What's the best financing alternative for your company?In today's capital markets environment, emerging companies have more choices than ever when it comes to financing their growth. A long period of low interest rates and strong economic growth has resulted in plentiful liquidity in both the debt and equity markets. In 2005, for instance, non-financial corporate business borrowing rose dramatically to $289 billion, compared to $174 billion in 2004 and $85 billion in 2003.
At the same time, venture capital and buyout firms continue to raise record-breaking amounts of capital for private equity investment. According to according to
1. As stated or indicated by; on the authority of: according to historians.
2. In keeping with: according to instructions.
3. Thomson Financial Thomson Financial
A major provider of information, analytical tools, and consulting services to the financial community. The firm, a division of Thomson Corporation, is best known to investors for its First Call segment, which publishes consensus earnings and the National Venture Capital Association, the second quarter of 2006 saw $11.2 billion in capital raised, the most since the first quarter of 2001.
For many growing companies, these favorable market conditions represent an opportunity to seek capital for expansion, provide liquidity for shareholders and founders and prepare for an eventual initial public offering (IPO (Initial Public Offering) The first time a company offers shares of stock to the public. While not a computer term per se, many founders, employees and insiders of computer companies have found this acronym more exciting than any tech term they ever heard. ) or a strategic sale. With capital so plentiful, it is more important than ever to determine the most appropriate form of financing for your company.
Equity or Debt?
An important decision is whether to seek debt or equity financing Equity Financing
The act of raising money for company activities by selling common or preferred stock to individual or institutional investors. In return for the money paid, shareholders receive ownership interests in the corporation. . In general, debt financing Debt Financing
When a firm raises money for working capital or capital expenditures by selling bonds, bills, or notes to individual and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise to repay is less costly on an absolute basis. However, debt is not "permanent capital," as it must be repaid over time. Furthermore, while your company will take on the fixed costs fixed costs,
n.pl the costs that do not change to meet fluctuations in enrollment or in use of services (e.g., salaries, rent, business license fees, and depreciation). of interest and principal payments, stockholders will not give up significant equity ownership, and the lender will typically take no role in managing the company--unless, of course, your company defaults on its obligations.
Various forms of debt include senior debt (either a term loan or a revolving line of credit Revolving line of credit
A bank line of credit on which the customer pays a commitment fee and can take and repay funds at will. Normally a revolving LOC involves a firm commitment from the bank for a period of several years. , both of which are secured by the assets of the company), subordinated debt Subordinated Debt
A loan (or security) that ranks below other loans (or securities) with regard to claims on assets or earnings. Also known as "junior security" or "subordinated loan". (typically unsecured) and a variety of new instruments that have recently evolved to meet the needs of emerging companies.
These include "venture" debt, a form of senior debt provided to riskier, less creditworthy cred·it·wor·thy
Having an acceptable credit rating.
credit·wor borrowers (even pre-revenue companies) where the lender will seek warrants or other equity participation, as well as "second-lien" senior debt and other forms of asset-backed financing (see cover story of the September issue, "Second-Lien Lending Rides a Gusher").
Senior secured debt is usually the least expensive option, with a cost of capital typically based on the lender's prime rate or a spread over LIBOR LIBOR
See: London Interbank Offered Rate
See London interbank offered rate (LIBOR). , the London Inter-bank Offered Rate. Subordinated debt, by contrast, will most often target an internal rate of return in the mid-teens to low twenties. With subordinated debt, however, you usually only pay interest for the first few years, then repay all of the principal at maturity five to seven years from the original date of the loan.
Private equity is fundamentally different from debt. By definition, private equity involves the exchange of permanent equity capital for ownership. Investors will purchase anywhere between 10 percent and 100 percent of the company. Private equity investors typically require that your company grant board representation and a voice in strategic decisions.
These partners may be helpful in developing long-term strategy, recruiting new senior staff, establishing a seasoned independent board, evaluating potential acquisitions, developing stronger financial systems and controls, as well as preparing your company for an eventual IPO or sale.
Another advantage of private equity is that, unlike some forms of debt, it can be used to provide personal liquidity for business owners. This, in turn, allows them to diversify their net worth, thus reducing their overall exposure to a concentration of risk.
A Financing Checklist
Companies often require different forms of capital at different stages of their development. Initially, many will finance their growth with personal assets, credit card debt Credit card debt is an example of unsecured consumer debt, accessed through ISO 7810 plastic credit cards.
Debt results when a client of a credit card company purchases an item or service through the card system. and bank loans. However, many successful companies will reach a stage at which their internal resources may be hindering their ability to grow. When your company reaches such an inflection point Inflection Point
An event that changes the way we think and act.
-Andy Grove, Founder of Intel.
For example, the fall of the Berlin Wall was an inflection point in global politics and the commercialization of the Internet was an inflection point in technology. , you need to decide whether debt or equity capital is the best option.
Choosing the right financing vehicle requires careful consideration of your company's business, goals and willingness to involve an active, experienced financial partner. The current capital markets environment has expanded the range of financing possibilities, making both debt and equity capital more available to small and midsized businesses than in the past. Since capital markets are dynamic, however, the cost and availability of capital can change quickly.
Peter Y. Chung is a Managing Partner in the Palo Alto Palo Alto, city, California
Palo Alto (păl`ō ăl`tō), city (1990 pop. 55,900), Santa Clara co., W Calif.; inc. 1894. Although primarily residential, Palo Alto has aerospace, electronics, and advanced research industries. office of Summit Partners, a private equity and venture capital firm with offices in Palo Alto, Boston and London. He can be reached at 650.614.6701 or firstname.lastname@example.org.