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2.4 Sort Through the Pros and Cons
Advantages and Disadvantages for the Entrepreneur
As you've seen, there are many options for funding your business's
expansion. And each option has pros and cons to consider. Choose the
type of funding you are interested in to learn about its advantages
and disadvantages.
Risk Capital Long-Term Financing
Conventional Long-Term Financing
Risk Capital Short-Term Financing
Conventional Short-Term Financing
Equity
Advantages
- Low financial risk. No obligations for cash payment.
- No restrictive covenants that could cause default.
- Provides stability and permanency.
- Investors generally seek to realize on their equity investment in the
marketplace (i.e. at no cash cost to the company).
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Disadvantages
- Dividends are not tax deductible.
- Dilutes your equity interest.
- Takes time to access.
- Loss of voting and, potentially, management control.
- Set-up costs are high.
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Subordinated debt
Advantages
- Flexible and can be tailored.
- Less expensive than equity.
- Fills a financing gap and high leverage is available.
- Not as much dilution as straight equity.
- Available to a variety of industries.
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Disadvantages
- Takes time to access.
- Expensive relative to other sources of short- and long-term financing.
- Some cash flow servicing requirements.
- Investors will take a more active role in your company than other lenders.
- Set-up costs are high.
- Restrictive covenants often apply.
- Does not provide the stability of equity.
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Term loans
Advantages
- Longer repayment terms.
- Easy access.
- Flexibility.
- Tax deductibility of interest.
- Suitable for long-term needs: permanent current assets and fixed assets.
- Low cost relative to other long-term sources of financing.
- Commits the lender for a long term.
- Does not dilute equity.
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Disadvantages
- Ties up your assets.
- Increases your financial risk given the cash payments of interest and
principal.
- Commits you: prepayment will be subject to penalties.
- Often includes restrictive covenants.
- You may not have suitable security to offer, or your
business/financial risk may be too high.
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Leasing
Advantages
- Up to 100% of the asset cost can be financed.
- Terms may be longer than term loans because you can tailor the lease to the
life of the asset.
- Maintenance and other services are provided.
- Cancellation options are available. This may be beneficial where technology
is advancing quickly.
- Lease payments are tax deductible.
- The cost may be comparable to a term loan (the lease payments will include
an implied rate of interest), but the legal cost to set the lease up should be
less.
- Limited restrictive covenants.
- Does not dilute equity.
- Flexibility. You may have limited needs (e.g. two years) but the asset life
is less than 10 years. You can structure the lease around your limited needs.
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Disadvantages
- If you default on your payments, it is quite easy for the lessor to walk in
and legally remove a potentially critical piece of equipment used in your
operation since the lessor owns the equipment.
- Increases the financial risk due to the fixed stream of cash payments.
- Cancellation costs are high.
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Mortgage financing
Advantages
- Long-term commitment, without equity dilution.
- Maturity matches the long life of the asset.
- Interest is tax deductible.
- Relatively inexpensive source of long-term financing.
- Easy to access.
- Considers the value of the asset, more than the value of the business.
- Standard documentation requirements. Restrictive covenants will be basic.
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Disadvantages
- Fairly rigid instrument.
- Increases financial risk due to fixed stream of interest and principal
repayments.
- Committed, repayment will hold penalties.
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Asset-based
Advantages
- Ideal for growing, highly leveraged and turnaround situations, because of
the higher level of risk assumed by the lender.
- No complicated financial covenants, which require monitoring and compliance. This results in less
chance of default under a loan agreement.
- Given the heavy reliance on the value of the collateral, it increases the
opportunity for leverage.
- Lowers the need to raise equity, avoiding equity dilution.
- Interest is tax deductible.
- Easy to access.
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Disadvantages
- Not suitable for all industries; needs high levels of receivables and
inventories.
- Increases your financial risk, due to interest servicing.
- More expensive than conventional short-term financing.
- Onerous inventory and receivables monitoring requirements, sometimes as
often as daily.
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Factoring
Advantages
- Factors assume the risk of your receivables but not your business/financial
risk. Therefore, financing is accessible even if your company's overall risk is
relatively high.
- Increases the turnover of your accounts receivable, in turn increasing the
amount of available working capital and, therefore, reduces other financing
requirements.
- Lowers administrative duties and costs. The factor may assume collection,
booking and reporting.
- May protect your company against bad debts.
- Suitable to finance temporary working capital and offset permanent current
asset requirements.
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Disadvantages
- If the volume of your receivables is low, your situation may not be suitable.
- Relatively expensive, particularly when invoices are numerous and small in dollar
amounts.
- Not commonly accepted in many industries.
- Not suitable for most long-term needs.
- Possible negative impact on customer relationships.
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Bank line of credit
Advantages
- Easy and fairly quick to access.
- Relatively inexpensive.
- Flexible.
- Facility revolves up and down, maximizes cash management.
- Suitable for short-term temporary needs.
- Usually, reporting requests are minimal.
- Negligible effect on control and ownership.
- Interest/fees are tax deductible.
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Disadvantages
- Increases your financial risk, cash servicing required.
- Amount available is limited by the ceiling.
- If you are experiencing problems, lender is in a position to demand/cancel
the line, or realize on the security.
- Not suitable for long-term requirements, where you expect returns over a
long period.
- You may not have suitable security, or your business/financial risk may be
too high.
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Supplier credit
Advantages
- Very inexpensive source of financing.
- Very limited documentation required.
- Easy access.
- No costs.
- No controls.
- No security.
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Disadvantages
- Likely not sufficient to bridge fully the timing difference between paying
for supplies and receiving cash from sales.
- Very short term in nature.
- If you do not pay on time, the supplier might cut off future supplies, which
could have adverse effects on your business.
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Exchanging Control for Growth Potential
Many entrepreneurs may be reluctant to make the concessions
needed to obtain venture capital, but not the owner of Bfound.com.
He understood that in order to take the company to the next
level, he would have to give up some control. He then had to
convince his partners that this was the right path. As one partner
put it, giving up some control of the company requires a shift
in mindset.
But Bfound.com wanted more than money. It was looking for a
partner who would invest knowledge and contacts. Unlike some
entrepreneurs who may be nervous about taking on an active investor,
Bfound.com appreciated the advantages that such a partnership
could bring.
In the end, Bfound.com's owners found that giving up some control
let them acquire the capital they needed. The company succeeded
in three rounds of financing. In the first round an active private
investor brought in management expertise and $750,000 to fuel
Bfound.com's near-term growth. In the second round two private
investors and a venture capital firm provided $1 million. In
the third and final round Bfound.com was bought, for an undisclosed
sum, by a large U.S.-based software applications developer.
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