Risk appetite crucial in choosing debt financing options for small business

In the world of small businesses there are two sources of financing — debt and equity. But, which is a better option? Depends on your risk appetite.

Traditionally, debt financing is the preferred source of funds for start-ups and small businesses. It means borrowing money from an outside source with the promise of repaying the cash plus the agreed upon interest for a certain period. This could be banks, family or friends.

Equity financing is raising funds through the sale of shares of a business to investors. Meaning, they become partial owners of your business.

Unlike debt financing, the funds raised isn’t paid back on monthly instalments with interest. In this case, investors are entitled to share profits with high returns in the long run.

Most investors expect return on investments in five to seven years and shrewd ones have in place an exit strategy.

Be it either an initial public offering, merging with a bigger firm or as a business owner have capital to buy back the original shares from them.

Don’t forget that in the case where the business does not grow as expected they stand to lose all the money they injected into your business.
The majority of small businesses are not attracted to equity financing. Why? There are a few key reasons.

First, when you start a business you want to exercise full control but once an investor funds it you might lose that control. Also, you may find yourself digressing from the original ideas for your business.

Remember, investors want to know how their money is being spent which influences your business. The key with equity financing is to know and understand the value of the investor to your business.

Small businesses tend to forget the intrinsic value of equity shareholders. We all know banks require collateral when it comes to lending and can only finance you up to a certain amount and whether your business is making profits or not you will be required to repay the loan in monthly instalments. The bank takes up the collateral if one fails to service the loan.

Then why not seek for equity financing? With equity financing one has no monthly payments, no interest payments and no liability.

By liability we mean the investor will take the hit in case the business does not succeed not you or your family. But, in this case it’s a matter of control.

Control can be leveraged against the investor impact to your business. Equity investment should be viewed as a long term solution for injecting both cash and experience into a business.

Equity financing comes in many forms. We have angel investors, venture capitalists, initial public offering or buyouts. Each form falls in place at different stages in business.

Angel investors are individuals who invest their own money in a business, typically during the start-up phase.

Venture capitalists, on the other hand, usually fund businesses that are in the early stages of growth and invest substantial amounts. They are likely to focus on potential growth rates.

For those that invest in start-up phase tend to look more into the individual then followed by the potential growth.

Angel investors and venture capitalists seem similar, but the difference is that the latter are controlled by a firm and not an individual. Buyouts (equity) funds purchase significant portion of mature businesses with a specified exit period. That is, once they make a certain returns they exit.

As for initial public offering it depends on the nature and stage of your company. In Kenya, small medium enterprises list on the Nairobi Securities Exchange under the Growth Enterprise Market Segment to raise substantial capital while benefiting from liquidity to meet their needs.

The decision of equity versus debt financing depends on the business owners. Both have their own pros and cons. It all comes down to the stage of your company and your risk appetite.

Ms Waweru, is a financial adviser at Anchorage Limited.