Choosing between equity and debt

 

If you’ve concluded that seeking outside investment offers the best financing strategy for your business, and you have confidence that you can access sufficient financing from outside investors, what should your strategy be: debt or equity? To determine the answer, consider the following:

• How much money does the business need, and when do you need it?
• What types of expenditures will the money finance?
• How and when will the business pay back the money and any associated interest or return?
• What types of financing exist for the various stages of business development?

Most entrepreneurs generally use a combination of different types of financing over the life of the business. In fact, certain types of loans require that a business maintain a balance of equity and debt (called“leverage ratio”) that is appropriate for the stage of the business and the industry in which it operates.

Typical uses for debt and equity financing

• Short-term debt is used to finance assets that can quickly be turned back into cash—such as accounts receivable amounts, tax credits, newly signed contracts, and inventory.
• Long-term debt or term loans are used to finance assets with longer lives, such as capital equipment or the purchase of land and construction of a plant or building. 
• Equity investment is usually required to fund a business’ start-up losses as it does not yet have a track record or any certainty that it will generate the cash flow to fund debt and interest payments.

Observations

• Financial institutions do not give loans for start-up costs or the value of intellectual property unless an entrepreneur pledges personal assets as a collateral for the loan.
• Technology entrepreneurs do not seek early-stage loans for their businesses unless they are certain that the business will generate enough cash flow to repay the loan over the term.
• Long-term debt and term loans are usually only available to later-stage companies with cash flow or sufficient equity investment to ensure the repayment of the loan. Smaller, earlier-stage companies with some equity may have access to small business equipment loans through a financial institution.
• Friends and family investors usually constitute the most willing investors for initial rounds of equity investment.
• Angel investors typically invest earlier in the life of a business than venture capital investors, and they also consider medium-growth potential businesses.
• Venture capital (VC) investors only invest in high-growth potential businesses that require a minimum level of capital. (Different VC firms have different requirements, often posted on their websites.)
• Smart entrepreneurs stretch their cash by “bootstrapping” where possible.
• Smart entrepreneurs align the timing of their application to government programs that require matching funds (provided by the start-up) with the timing of cash equity investments.

Advantages of debt over equity

• Debt does not dilute the entrepreneur’s ownership in the business.
• The lender is only entitled to the repayment of the debt (i.e., the principal plus agreed-upon interest payments) and has no claim on the future profits of the business.
• Interest on the debt is a deductible expense of the business for tax purposes.
• Arranging debt financing is less complicated because the company is not required to comply with federal and provincial securities laws and regulations.
• The company does not have to send updates to shareholders, arrange shareholder meetings and seek the approval of shareholders before taking certain actions.

Disadvantages of debt

• Debt, unlike equity, has to be repaid on a specific schedule.
• Interest presents a fixed cost, which raises the company’s break-even point. High interest costs during difficult financial periods can increase the risk of insolvency.
• To cover both the operating expenses of the business and the principal and interest payments, you need cash flow and need to plan for this appropriately.
• Lenders and investors consider a company with a larger debt-to-equity ratio as carrying greater risk. Accordingly, a business is limited as to the amount of debt it can shoulder.
• The company is usually required to pledge assets to a lender as collateral, and the owners of the business may have to personally guarantee the repayment of the loan and interest. (This happens often in early-stage ventures).

 

References

Canadian Bankers’ Association. Retrieved April 19, 2009, from http://www.cba.ca/lang.php
Schwartz, D. (n.d.).Debt vs. Equity—Advantages and Disadvantages.Retrieved April 22, 2009, from http://smallbusiness.findlaw.com/banking_financing/be1_5debtvsequity.html.

Tags: debt, equity