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.
- 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.
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.
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.
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:
- 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.
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.
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.
Personal Finance
5C’s of creditworthiness: What lenders, Investors look for in a business plan
Business owners need to be aware of the criteria lenders and investors use when evaluating the creditworthiness of entrepreneurs seeking financing.
Banks usually are not a new venture’s sole source of capital because a bank’s return is limited by the interest rate it negotiates, but its risk could be the entire amount of the loan if the new business fails. Once a business is operational and has an established financial track record, banks become a regular source of financing.
For this reason, the small business owner needs to be aware of the criteria lenders and investors use when evaluating the creditworthiness of entrepreneurs seeking financing.
Will the business that an entrepreneur actually creates look exactly like the company described in the business plan? Of course, not.
The real value in preparing a business plan is not so much in the finished document itself but in the process it goes through – a process in which the entrepreneur learns how to compete successfully in the marketplace. In addition, a solid plan is essential to raising the capital needed to start a business; lenders and investors demand it.
Lenders and investors refer to these criteria as the five C’s of credit.
READ: 5 ways to raise funding for your business
1. Capital: A small business must have a stable income base before any lender is willing to grant a loan. Otherwise, the lender would not be making, in effect, a capital investment in the business. Most banks refuse to make loans that are capital investment because the potential for return on the investment is limited strictly on the interest on the loan, and the potential loss would probably exceed the reward. In addition, the most common reasons that banks give for rejecting small business loan applications are undercapitalization or too much debt. Banks expect a small company to have an equity base investment by the owner(s) that will help support the venture during times of financial strain, which are common during the start-up and growth phases of a business. Lenders and investors see capital as a risk-sharing strategy with entrepreneurs.
2. Capacity: A synonym for capital is cash flow. Lenders and investors must be convinced of the firm’s ability to meet its regular financial obligation and to repay loans, and that takes cash. More small businesses fail from lack of cash than from lack of profit. It is possible for a company to be showing a profit and still have no cash – that is, to be bankrupt. Lenders expect small businesses to pass the test of liquidity, especially for short term loans. Potential lenders and investors examine closely a small company’s cash flow position to decide whether it has the capacity necessary to survive until it can sustain itself.
READ: How to scale as a small business on a budget
3. Collateral: Collateral includes any asset an entrepreneur pledges to a lender as security for repayment of a loan. If the company defaults on a loan, the lender has the right to sell the collateral and use the proceeds to satisfy the loan. Typically, banks make much unsecured loans (those not backed up by collateral) to business start-ups. Bankers view the entrepreneurs’ willingness to pledge collateral (personal or business assets) as an indication of their dedication to making the venture a success. A sound business plan can improve a banker’s attitude towards venture.
4. Character: Before extending a loan or making an investment in a small business, lenders and investors must be satisfied with an entrepreneur’s character. The evaluation of character frequently is based on intangible factors such as honesty, integrity, competence, polish, determination, intelligence, and ability. Although the qualities judged are abstract, this evaluation plays a critical role in the decision to put money into a business or not.
READ: 7 Ways to pay for your higher education
5. Conditions: The conditions surrounding a funding request also affects an entrepreneur’s chances of receiving financing. Lenders and investors consider factors relating to a business’ operation such as potential growth in the market, competition, location, strength, weakness, opportunities and threats. Another important condition influencing the banks is the shape of the overall economy, including interest rate levels, inflation rate, and demand for money. Although these factors are beyond an entrepreneur’s control, they still are an important component in a banker’s decision.
The higher a smaller business scores on the five C’s, the greater its chances of receiving a loan.
Written by Chukwuma Aguwa
Personal Finance
Don’t be fooled by COVID-related scams
Always consult the institution in charge of health-related matters to confirm any fishy information you come across.
The nature of and the manifestation of the Covid-19 disease is such that there’s only a little time available to remedy the situation before it gets chronic. Although the infection begins by exhibiting mild symptoms, if you do nothing in a short time, it could lead to death in a matter of days.
This whole picture has caused many to become desperate about Covid-related issues, launching into panic mode at the sight of any information. As a result, such people are not far away from falling for fraudsters.
With the different kinds of news flying around, you mustn’t be fooled by Covid-related scams.
The Coronavirus threatens the health of millions of people around the world daily, also killing thousands along the way. To curb the spread and remedy the situation, bodies like the CDC, WHO, and every country’s local health organisation like the NCDC, frequently circulate information around communities. However, it has also led to fraudsters taking advantage to provide fake news, and even asking for donations.
Each day, there seems to be a new account or NGO asking for donations into the health sector, and though some are legit, many are just fraudsters posing to take advantage of innocent citizens. So far, numerous complaints about scams have been recorded, especially with people who are looking to support the health cause in any way they can.
READ: Africa to spend $9 billion on Covid-19 vaccine, access to supply is big problem
Channels used for COVID-related scams
There are three major ways scammers take advantage of the haziness of the situation to dupe people. To start with, they appeal to the emotions of humans, who see the high death toll and suffering. As a result of what is happening, people have been willing to donate funds for medical supplies, isolation centres, and financial compensation for medical workers.
Scammers take advantage of this by posing as charity organisations and solicit for funds. Most times, as soon as their target is met, they clear their footprint without leaving a trace behind.
Another way they scam people is by manufacturing and selling fake or low-quality health products. Everyone wants to get their hands on a cure, or something that can at least protect them from the virus, and scammers are meeting their needs by providing just that.
READ: China joins WHO vaccine programme as it fills huge gap left by United States
The World Health Organization currently approves only one vaccine, and any other thing outside it is outrightly fake or just a supplement that will help your body. Currently, only the Pfizer vaccine is clinically tested and approved to work. Be sure to not throw your money in the wind by purchasing some of these fake drugs around.
Lastly, scammers create systems to extract a patient’s personal information, thereby having access to the person’s true identity. It could be in the simple form of opening a registration portal where you supply all your details.
Therefore, only give information to approved bodies and not any random online site that appears legit. These fraudulent individuals can do a lot of damage to your identity. Stay vigilant, only communicate with approved bodies, and always ask questions if you are not sure or suspect foul play.
The place of electronics in COVID-related scams
These fraudsters usually reach out to you through the digital sphere. Hence, watch out for cold calls, text messages, or emails requesting donations to certain bodies. The best way to confirm the legitimacy of such a message is to visit the organisation’s official website in a different browser. Never follow the link in the mail or text directly, as it can be easily embedded with spyware. Therefore, a single click could see them extract all your personal information, including bank details.
Also, please stay away from those who claim to have a cure, and accompany it with testimonies of people who have used it. They are low graders desperate for your money. Vet them by searching online and see what people are saying. In all, always look out for suspicious messages, and opt out if you are sceptical.
In a nutshell, you should not believe any cure, vaccine or supplement that the World Health Organization does not approve of.
Conclusion
The government or legit health institutions do not cold call citizens to request donations or coerce them into making one. If you receive a call out of the blues, chances are it’s a scam, which is why they mostly try to hurry you to donate before you realise it. Always consult the institution in charge of health-related matters to confirm any fishy information you come across.
