If you are planning to raise capital for a business, you will be faced with an important question: Should you use debt (borrowed funds), equity (capital that does not need to be repaid), or a combination of the two? Whether your business is a start-up venture or an established company, the decision you make will have a serious impact on the future growth and profitability you experience.
Many business owners favor debt financing because creditors and lenders have no direct claim on the future earnings or value of the company. Your obligations to the creditors end when you repay the debt. Another advantage of debt financing is that you can deduct the interest paid on loans on the company’s tax return. The deduction lowers the real cost of the money you borrow.
Yet, despite these advantages, debt can put a considerable strain on your business, especially if cash flow is weak. Regardless of your business’s financial position, you must repay both principal and interest in a timely manner, and usually within a relatively short amount of time. In the creditor’s eyes, the longer the term of the loan, the greater the risk that you won’t be able to pay it back in full.
Although your obligation to the creditor ends when you repay a loan, the creditor may include restrictive covenants (e.g., restrictions on capital expenditures) as a contingency for granting the loan. These covenants may severely limit your control over business operations.
Also, interest is a fixed cost, a cost that will increase your company’s break-even point. If your business experiences financial problems, debt will only make it more difficult to realize a profit.
Equity financing provides capital that does not need to be repaid, making it particularly attractive to businesses without enough cash flow to handle borrowing and going into debt. In addition, equity financing has no fixed cost. Typically its cost depends on the future value of the company.
Equity financing can, however, significantly dilute your ownership interest and may diminish your operating control. Due to the risks involved, equity providers may request a seat on your board of directors or some other position of authority. If your business is well established, this may be an infringement. If your business is new, you may benefit from the investor’s knowledge.
The real cost of equity financing is often greater than debt financing for two reasons. First, due to the higher risks usually associated with equity investments, investors require greater returns than creditors. Second, dividends are not tax-deductible, leading investors to expect sizable capital gains from business growth.
When weighing the advantages and disadvantages of debt versus equity, you may discover that neither straight debt nor straight equity adequately meets the capital needs of your business. In this case, you may want to consider a debt/equity combination. One option is to couple debt with equity additions, which are warrants that enable investors to purchase a portion of your company’s stock at a fixed price sometime in the future. Such an arrangement will improve your chances of securing financing because investor risks are reduced and returns are increased. It will also minimize debt service and limit the amount of equity you must give up.
Finding the Right Ratio
What is the correct debt-to-equity ratio for your business? There really is no right or wrong answer. However, if a business has an abnormally high debt to equity ratio, there is some risk the IRS will attempt to recharacterize debt instruments as equity. Also, potential investors or lenders will look for a debt/equity ratio that is consistent with the industry average for your particular business. Bankers have access to these industry standards.
If your business currently has a high debt-to-equity ratio compared to others in your industry, you should consider seeking equity financing. Lending institutions usually avoid highly leveraged companies for fear that these companies will have difficulty meeting interest and principal payments.
If your business has a low debt-to-equity ratio, consider pursuing debt financing. Lenders view highly capitalized businesses as stable and, consequently, are more willing to make favorable loans.
Of course, the amount of debt or equity your business is currently carrying should not be the only determining factors in the type of financing you pursue. Beyond ratios, factors that affect business stability, such as the level and volatility of cash flow, should be examined. For example, if you expect cash flow to increase in the near future, your business may be able to take on additional debt. However, if cash flow is likely to decline, you may want to rely more on equity financing to avoid negative financial leverage.
It is often difficult to make a decision about the debt/equity combination. Including all business advisers in the decision-making process will make the final decision easier to reach, as well as the best one for your business.