The difference between venture capital and working capital
According to Vaitkunas, “Businesses should use equity to finance long-term assets and working capital to finance short-term assets. You want to apply the matching principle and match the length of the asset life to the length of liability life.” A long-term asset takes more than one 12-month business cycle to repay, while a short-term asset will normally be repaid in less than 12 months.
When to Dilute Equity
“Equity is a precious commodity,” Vaitkunas stresses. “It should only be sold when there is no other option. The equity partner should bring experience and/or contacts that cannot be found elsewhere.” The best strategy is to secure equity financing at a time when you can negotiate and preferably dictate some of the terms. Ideally, absolute control should remain with the owner.
Timing is everything when it comes to equity financing, Vaitkunas continues. “Sometimes it’s best to simply take your time and wait for the best value proposition. While you’re waiting, you can grow within your means using short-term liabilities.”
It’s usually not a good idea to look for equity when a business is new, struggling to earn a profit or suffering from a setback. Unfortunately this is exactly the time when many business owners start thinking they need to “find an investor.” This process can take a lot of time and consume a lot of energy, which are taken away from the business, and this can have an aggravating and compounding effect on the existing problems.
As a rule of thumb, equity partners should only be sought once a company has a proven track record of sales and profitability and there is an identifiable and specific need for the money. Then, it is important to show how an injection of capital will create even greater profits and higher sales. A business that has a proven level of profitability, some historical sales growth and even more future sales growth potential is a much more attractive investment to potential equity partners.
Financing Working Capital
Working capital shortages are a short-term problem that can be financed with senior debt or mezzanine debt. In the alternative, short-term financing is also available from factoring or A/R financing providers who look to certain accounts receivable and inventory assets as collateral. A combination of these types of alternative strategies can boost available working capital to the point where the need for an equity partner disappears.