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 Equity vs. Debt: how should entrepreneurs fund their business ventures?

 

 Entrepreneurs need to be mindful of the risks associated with sourcing funding for their businesses. Similarly, the choice between funding a business with debt or equity will have major implications for the company down the line.

This is according to Jean-Claude Mutajogire, Country Manager at Business Partners Rwanda (BUSINESS/PARTNERS), who says that entrepreneurs should be cautious of the amount of finance they apply for, as the wrong amount could jeopardise their business' success.

He explains that while applying for too little funding may not satisfy the financial needs of the business, securing funding in excess of what is required will put additional pressure on cash flow. “This debt needs to be repaid to the lender, and the more debt the business is in, the higher the repayment will be."

There is also the risk of the business owner being tempted to utilise the additional funds for private use, says Mutajogire. “Obtaining too much money could lead to the improper use of the additional funds suddenly becoming available to the business owner. This money is also very likely to be spent on unnecessary items that will not necessarily improve the position of the business."

Mutajogire adds that asking for too much funding can also hinder an entrepreneur's approval rate for finance. “Should an entrepreneur apply for an amount that the financier believes is unjustified, the possibility exists that the application will be rejected. This could be for a few reasons, such as the financier not being confident that the entrepreneur is familiar with his/her financial position and the needs of the business, or that the applicant is not fully transparent on the proposed application of funds."

The financial needs of a business stem from either its current position, or the proposed plans for the business, such as expansion, increasing capacity, acquisitions or capital to develop a new product range.

“When applying for finance, an entrepreneur should be very clear on the position and strategy of the business as this will determine what type of funding is appropriate for the business. For example - is short or long term finance more suitable or should the finance be in the form of debt or equity," says Mutajogire.

Bringing an investor into the business usually implies that equity will be introduced and that the investor will obtain a shareholding in the business. Mutajogire says that although this format of funding has the advantage of no fixed repayment terms, in the process the entrepreneur parts with a portion of ownership of their business. “When opting to go with this finance option, selecting an investor should be done with caution, and both parties should agree on what their expectations are."

He adds that businesses with high growth potential should also be wary when being offered funding. “Investors may offer the entrepreneur more funding than what is required, which will result in the investor obtaining a larger shareholding in the business. Introducing this equity may prove to be a very expensive exercise in the long run. If the entrepreneur decides to buy the investors' shares at a later stage, this figure could be significantly inflated due to the growth that the company has experienced."

He warns that although entrepreneurs may be tempted to spend any additional funds available, they need to understand the potentially dangerous long term effects of utilising these funds, and instead carefully allocate funding to items that will grow the business.

“Not all entrepreneurs are financially orientated or familiar with the financial principles, which is why professional advice is recommended when establishing what type of funding is appropriate. Sound, professional advice will guide and steer the entrepreneur to the most suited solution for their particular needs," concludes Mutajogire.

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