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Wednesday, Oct 4, 2023


SMALLBIZ.COL/20inches/1stjc/mark2nd Business owners frequently approach me for a loan when what they really need is an equity investor. I’m the chief credit officer for a loan fund. The biggest difference between debt and equity is that debt has a specific term for repayment, an interest rate and a specified repayment schedule frequently level monthly payments, as in a mortgage, for example. Equity investments are typically structured as a means of sharing in profit (or lack thereof) and don’t limit the upside (or the downside) of what the return can be. Bankers offer debt, not equity. Here are some examples of when you want to consider obtaining equity. – If you cannot see how a loan can be immediately repaid, but you’re sure that future profits will be there if the debt service can just be put off for a year or so. – If you’re launching an untested product or entering an untested market, or doing both, you don’t want to be saddled with a very certain debt. – If your company needs patient capital to meet day-to-day needs for receivables, inventory and payroll; then debt won’t work unless profits can replace it very quickly. Chances are you really need an equity investment of permanent working capital. – If you need outside expertise in marketing, management or product development to realize your company’s potential then an equity investor that has a voice on your board may be the answer. Most business owners have an allergy to the whole notion of seeking equity investments. They believe the following myths about obtaining investment dollars: Myth No. 1: You have to give up controlling ownership to obtain debt. This isn’t true; lots of deals are done without signing 51 percent of the stock to equity investors, each deal’s different and it depends on the size of the new investment in relationship to a company’s existing net worth (including any subordinated officer’s debt). Myth No. 2: The cost of obtaining equity is too high. In fact, it’s coming down all the time. Not every deal requires a ton of legal work or underwriting. Some joint ventures can be structured cheaply and quickly and involve little more than an agreement. Myth No. 3: You must be publicly traded if want equity dollars. This depends on the investor. Yes, public pension funds have to have a degree of liquidity to their investments, but does a wealthy retired businessman looking for a long term, high yielding investment? Not necessarily. Private placements can work fine for him. Myth No. 4: You have to report all your company’s income if outsiders take an equity piece. This is not a myth, actually it’s completely true. The laws regarding fraud and misrepresentation apply. If you’re dishonest with the IRS, don’t take on investors. It will only multiply you chances of getting caught. Once the myths are dispelled, small companies can better understand the importance of the equity option especially for a business located in the San Fernando Valley. In many cases debt no longer addresses a company’s needs for expansion capital because: – Companies lack debt repayment ability on a historic basis due to their need to borrow large amounts of debt after the 1994 Northridge earthquake. – Real estate equity has been destroyed by declining real estate values leaving insufficient collateral for new lending. – In a low-inflation, stable-interest-rate environment, debt financing doesn’t make sense because financing costs can’t be passed along. – The balance sheets of small companies are already too highly leveraged when contrasted to those of publicly traded companies able to attract private investment dollars. At some point the banks just say no. These reasons, along with a long sustained bull market in equities and a liberalization of securities laws to permit greater access to equity by small companies, all point to a new direction for small business financing in the future. New investment instruments and the number of new ways of structuring equity deals for smaller companies have exploded since the l980’s. Limited liability corporations, changes in Securities and Exchange Commission Private Placement Rules, Small Corporations Offering Registers tell part of the story. Changes in securities laws, both nationally and at the state level, are partially responsible for this; but I think it’s more a function of supply and demand in the market. Lots of capital is seeking highly yielding investments now that interest rates are below 10 percent. That’s hard to find in an overvalued stock market. The explosion of baby boom investment dollars will only further serve to fuel this demand. Smaller companies will be the future for investors seeking higher yield. This segment of the economy can put capital to good use to create new jobs and income if it opens itself up to the possibilities and uses for equity dollars. Small companies must also find the right help in obtaining it. That’s the subject for my next article. Bruce Dobb is the credit officer with the Valley Economic Development Council’s Revolving Loan Fund.

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