Equity vs. Debt: how should entrepreneurs be funding their business ventures?
Provided by Business Partners Ltd, South Africa's leading investor in SMEs
During the process of securing funding, entrepreneurs and business owners are not always aware of the pros and cons associated with asking for too much or too little finance for their business, or whether they should consider debt or equity to fund their business.
This is according to Gerrie van Biljon, executive director at Business Partners Limited (BUSINESS/PARTNERS), a leading risk financier for SMEs in South Africa, who says that entrepreneurs should be cautious of the amount of finance they apply for, as the wrong amount could jeopardise their business’ success.
He explains that while applying for too little funding may not satisfy the financial needs of the business, securing funding in excess of what is required will put additional pressure on the cash flow of the business. “This debt needs to be repaid to the lender, and the more debt the business is in, the higher the repayment will be.”
There is also the risk of the business owner being tempted to utilise the additional funds for private use, says van Biljon. “Obtaining too much money could lead to the improper use of the additional funds suddenly becoming available to the business owner. This money is also very likely to be spent on unnecessary items that will not necessarily improve the position of the business.”
Van Biljon adds that asking for too much funding can also hinder an entrepreneur’s approval rate for finance. “Should an entrepreneur apply for an amount that the financier believes is unjustified, the possibility exists that the application will be rejected. This could be for a few reasons, such as the financier not being confident that the entrepreneur is familiar with his/her financial position and the needs of the business, or that the applicant is not fully transparent on the proposed application of funds.”
The financial needs of a business stem from either its current position, or the proposed plans for the business, such as expansion, increasing capacity, acquisitions or capital to develop a new product range.
“When applying for finance, an entrepreneur should be very clear on the position and strategy of the business as this will determine what type of funding is appropriate for the business. For example - is short or long term finance more suitable or should the finance be in the form of debt or equity,” says van Biljon.
Bringing an investor into the business usually implies that equity will be introduced and that the investor will obtain a shareholding in the business. Van Biljon says that although this format of funding has the advantage of no fixed repayment terms, in the process the entrepreneur parts with a portion of ownership of their business. “When opting to go with this finance option, selecting an investor should be done with caution, and both parties should agree on what their expectations are.”
He cautions businesses with high growth potential regarding taking more funding that what is required. “Investors may offer the entrepreneur more funding than what is required, which will result in the investor obtaining a larger shareholding in the business. Introducing this equity may be a very expensive exercise should the entrepreneur decide to buy the investors’ shares at a later stage, as this figure could be inflated due to the growth that the company has experienced.”
He warns that although entrepreneurs may be tempted to spend any additional funds available, they need to understand the potentially dangerous long term effects of utilising these funds, and instead carefully allocate funding to items that will grow the business.
“During the process of establishing what type of funding is appropriate, professional advice is recommended as not all entrepreneurs are financially orientated or familiar with the financial principles. Sound, professional advice will guide and steer the entrepreneur to the most suited solution for their particular needs,” concludes van Biljon.
For professional guidance on funding, entrepreneurs can contact the BUSINESS/PARTNERS Entrepreneurs Growth Centre on 0861 SMEFIN (0861 763 346) or email firstname.lastname@example.org for free support and guidance from experienced and seasoned mentors.
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