Friday Financing Tip #2: The Price of Money

Make sure you know how much your money is costing you. Angel/venture capital is the most expensive money you can get. Entrepreneurs often forget this, falling into the illusion of not having to "pay the money back". But if your company is successful, the share of profits that goes to your equity investors will be considerably more than if you borrowed the money.

Equity investors typically look to make about a 40% or higher return on their investment. A bank or "senior lender", on the other hand, will only be looking to make "prime plus", currently around 10-15%.

So the loan sounds like a better deal, right? What's the catch?

It all depends on how long you need the money for before you can start paying it back. With a bank loan, you start paying back the principal of the loan immediately, along with the interest. Also, the typical term for a bank loan is no more than three years. Investors, on the other hand, look to make their money over a three to seven year period. And while a small portion of the profits may be paid to them as dividends when the company becomes profitable, the bulk of the money they make gets "paid" when they sell their stocks, either back to you, to another investor, or on the open market.

There is another option called "mezzanine financing" or "subordinated debt", which is usually a combination of a loan and equity investment. Typically the interest rate is approximately the same as for a conventional loan, with the difference being that the principal is paid at the end of the note, rather than evenly throughout the term of the note. The "price" of that is that it also includes warrants for an equity stake in the company, usually calculated such that the lender/investor would see something like a 20-30% return on the investment. It's cheaper money than pure equity investment, but is easier on your company's cash flow than conventional lending.

Finally, for a successful company, the very cheapest money, long-term, is market equity, i.e., "going public". If your company is doing well, the value of public market capitalization will be far greater than any venture capitalist would invest, and you'll give up far less control of your company in the process. However, it costs money to go public, and it takes time. From the time you start planning for it, it will take two to three years minimum before it results in usable capital for your business. Also, once a market is established for your stock, it's relatively easy to go back to the public market for more capital.

Going public may not be as inaccessible as you think. An initial public offering can be as little as $500,000 (or as much as $1 billion in rare cases). To go public on the OTCBB (Over The Counter Bulletin Board), a company can have as little as $100,000 in annual revenue when it starts the process, though should plan to be at $500,000 by the time of the IPO.

Bottom line - there's a trade-off. It all depends on how long you need the money for and how much of the risk you want your financer to share. Be sure to explore all your alternatives and know for sure just how much your money is costing you.