A company’s existence depends heavily on financing. Whether they are public or private limited companies, all businesses are founded to make profits. Greater growth is key to increased revenue, and businesses globally strive to achieve greater growth by scaling up operations.
The list of reasons why businesses seek financing is extensive; however, a common misconception among non-business savvy individuals is that businesses typically seek financing because they may have suffered a revenue loss and are looking for funding to scale up from the loss. This idea that a company’s losses will necessitate financing is false, and as you will learn by reading this article, it is also impossible. No investor ever invests into a company that constantly records losses; it is not worth the risk.
Globally, equity financing and debt financing are the two primary methods of sourcing funding for businesses. Choosing the best financing strategy has become a problem for businesses looking to raise capital. A hybrid financing model, which applies both equity and debt financing, is another technique available to businesses.
This study examines potential financing options and the steps to follow in selecting the best financing method for your business.
Steps to selecting a suitable financing option for a company
It is generally acknowledged that deciding which financing option is best for a company is the first step to financing.
When a business offers shares in exchange for investment, this is known as equity financing. In this case, the investor becomes a shareholder in the company and is not entitled to the return of their money with interest. The shareholder is entitled to dividends on his share, though, after the directors have declared them.
As opposed to equity financing, debt financing involves a loan structure. In this case, the investor’s money is returned along with the interest that is due on the debt. The investor does not hold any stock or have any involvement in the operations of the company.
While some options are more favourable for the funding of certain companies, others are not. The best course of action is to consult professionals before choosing the funding style you intend to take. It’s important to understand the conditions to watch out for when raising money for businesses.
1. The investor’s expertise
When deciding whether to use an equity financing strategy or a debt financing strategy, the investor’s expertise is a key factor. An investor with extensive knowledge of corporate management or the industry practice in which the company operates is attractive, hence the adoption of equity financing by the company.
It is obvious why a company will choose equity financing over debt financing in such a case: the investor can contribute his expertise to the company’s success.
For instance, a company choosing to invest in their company with Aliko Dangote, the richest man in Africa, would probably prefer the equity financing option due to Dangote’s track record of successful business management.
2. The nature of the product or service the company offers
A debt financing option might be the most effective for raising capital if the company provides a cutting-edge product or service that is new to the market. While raising capital, the business founders can maintain control of their product or service by using debt financing.
If given shares in the company, high-net-worth investors would probably jump at the chance to seize control of it. Investors may view the company from a variety of perspectives and aim to control the earnings in the future. A debt financing strategy would preserve the company’s management structure.
3. The duration of the project
The length of time needed to complete the proposed project is crucial to selecting a financing method. Equity financing projects are likely to be chosen for projects that take longer to complete. Businesses use planning strategies to their advantage.
It can be very risky for the business to have a long-lasting project and debt financing, especially if the company doesn’t generate much revenue annually.
For instance, if a Nigerian business requests funding to build a factory in Kenya, it will probably take years to complete the project. If the factory construction process takes five years and the funds needed to complete it were borrowed and due after that time, there would be interest due at the end of each year the loan is outstanding, which may likely lead to insolvency.
Even more damaging is the fact that the company hasn’t yet begun operating in Kenya, for which they obtained the loan, but has already begun paying the loan’s excessive interest.
This is similar to the Dangote Refinery, which began construction in 2016. The Dangote management sought a $3.4 billion loan from the Nigerian National Petroleum Corporation (NNPC) in 2021, and the management opted for a 20% equity stake in the refinery as a consideration for the investment.
As of the date this work was published, the Dangote refinery is yet to be completed. The adoption of the equity financing method by Dangote saved the company millions of dollars in interest payable from 2021 to this date if the company had opted for a debt financing structure.
4. The amount of funding
Equity financing is more appropriate for funding larger amounts. The likelihood of the business paying the interest and the principal sum increases with the small size of the loan offered. For instance, a business with a 20 million dollar annual revenue seeking a 15 million dollar investment will be wary of using a debt financing structure.
The market’s shifting demand for a company’s shares affects the share price of that company. Companies can take advantage of the high demand for their shares to increase the price at which they are sold, giving investors a considerable equity stake while still receiving the necessary funding.
The majority of establishments’ routine business operations include raising capital. Companies look to leverage debt or equity financing models to gain additional capital if growth prospects look promising.
The information above is a checklist to help businesses select a financing strategy. Nevertheless, the agreed-upon financing method is a joint effort between the company and the investor, with the investor typically having the most sway in the decision.
Frequently Asked Questions (FAQS)
Not at all; the point of financing is for the investor to make profits off of their investment. Investing in a business at a loss is a high-risk strategy.
Banks, financing institutions, and high-net-worth individuals are some of the various investors one can approach for funding.