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SMART ANSWERS
By Karen E. Klein
APRIL 25, 2000


Beware the Financing Roller-Coaster

Give up equity in your startup or take on debt? Each has its ups and downs

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Q:  I'm opening an amusement park with startup costs of $4.2 million, of which investors are contributing $1.1 million. What would constitute a reasonable equity-distribution plan for my investors?

-- K.G., Houston

A:  In a venture as risky as a new amusement park, private investors will likely want somewhere near 60% equity and returns of three to five times their original investment over three to five years, say experts.

If you do not want to give up so much equity, you can structure the investment as mezzanine financing, where you make monthly interest payments (known as "current coupon") out of cash flow. The advantage? Mezzanine investors will typically demand less equity, and it will be in the form of warrants (which give them the right to buy as much as 25% of the company at a discount), which they exercise when the company is sold or becomes profitable enough to repay the principal. The disadvantage of debt financing compared to equity is that you have to make payments at a time when cash could be tight for your business.

If you believe that your venture will generate sufficient cash flow to pay your investors back more quickly, they might agree to take less equity because a shorter loan term is less risky than a longer one. Be careful what you promise, however. If your business plan is flawed or things don't take off as quickly as you hope and you fall behind in payments, your investors may exact monetary penalties that could severely strain your company, or they may demand more equity.

"It's better to give away more equity upfront and give yourself a buffer when it comes to payback," says Peter Cowen, a strategic planner and investment banker based in Westwood, Calif., who specializes in early-stage companies. "Be cautious. If you think you can give your investors liquidity in the first year, wait two years. And if you can't ensure current income to the investors at all, that's O.K. too." The lesson? Think twice before you put your amusement park on the investment roller-coaster.


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