Welcome to the second installment of Debt Financing 101. Last time we learned the ins and outs of an Asset Based Loan. Today we will take a closer look at what exactly equity financing is and where it falls in what we call the “capital stack.”
What is Equity Financing?
Investopedia defines Equity Financing as “the process of raising capital through the sale of shares.” This is what a company is referring to when it“raises a round” — in other words the company is receiving funds in exchange for a stake in the business itself.
What is a Capital Stack?
The capital stack is the sum of all capital invested into the company — both debt and equity. At the top of the capital stack is common equity, followed by preferred equity, mezzanine debt and senior secured debt, or the ABL facility discussed in the first part of the series. The best way to think about this structure is from highest to lowest returns and/or highest to lowest risk. The investors at the top of the stack are taking the highest risk by investing equity in exchange for shares, and therefore will receive the greatest returns. At the bottom, is the debt facility. As the lender’s loan is secured by tangible assets (inventory and/or receivables), the likelihood of payoff is high but returns are notably lower.
Debt and equity serve different purposes — debt is used to finance working capital needs while equity can be used to make longer term investments in the business. As an investor in the consumer goods space, Steven Himmel, a principal at Vanterra Capital, notes that “[…] debt is a great alternative for early stage founders to secure capital for growth while avoiding dilution. I’m happy to see how much this market has grown in the last few years. It’s a welcome addition to many of our portfolio companies.”
For efficiently run operating companies with relatively low cash burn and strong growth, oftentimes using debt to bridge to the next funding round can help ensure a more successful raise at a higher valuation. It is also significantly cheaper when thinking about the limited dilution the company is taking to financing its continued growth. Ultimately a company that has a strong balance sheet including ample cash can look to debt, venture and ABL alike, to achieve its growth goals. Debt can be a great tool to help a business ensure fundraising takes place at more preferred terms.
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