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Financial Literacy

Between loan and equity funding, which is best for startups?

Loan and equity are both viable means of funding businesses. Entrepreneurs choose either or the bother of them, depending on what works best for them.

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Loan and Equity funding
  • Loan and equity are both viable means of funding businesses
  • Some business owners choose either or the bother of them, depending on what works best
  • Loan and equity also have peculiar advantages and disadvantages
  • Read further to see our financial experts’ insights on this topic

In the early 2000s when Charles chose to resign from his high-salaried bank job to pursue his interest in fashion, he knew for sure that he was doing the right thing. At the time, some of his friends were opting to leave Nigeria altogether for greener pastures elsewhere. He could have done the same thing but chose to stay.

This wasn’t an easy decision by any means because it came with many challenges. As an entrepreneur, Charles had to solve a whole lot of problems all by himself; including funding his business. Although his experience in the financial services sector helped out in this regard, he still had some difficulty deciding on the best funding option for his business.

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Funding has long been one of the biggest challenges facing entrepreneurs around the world. It goes beyond merely finding the money, to include knowing the right form of funding to seek. This is very important because oftentimes, the difference between a successful startup and a failed one lies in how the seed-funding is secured.

Loan versus Equity Investment

These are the two main types of credit facilities available to entrepreneurs and startups. When it comes to loans, an entrepreneur can raise debt by borrowing money which must be paid back to the lender (with interest) after a specific duration. Loans can be accessed from the likes of banks, credit unions, finance companies, etc.

Equity funding, on the other hand, basically entails selling a portion of one’s stakes in the business to equity investors who are willing to help you raise much-needed funding.

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The pros and cons

Now, both loan and equity have their respective advantages and disadvantages. As mentioned earlier, there really is no one-size-fits-all approach to securing funding. However, bearing in mind the advantages and disadvantages of each funding type and knowing fully well the aims and objectives of a startup will better guide the entrepreneur into choosing what works best for them.

Tax Waivers for startups - Emotional intelligence

Loan, for instance, can enable the entrepreneur to secure immediate funding without necessarily letting go of full ownership of the business. Therefore, assuming that Charles who was mentioned earlier, had chosen to raise debt to finance his fashion business, he would have been able to, among other things:

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  • Access funding faster and because loan is faster than equity funding
  • Retain ownership and control
  • Make all the decisions without external interference
  • Forget about his liability forever once his debt is offset
  • Interests paid on his loan would be tax-deductible
  • Generally, debt financing is cheaper for the very fact that you get to retain full ownership.

[READ: Extramile Africa to drive financial inclusion with N4 million soft loans]

On the flip side, getting a loan to fund your business can also come with some disadvantages. According to Investopedia, “debt financing sometimes comes with restrictions on the company’s activities that may prevent it from taking advantage of opportunities outside the realm of its core business.”

More so, the inability/failure to pay back a loan as at when due is generally bad for anybody’s credit score. It may also attract extra charges.

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Meanwhile, equity also has some advantages which can not be ignored. First of all, the entrepreneur is under no obligation to pay back the funding. What this means, therefore, is that he/she will have more money to run the business without thinking about how to pay monthly interests.

However, the very fact that this type of funding requires giving up a percentage of one’s stake in a business is something a lot of entrepreneurs have issues with. Charles, for instance, was very worried that he may eventually lose control of the creative vision he had for his business. This alone informed the final decision he took.

This is a serious concern, particularly so at a point when a business is just starting out. After all, nobody can really understand the vision of a company than the person that founded out. And when he/she has to give up control just to raise funding, it becomes problematic.

[READ: BoI’s disbursements to businesses increased by 130% in FY 2018]

Another disadvantage is that equity funding is not really easy to access. Around the world, equity investors are very choosy when deciding on whether to invest their money in a particular business or the other. In Nigeria, we do not even have a lot of them as much as we have lenders. Therefore, their scarcity in itself is a problem. Perhaps it is all for the best after all.

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What the experts are saying

Opinions were, unsurprisingly, split among the experts we interviewed in the course of researching this article. Although financial expert, Kalu Aja, acknowledged that both have advantages and disadvantages, he did add that “Capital Assets Pricing Model says equity is more expensive than debt”.

Once again, imagine giving up a significant portion of your ownership in a business to someone (or a set of people) whose strategic direction may not even align with yours. That’s right, equity funding is expensive!

[READ: Meet Sola Akinlade, co-founder of Nigeria’s foremost payment platform Paystack]

Segun Olarinmoye believes that there is no wrong or right answer when trying to decide which is the best between equity funding and loans.

