The amount of equity invested in a new business venture will impact everything from the interest rate on borrowed money to the ability to weather the unexpected.

When considering the development of a new diagnostic imaging center, one of the key factors that a financing source -- manufacturer-based, independent bank, or other third party -- considers is how much cash equity the owners are putting into the project. They want to know this answer for a variety of reasons and will analyze the answer in a few different ways.

The purpose of this article is to explain what equity is, why it is considered important, how to get it, how to determine the amount needed, and how much makes sense for a particular situation.

WHAT IS EQUITY?

Equity is your ownership interest in a given asset. That asset can be your home, a racehorse, a business, or any one of a number of other things that people tend to own. Your ownership interest is determined by the percentage of equity you have purchased or acquired in some other fashion (inheritance, for example) in that asset.

If the racehorse costs $3 million and you paid $1 million of the $3 million purchase price, then your equity ownership interest is 33.3%. If that racehorse wins a $10 million race, you net out the costs from training, feeding, housing, etc (call it $2.5 million) and that leaves $7.5 million to be shared among the ownersyour fair share as a result is $2.5 million, an excellent return on your equity investment.

On the other hand, if the horse came in last, your partners might ask you to put up more money or you might just get rid of the horse. In that case, you may lose most or all of your $1 million investment.

Acquiring equity is how you build your net worth. It is also fun to own thingsit might be risky, but that is part of the fun and part of the thrill. Businesses, houses, even technology all mean something different if they are ownedeven if only partly owned.

Project equity is money usually invested in a very specific business that results in one's rights to ownership of a project in an amount equal to one's percentage of investment. If a project requires $1,000,000 of equity investment and you invest $100,000, you will own 10% of the project. You will be entitled to 10% of the distributable profits, losses and, if the project is sold, 10% of the net purchase amount after other expenses are paid.

HOW AMOUNT IS DETERMINED

Project equity is usually defined as the amount of cash required to get the project up and running, and until it begins to cash flow positively on its own. The art of determining equity comes from a couple of factors and from the early stages of the development of a project.

In the first phase of the project, a feasibility study is undertaken by either the would-be owner or someone that person hires, the cost of which should be factored into the pre-development portion of the project. This is the time frame that involves assessment and analysis that result in a decision to go forward with a project. If someone is hired to produce such a report and it is determined not to go forward, then you have lost your equity. If the decision to move forward is made, then the cost ($25,000 to $50,000 or more) is added in to the equation as a pre-development cost and part of the up-front equity.

The next phase of the project, assuming the decision to move forward is made, is the development phase. There are numerous costs that need to be accounted for here. They include costs for consultants, lawyers, accountants, architects, engineers, equipment planners, equipment deposits, facility lease deposits (assuming you are planning to lease space in an existing building and not buy or build a new one, which would engender a whole other set of costs and equity requirements), leasehold improvement expense deposits, hiring of staff, etc. These costs can run into several hundred thousands, even millions, of dollars.

Once a project is developed and the doors open for patients to be seen, there is always a period of waiting for accreditation, licensure, and approval from the various third-party payors during which you cannot bill and collect. That usually lasts about 3 months; as a provider, you are building the business and patient flow. Even if you do start collecting cash in the fourth month, it is unlikely that the facility will be fully ramped, and so you need cash to cover this period of time as well. Often this cash is provided in the form of equity. It is also wise to have an established line of credit with a local bank or other credible source, as most businesses do, including private radiology practices.

HOW MUCH MAKES SENSE

There are other considerations for the amount of equity for a given project.

From a lender's perspective, the more cash equity, the easier it will be to finance. From an owner's perspective, the less out-of-pocket-cash, the better. These factors have to come into balance. An owner's experience in having developed successfully performing projects in the past, especially with the same lender, is a big factor for minimizing cash out of pocket. However, if out-of-pocket cash is minimized too much, it may result in your having to personally guarantee an inordinate amount of the debt. Some amount of personal or corporate guaranty ought to be expected, but it can be minimized or even eliminated under the right circumstances with the right lender.

From an owner's perspective, especially if you have partners (other radiologists, the local hospital, a corporation, and/or other businesspeople), how much equity each partner is putting into the project can be considered a barometer for the type of support that you can expect from those partners. In some instances, you may want the lender to insist on personal or corporate guaranties as a way of adding to the seriousness of each investor's interest.

Take, by way of example, a new MRI-only center. The capital costs will look something like this:

MRI unit: $1.2 million to $1.4 million

Furniture, fixtures, and nonmedical equipment: $100,000

Leasehold improvements (assumes space is being leased): $200,000 to $300,000

The range of cost in this example is $1.5 million on the low end and $1.8 million on the high end. Assume that the owner/s have never done this before on their own and want non-recourse financing (no personal guaranties). If a lender is willing to consider non-recourse financing (most do not), that will require at least 30% equity ($500,000 to $600,000). A rule of thumb that is often used by some lenders is that they will lend only for equipment and leasehold improvements, leaving the owner responsible for the working capitalconsidered to be at least 3 months of operating expenseas their equity contribution to the project. Check your financial forecast and you will see if the $500,000 to $600,000 (30%) provides enough money for covering that period of time, then you are probably going to get what you want. Consider, too, that your up-front costs for feasibility and other business planning services (including costs for consultants, lawyers, and accountants) will be borne by you as well. Again, assess whether the $500,000 to $600,000 will be enough to cover your costs and whether it is enough to keep your partners interested in what you are all doing.

Note that if you are accepting of personal guaranties, the amount of equity required can readily drop to between 15% and 20% (you still want 3 months of operating expense in the bank as working capital when the doors open). If more than 30% equity is invested, a project is likely to gain a much easier time of obtaining financing without being required to provide personal guaranties.

The answer to "how much makes sense?" depends on a variety of factors, but if you go with what you think makes sense and will not keep you up at night, you are probably making the right decision.

SUMMARY AND CONCLUSION