The essentials of debt and equity financing.
By Marty McGhie
* Traditional debt financing: This type of financing is usually done through a bank or credit union. As with lease financing, traditional financing will typically tie the term of the loan to the useful life of the asset. Options here often include fixed or variable rates, balloon payments, prepayment clauses (usually after a fixed amount of time), refinance options, and other choices.
Having the flexibility in a financial instrument can become a significant advantage when financing assets, particularly equipment. If you decide to sell off older equipment for new and the debt term isn’t complete, a flexible loan can make it a much easier deal to pull off.
But as I mentioned earlier, traditional financing will probably require more stringent covenants. Unless you have well-established banking relationships with outstanding credit, you will likely have to pledge business collateral such as cash, accounts receivables, inventory, and possibly personal guarantees. These types of restrictions can also affect future financing needs if your current assets are already pledged.
* Line of credit: An established line of credit with a lending institution is often utilized when operating capital is needed. A line of credit can be used to smooth out the peaks and valleys of cash flow; in addition, a line of credit can be used for equipment financing. For instance, last year our company knew we would be investing in three or four different pieces of equipment at different times. With that in mind, we established an equipment line of credit with our bank for a fixed amount that would cover all of the equipment costs. As a result, when it came time to purchase the different pieces of equipment, the financing was already in place.
As the above description illustrates, a line of credit provides flexibility in terms of when you need to use it and how often. You can often negotiate some flexible terms with a line, such as variable rates and waivers of prepayment penalties. A line of credit carries with it the same disadvantages as traditional debt financing: more stringent covenants.
Equity: a blessing and a curse
Using equity instead of debt to obtain capital requires a very different business philosophy. Essentially there are two types of equity, inside money (meaning your own), and outside money.