“There is no right or wrong answer. There are different types of startups and different scenarios, you have to choose what fits that particular scenario. Looking at the big picture if you know what you are doing debt can be cheaper.

“In terms of equity, for example, if you aren’t making any profit for years your shareholders can still be with you. That can happen in debt which requires frequent payment. See a business like Amazon or Jumia they haven’t been making a profit but they ultimately will in the future so if you believe in the dream equity offers you that flexibility to invest.”

On the other hand, a financial expert at Investment One, who chose not to be mentioned, said that equity funding is the best. He gave reasons for his belief;

“Generally speaking, Equity is best. This is because startups usually don’t have the capacity to repay loans at their early stage of existence (particularly early-stage startups); both from the standpoint of cash flow maintenance and the standpoint of revenue generation capacity.

“Equity affords them freedom from the frequent outflows resulting from interest and principal repayments. Also, equity tends to be accompanied by management expertise and social capital (i.e. networking) from the investor.

“There is an argument, however, that loans make startup Founders sit up; in that realising that they have financial obligations make them prudent and motivates them to work hard. But honestly, this isn’t the best way to motivate founders.”

Lastly, Chu Achara, a banker at First Bank of Nigeria, also believes that equity funding is the best for a startup. However, he believes that “as the business grows, a loan may be used because theoretically, loans are cheaper.”

In conclusion, it is the entrepreneur that will eventually have to decide which funding option works best for them. However, it is important to consider the pros and cons before making any such decision. Left for the authour of this article, however, loans would do just fine; especially during the early stages of a business. By the way, Charles eventually made do with a loan, just in case you are wondering.

Patricia

Emmanuel covers the financial services sector for Nairametrics. Do you have a scoop for him? Well then, contact him via his email- [email protected]

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Investment Tips

What bad stocks have in common with bitter relationships 

The feeling you get from marrying the wrong partner is similar to that felt after buying the wrong stocks.

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I have always argued that stocks cannot be summarised into one statement for a newbie, until recently when a friend told me that it could.  

“Simply put, buying stocks can be likened to relationships, he said.  

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did not immediately agreebut over the next few minutes, he explained to me what he meant, and drew several analogies to back his claims.  

While he is no expert, I understand that he has drawn his conclusion from his experience buying stocks for himself over the past 5 years, so I took his points seriously. These points have been summarised in this article. 

READ MORE: Cocoa prices melt lower as COVID-19 weakens demand 

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When it crashes, there is no telling how far it can go  

My friend mentioned of some company’s stock he bought in 2016 in the hope of selling short-term. At the time he bought, there was a dip and he expected things to pick up within some months so he could sell-off.  

Two years later, the stock price had plummeted 50% down from the price at which he bought. Without saying, he became a long-term investor because he was not ready to sell off at a loss.  

 

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How does this liken to being in a bad relationship?

As the value plummets, you keep hoping it will rise again and then before you know it you are stuck for the long haul. Same thing can happen with a wrong partner. You remain there hoping things will be better but it gets worse. 

It could happen sometimes that a company’s stock market price comes crashing and it never goes back to where it was againThe factors which triggered its fall, may not even be able to return it to its starting price.  

 

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The stock price is not indicative of the company’s profitability 

For some reason, there are company stocks market prices that remain low year after year despite the billions declared in profits, and the dividends paid out to shareholders.  

Sometimes, the stock market price could still slump even when the company has positive records in its financials. Market experts are not always able to explain this, but it remains true. Some of the most profitable stocks are undervalued.  

 

You can never take stocks at face value

That a stock has been on an upward trend in the last few months does not mean it will remain so. One must always consider several other factors before purchasing a stock.  

While it is important to look at past performance, there are other things that could point to the likely future of such stocks. 

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Say, for instance, the company has just announced a new board chairman who was implicated in some fraud cases in the past. It doesn’t matter how well the stocks have performed in the last 365 days, or the chairman’s competence, the stock prices are most likely to slump due to loss of investor confidence.  

There was a recent case where the CEO of an internet service provider company was alleged to have been involved in sexual harassment, and was eventually pressured by shareholders to resign. The pressure came not necessarily because they thought he was guilty, but because of the implications on the company.  

You have to probe to discover the real qualities.  

 

The most expensive stocks are not necessarily the best. 

If you ever heard a stock described as under-priced or over-valued, then you should understand that the price you pay is not necessarily suggestive of the value.  

Some great stocks, with good potentials, high liquidity, good company profile and adherence to corporate governance ethics, are not as expensive as they should be. While some other stocks are ridiculously overpriced, even when they do not have as much promise. Some of these overpriced stocks could still be basking in past glory or just positive media hype.  

