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 Thomson Financial 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) 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. In general, debt financing 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 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, both of which are secured by the assets of the company), subordinated debt (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 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, 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 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, 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 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 [e-mail].