Outside Capital: What Are You Really Giving Up in Return?

As professional services founders, we all understand that in the course of founding and scaling a business, there are times when an infusion of cash becomes helpful, if not crucial: funding a hiring surge, acquiring a competitor or bridging a gap before a large retainer kicks in, just to name a few examples.

Those of us who have actively sought capital have faced a spectrum of choices that range from reducing partner-level compensation to seeking a bank loan to pursuing private investment.

All these options have their benefits and drawbacks, but in general, squeezing compensation can be awkward and limited, loans follow contract terms to their eventual repayment, and private investment creates new, initially-silent partners who actually have a permanent voice in how a business is run. For founders, any new capital-oriented relationships require careful, ongoing management.

At my firm, we help clients with transformative, capital-related decisions. I’m offering these thoughts not as an advertisement but for the benefit of the community, and they dwell on the dynamics of working with lenders vs outside investors.

Debt vs. equity capital

Entrepreneurs in need of operating capital often prefer debt over equity financing because it’s less expensive and preserves a business’s current ownership structure. 

• Taking on debt using an illiquid asset as collateral, such as accounts receivable or owned office space, provides liquidity that can bring much greater flexibility to a business than if the capital had simply remained tied up in the asset itself.
• Although this collateral could become the lender’s property if the business defaults on its obligation to repay its loan, the lender only has a limited connection to the business to which it has provided capital.
• The lender has no influence on business management decisions and doesn’t share in future profits or losses.
• Once the debt is repaid, the business and the lender’s relationship typically pauses until the next time the business has a need.

It’s a much more consequential decision for a business to receive financing from an equity investor, which becomes a partner in the business.

• While there are no monthly debt payments for the business founder to worry about, the investor shares in all profits going forward and, along with the founder(s), absorbs any losses.
• Because of this, investors have a vested interest in the company succeeding and will exert pressure if they feel the business is not being run in the right way.
• Investors may bring business experience or connections that can help a growing business gain traction.

Factors to consider 

If you’re stuck trying to decide how to fund rapid growth or major changes in your business, it can be helpful to consider these questions:

1. Could you relieve your cash flow needs by other means? If sales are low or expenses are high, you may be able to strengthen your business’s financial position and avoid the need for capital through some belt-tightening or restructuring. If you’re in an industry with creditworthy customers who are slow with payments, another alternative to consider is selling those invoices to a factoring company in exchange for immediate cash.
2. What outcome are you expecting with an infusion of cash? In short, are your goals realistic? Will capital make a noticeable enough improvement on your business that you can repay a lender? What level of risk is the lender or investor taking on? Is that risk level justified by your business’s prospects? You must be able to tell your capital provider a convincing story of how you plan to repay this capital over time.
3. How would you reduce your capital provider’s risk? For a bank, the value of the collateral you provide will be one of the biggest factors in your ability to get a loan. An equity investor, on the other hand, might be more likely to provide upfront financing for sales and marketing costs involved in landing a major contract. In return, they might want to prioritize efficient sales processes and would have a clear understanding of how the economics of long-term contracts could benefit them.

Regardless of the capital source you end up choosing, there’s always a tradeoff required. Debt commits a portion of your company’s future earnings toward payments, while equity chips away at your autonomy as leader of your business.

If you’re in the midst of navigating this decision, one of the most valuable tools at your disposal might be your fellow Collective 54 members. Feel free to contact me through the portal if I can be of help by offering my own perspective.