear up for your crazy sales efforts.
Finding a financing partner that understands your industry and seasonal trends can allow a more customized financing that fits your business. As always, the best time to look for capital is when you don’t need it. For seasonal businesses, this means securing funding well before you start feeling the capital crunch. After a seasonal high is a good time to finalize this kind of financing. You’ll have more time because the business has slowed down, but all of the data showcases strong performance.
Grow Sales and Marketing
A fast growing business can also leave a company feeling the need for more capital. If the sales and marketing engine is working well in the business, management can naturally feel the need for more funding to grow the business faster. Each business is a bit different to assess when you might be able to say the sales motion is working. But if you have data that shows predictable customer acquisition activity, you may have a strong case to get a financier comfortable with how your business works.
While the default for funding growth over the last couple of years has been Venture Capital, there are alternative options that now exist without the loss of ownership. If your need is mostly digital ad spend, opening new channels, or hiring to support more growth, these efforts can be supported by less dilutive options. You can use your existing customer relationships to access capital, as we explored in another post. There are also more and more capital providers that are leveraging your sales efficiency numbers to offer you financing.
Many financiers are looking to finance consistent sales growth, and not just large assets like real estate and equipment. If your business continues to grow at an accelerated rate with their capital, it provides them more opportunities in the future. Unlike VCs that deploy the majority of their capital into the company at the first investment, lenders want to grow with your business and give you more and more money over time.
One example is the new wave of financiers that are focused on ecommerce companies. These capital providers assess sales performance accurately and in real time to provide funding. Ecommerce lenders typically start with smaller amounts of capital to see how their capital is performing in the business. As the funding proves to bring the desired growth, the financier will supply the business with ever-increasing amounts of capital.
New Product
Another common reason for a business to need funding is new product initiatives. Companies of all sizes decide to build or acquire new products for various reasons. Management may find that a new product can bring new revenue to smooth out seasonality in the business, supply new growth, and/or add value to grow customer relationships. Depending on the build out or process to acquire a new product, this could be a large initiative that requires product costs as well as other operational costs to support the business line. The funding requirement will largely be driven by how long it will take the product to become profitable.
Unlike short-term seasonal funding gaps, product efforts require longer-term funding structures, like term loans, to get the product to a profitable state. A term loan is debt capital that has a schedule of repayment that pays back over time. In our personal lives, we see this in mortgages – a large sum of capital that we pay back based on agreed upon rates. In the case of financing a new product, your core business would ideally only support the loan for a while. The results from the new product would support the financing costs.
Getting A Business to Work
If you’re just starting a business or still finding product/market fit and can’t bootstrap on your own, you may be limited to funding with equity. As we said before, every capital source has its place in a business – even equity financing. Debt providers need comfort that the repayment process will be met by the company without interruptions. Without numbers to show that the business has consistency or assets to repay the debt, you may be left to sell your precious, limited equity. Although the capital is expensive, it’s likely a better option than committing to immediate repayment that debt requires.
However, this still doesn’t mean you have to sign up for the time pressures and exit expectations VC can bring to your business. Equity financing at this stage can be provided by individuals and/or firms that are aligned with your vision and expectations for the business. Some individuals who may make good equity investors at this stage can be friends, family, or founders who are in a position to provide investment to the company.
While it may be difficult to understand just how much capital you need to get the flywheel going, the ever-decreasing costs of starting and running a business can help small capital infusions go a long way. Most companies don’t need a fully finished product or millions of dollars to get to a working business model. If you have to raise equity, raise what you need, and let non-dilutive capital do the rest.
World Domination
What about VC, you ask? VC is built to fund efforts that don’t have well-understood or predictable outcomes but can build businesses at an outlier pace and size. If you’re throttling the business to grow at an unnaturally accelerated rate to achieve market dominance and/or wage war in an arms race with competitors, VC is likely the option for you.
As with any capital source, the need should justify the use. For example, there’s no other way to build out the network and infrastructure to scale Fastly at the rate needed to meet the market demands without large sums of VC dollars. Companies in this position should absolutely use the funding that was purposefully built to create these outliers. But the data suggests that only .6% of companies actually have this need.
Additionally, even if you’re using Venture Capital to accelerate sales and product development to achieve market leader position, supplementing VC with other capital sources to fund specific needs can help you lower the overall cost to your business.
No Funding to Rule Them All
Your business may have one need at a time, but most likely you’ll have a combination of needs throughout the life of the business. Don’t try to use one form of capital to fund all the needs of your business. Use dedicated funding sources for dedicated efforts, and you’ll be rewarded with a healthy business and lower cost of capital.
As you can see, most of the common reasons for fundraising can be met by capital without dilution. Funding losses or something new doesn’t automatically mean VC is the right capital source for you. The reason WHY your business may need funding should drive your capital selection. And there are lots of options out there to select from.
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