Understanding The Difference Between Debt and Equity

Dear CFO,

The business I run needs an infusion of cash. I asked my controller to analyze the best way to obtain it and he referred me to you. I run a growing small business and in my budget for next year, I am projecting a need for capital to support sales growth and product development. 

Growing too fast for cash flow, Minot, ND

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As you’re finding out, growth can be expensive. It does sound like you are at least ahead of the curve by thinking about it now. For a small business, resources for capital are typically limited to debt and equity. Larger companies may also fund capital needs with hybrid forms or venture capital.

Before deciding on the capital infusion, look at your business and decide if you would prefer to slow growth and development for now, so you can bootstrap without the capital infusion.

If you decide you’d prefer not to hinder your growth or lose momentum, weigh the two options of debt and equity and decide which to choose.

Debt Financing for Your Company

If you choose taking on debt to increase your cash flow, you’ll be in the company of 87% of small businesses. Some sources of financing for small businesses include leases, lines of credit, credit cards, term loans, and “Vinnie”-type loan sharks. (A word of advice: Don’t use Vinnie because there are so many ways that borrowing from disreputable sources will get you in trouble.)

Requirements

Collateral – Generally, the lending institution will require that you pledge something of value (usually business assets) as security for the repayment of the loan. If the loan is not repaid, the lender can sell the assets to recoup the money loaned.

Covenants – Included in the financing documents are typically covenants that require the company to meet certain performance requirements. This might include monthly financial statements, borrowing base certificates, and certain ratio requirements (debt to equity, interest coverage, net income, or others) and other reporting requirements.

Personal Guarantees – In a smaller business or those with a questionable credit history, the owner may have to pledge personal assets (usually a home) directly or as part of a personal guarantee. Avoid personal guarantees if you can.

Advantages of Debt Financing

Lower Cost – Except for credit cards, debt financing is typically at a lower interest rate than the return expectations of an outside investor.

No Loss of Equity – The bank or leasing company does not want to run your business. You have full control and don’t need to seek input on business decisions. That is, so long as the decisions don’t lead to violations of covenants.

Matching – You can match the type of debt to the project: a lease to finance new equipment, a line of credit for a short-term shortfall (ex.a large project that has upfront costs), or a term loan to support hiring the new employees to support the growth.

Available to Virtually Any Business with Assets – Since the bank usually seeks collateral for loans, service businesses might need to personally guarantee or pledge other assets as collateral.

Improvement of Business Credit Scores – Similar to building personal credit, timely and consistent payment leads to better credit scores.

Disadvantages of Debt Financing

Disciplined Repayments – A term loan will require that you make the required payment on time each month. A line of credit requires a pay down if the collateral decreases (for example, you are borrowing 80% of receivables under 90 days and that balance decreases).

One-Year Term – Most banks renew the term loans and lines of credit annually, even when amortizing over a longer term.

Higher Interest Rates – A bad personal or business credit history or other influences may keep bank rates high.

Equity Financing For Your Company

Equity financing means that you give up some piece of the ownership to your equity investor. If you are in the friends and family stage, equity financing may be less strident but should still involve paperwork to document the agreement. The amount given up in a non-public company is often determined by a valuation and in a small business or start-up, by the negotiating skills of the parties involved. That may sound facetious, but ultimately equity financing is about what each party believes is the opportunity; we’ve all seen examples of this on Shark Tank.

Requirements

Sales Pitch – It is up to you to identify and sell the opportunity to the potential investor, supporting your ask with historical numbers and/or projections. The numbers should be achievable.

Board or Oversight – If the investment is large enough in the eyes of the investor, they may require a position on your Board or an oversight role in the case of non-performance.

Performance Clauses and Other Requirements – Again, depending on the size of the investment, the investor may include performance clauses for certain margins, growth, income, etc.

Advantages of Equity Financing

Added Input in The Business – Partnership offers many advantages, so be sure to consider the positive benefits of taking on a business partner.

The Value of Your Investment Grows – If the investment makes a substantial improvement in your growth and profitability, the company gets stronger and the value of your interest grows.

Cash Flow – The cash comes in without immediate repayment terms. An investor usually has a longer time horizon than a bank.

Disadvantages of Equity Financing

Loss of Control – Even a minority shareholder can burden your control of the company.

Higher Cost – The investor is taking more risk and therefore requires a higher rate of return, which may be in the form of dividends when meeting milestones or with the sale of the business at some point in the future.

Factors to Weigh When Deciding on Debt and Equity

If you’re measuring the pros and cons of debt and equity, here are some questions to help guide you through your decision:

• How important is the full control of your business compared to the benefits of growth and product development?
• Can you qualify for debt financing based on your credit history, business history, and/or are you willing to provide additional personal guarantees or collateral?
• Will there be immediate cash returns from the growth and product development that will enable you to meet the debt repayment schedules?
• Does your customer base pay consistently and reliably enough to allow you to predict cash flow?
• Where are you in the business life cycle? Are you in the predictable place of a mature business or the risky place of a start-up?
• Are you already highly leveraged and additional debt is not available?

In most cases, after weighing the questions of debt and equity, most businesses opt for debt if they can get it. Debt is relatively inexpensive comparatively and equity can introduce a completely new paradigm into running the business. If you’re faced with this decision, remember to consider this caveat: don’t pass up equity automatically. Rather, evaluate equity against your own long-term objectives, your capabilities for growing the business, and the potential it offers. There are plenty of ways to mitigate a cash flow crisis or help your business during a crunch. Consider the merits of both debt and equity as you make your choice.

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