This explains why investors must conduct due diligence before putting in their hard-earned money. Sometimes the media hype around a company’s stock might not be giving you all the information you need to make a decision, so you necessarily have to go the extra mile.  

Subscribe to newsletters from financial news websites if you need to, take courses if you have to, but ensure to learn all you can.  

Remember price is what you pay for the stock, but value is what it is really worth, and there is no law stating that one must justify the other.  

READ MORE: Global stocks records astronomical gains in Q2 2020

When you get the wrong stocks, you get stuck! 

You know that feeling when you are sure that you have made the wrong choice, but also know that there is no way out? That’s the feeling you get when you marry the wrong partner, as my friend said. And that’s the same feeling you get when you get the wrong stocks.  

You simply get stuck.  

No returns. No dividends. Probably, no way to sell either because no one else is interested in buying from you. And if you do succeed in selling off at this point, you would most likely be doing so at a loss.  

If you study trends in the stock market, you will see some dormant stocks that have remained stagnant for long periods of time. No rise in share price, no fall in share price, and no share is being traded either.  

READ ALSO: Best time to make money trading BTCs

It is not a nice position to be in, and that is why you want to be sure of the company, its management, and board members who take the decisions before you decide to buy or not, even more so when you are a long-term investor.  

And even then, with the wrong stocks, you could suddenly find that your proposed short term investment of 6 months will run into years because you keep waiting for things to pick up before you sell.  

Patricia
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MSME

130 farmers to receive seed funding of N100,000 each

The target of the programme is to adopt farmers in 774 LGAs across the country.

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The National Information Technology Development Agency has kick-started a job and wealth creation programme where 130 farmers will each receiv, e seed funding of N100,000Border Closure: Nigerian rice farmers are struggling to feed a rice-hungry nation. CBN to give Niger Delta rice farmers single-digit loan 

The National Information Technology Development Agency has kick-started a job and wealth creation programme where 130 farmers will each receive seed funding of N100,000. The programme will be supervised by the Federal Ministry of Communication and Digital Economy.

According to a statement from the agency, the National Adopted Village for Smart Agriculture (NAVSA) programme is in line with the government’s drive to lift 100 million Nigerians out of poverty, and it will start with 130 farmers in Jigawa state.

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The target of the programme is to adopt farmers in 774 LGAs across the country, open the platform to all agriculture ecosystem players with access to information, facilitate and improve productivity, reduce the cost of production, and facilitate access to local and international markets.

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READ MORE: President Buhari directs Ministries of Power, Finance, BPE to seal Siemens deal

With all of this in place, it is expected that the farmers will be able to build sustainable business models and digital business opportunities that will create not less than 6 million well-paying jobs in the next 10 years.

“NAVSA Platform is aimed at digitalising agriculture to drive Digital Economy, as part of President Buhari’s agenda to leverage on technology and innovation to revolutionise the agriculture value chain,” the statement read.

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Among other things, the farmers will be empowered with a digital platform, smart devices (tablets), connectivity for data and calls, Digital agripreneurship skills, and enrolment with telecom operators and the National Identity Management Commission (NIMC) for identification.

All of these will be given to them at the end of the programme, which will last from July 1 to July 13, 2020.

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Patricia
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MSME

Business owners will now get CAC certificate with TIN

This will also allow them to easily request loans and credit facilities from financial institutions.

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PwC's MSME Survey 2020

As part of the Ease Of Doing Business Initiative, the Corporate Affairs Commission (CAC) will now work with the Federal Inland Revenue Service (FIRS) to issue Tax Identification Numbers (TIN) along with the Certificate of Incorporation.

This will save companies and small business owners the troubles of applying separately to the FIRS for their Tax Identification Numbers.

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This was contained in a statement signed by the Corporate Affairs Commission (CAC) on Monday, June 29, and seen by Nairametrics.

Conduct advanced financial calculations using Nairametrics Calculators

The statement reads in part “Certificates of Incorporation of companies registered under part A of the CAMA will henceforth carry Tax Identification Numbers (TIN) issued by the FIRS”.

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With this development, companies and business owners can now proceed to open a corporate account upon receiving their Certificate of Incorporation, rather than waiting another week or more for the issuance of Tax Identification Numbers.

READ MORE: How FG plans to support Women-owned MSMEs to recover from the pandemic

This also allows them to easily request loans and credit facilities from financial institutions and dispenses the need to visit the FIRS office.

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For the revenue collection agency, the development is set to improve the accuracy of its database of registered businesses operating in the country and can aid it to widen its revenue net.

 

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Patricia
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