A Bank Loan versus an Investor
One of their frequent questions that we get is what are the primary differences between sourcing capital from an investor force versus sourcing capital from a banking institution. First, as it relates to banks these companies are in the business of providing loans. They want to see that the amount of money that they are going to lend to the individual is going to be repaid and will be fully collateralized by assets are being purchased. A very common example of this is a mortgage where a bank lends an individual money to purchase an income producing property with the intent of having the property service collateral and the income generated from rental serving as the income to repay the financial instrument. At the end of the day the bank is not receiving an equity interest in the business and they will not participate in the capital appreciation. For instance, if a real estate investor seeks to purchase a one million-dollar property then they will
typically put $200,000 down and borrow the remaining $800,000 via a 30 year mortgage. As the mortgage is paid down and as the property appreciates in value the bank only continues to receive the monthly interest and principal payments that was agreed to by the borrower.
Conversely, if that same real estate investor wants to source the money from a private investor and typically the investors going to want a percentage share of the equity based on how much money they are contributing. In this case, an investor could put the hundred thousand dollars and set up a mortgage and they would receive an 80% ownership stake in the business. One of the reasons why many people will source capital for a bank rather than investor is simply so that they are able to control the amount of income that they are receiving. Additionally, the conservative use of borrowed funds allows for the amplification of a return on investment. Returning to our example above, let's assume that the real estate investor has the entire $1 million of capital on their own. A generous capitalization rate for income producing property is about 10%. As such, in a scenario where the entrepreneur purchases the billing out right they will receive a 10% return on
investment each year. However, by borrowing the funds with a significant down payment this return on investment is amplified four times given that the income produced is not only covering the mortgage but it's also producing a significant amount of income as it relates to the down payment. This is one of the reasons why many individuals will seek to borrow funds before they approach a private investor. Of course, one of the key elements to borrowing funds that the individual must have an appropriate down payment as well as a credit score that satisfies the bank. These days a FICO score of 700 is typically the minimum credit score that is accepted by most financial institutions as it relates to lending.
As it relates to credit scores, most investors do not care too much about this aspect of an individual's personal life. However, some investors do want to see that the individual is not marred with debt or has significant other financial problems before they provide the capital necessary to launch or expand a business venture. An entrepreneur that has significant financial issues typically will be focusing significantly on that and not the continued expansion of their business operations. As such, if an individual is approaching investors for a project and they can expect that a financial partner would one understand the personal financial situation before going to business with them.
One of the other things that needs to be made aware of is that when you are working with investors is that they are going to want a significant amount of equity as well as a significant amount of control over the business. This is especially true when working with investors like venture capital firms and private equity groups that almost always taking majority interest in the business. In the event that things do not go as planned these organizations will typically take control of the business and throw out the original entrepreneur. This is one of the ongoing risks associated with working with a private equity group or venture capital firm. Additionally, for very large investments it will typically want to have several seats on the board of directors. This ensures that they are able to continually oversee their investment and make any adjustments to management as needed if things are not going as planned. As such, it is important that an entrepreneur
that is seeking venture capital for a in injection for private equity group retain a qualified attorney so that the entrepreneur is aware of all the clauses associated with the investment. This is one of the key issues that entrepreneurs can have when they are so hungry for the actual money that they forget that they need to be able to make sure that what they're doing is economically viable. If one venture capital group is likely to put up funding for a specific project and it is also likely that several others are willing to as well given the very low capital rate of successfully raising money.
In closing, it is far easier for an entrepreneur to work with a lending institution given that the terms of repayment are usually flexible and are easy to deal with. Investors have significant expectations as it relates to returns on investment and expanding operations. As such, all these factors into aide when determining whether or not to raise capital from bank or from a private funding source.