Whether a farmer wants to expand his or her own operation or start a new one from scratch, without a doubt, a critical step is financial planning. In order to raise capital for such an endeavor, the farmer will, most likely, need to seek outside sources. Decisions between taking on outside debt or equity involve trade-offs between profit levels and risk management.
Outside equity financing allows investors to directly insert capital into the budget, granting some level of ownership of the operation back to the investors. Ultimately, the investors decide the amount of capital they provide based on anticipated returns and the level of risk they are willing to take. If the operation does well, the investors will be rewarded by returns, which might include annual distributions at harvest and any appreciation when the farmland is sold or the investment divested. However, if the operation is not prosperous or even out right fails, the farmer and the investors may lose money, but everyone retains the same proportions of ownership.
When issuing debt, lenders expect some sort of risk management in the form of a mortgage on the farmer's land or liens on its infrastructure. Upon an agreed term, the farmer will return the loan, plus interest, to the lender. If the operation is successful, the farmer can repay the loan as well as increase his positive reputation to future lenders. If the operation is not successful, the farmer will default on the loan, and may expose his farm to foreclosure.
According to Professor Duncan Chembezi from Alabama A&M University, an experienced farmer will have his finger on the pulse of the operation, in order to keep a healthy debt/equity ratio that is the right fit for the operation. Maintaining low debt in relation to equity will reduce the amount of financial risk.
Where does your operation stack up against the national average?
US Farm Debt/Equity Ratios (percentage)
A farmer does not have to choose only one of these two options to fund his or her operation; a healthy mix of debt and outside equity financing could be beneficial to the business in the long term. Using both will allow the farmer to retain a higher level of ownership in the operation, as well as require a lower level of mortgaged assets for a smaller loan. Bringing in outside capital in the form of private equity investors may allow a producer to work a larger piece of land, which in turn brings economies of scale and greater profits. Another advantage of selling outside equity to passive investors is that family farmers with a high net worth (from land values), but low income, can increase their standard of living or pay for major life events - like education or medical expenses - without losing control of their land.