Introduction : Many people believe they should choose between debt or equity financing for their companies. This is perhaps based on the view that money is money, and it does not matter how you get it. For us as outside equity investors, however, the differences matter a great deal. When we make investments this usually requires an injection of equity from us as well as additional debt from the company's bankers. This article will explain the difference between debt an equity and advantages vs. disadvantages of choosing them , in addition to review some of the issues and outline an approach for finding out the best mix. Equity and Debt Features: First, it is necessary to understand the differences between debt and equity financing. Some of the key features are listed below. Debt Must be repaid or refinanced. Requires regular interest payments. Company must generate cash flow to pay. Collateral assets must usually be available. Debt providers are conservative. They cannot share any upside or profits. Therefore, they want to eliminate all possible loss or downside risks. Interest payments are tax deductible. Debt has little or no impact on control Equity Can usually be kept permanently. No payment requirements. May receive dividends, but only out of retained earnings. No collateral required. Equity providers are aggressive. They can accept downside risks because they fully share the upside as well. Dividend payments are not tax deductible. Equity requires shared control of the company of the company. Debt allows leverage of company profits. and may impose restrictions. Shareholders share the company profits. Debt vs. Equity Disadvantages Advantages and In order to expand, it is necessary for business owners to tap financial resources. Business owners can utilize a variety of financing resources, initially broken into two categories, debt and equity. "Debt" involves borrowing money to be repaid, plus interest. "Equity" involves raising money by selling interests in the company. The following, discusses the advantages and disadvantages of debt financing as compared to equity financing. ADVANTAGES OF DEBT COMPARED TO EQUITY Because the lender does not have a claim to equity in the business, debt does not dilute the owner's ownership interest in the company. A lender is entitled only to repayment of the agreedupon principal of the loan plus interest, and has no direct claim on future profits of the business. If the company is successful, the owners reap a larger portion of the rewards than they would if they had sold stock in the company to investors in order to finance the growth. Except in the case of variable rate loans, principal and interest obligations are known amounts which can be forecasted and planned for. Interest on the debt can be deducted on the company's tax return, lowering the actual cost of the loan to the company. Raising debt capital is less complicated because the company is not required to comply with state and federal securities laws and regulations. The company is not required to send periodic mailings to large numbers of investors, hold periodic meetings of shareholders, and seek the vote of shareholders before taking certain actions. DISADVANTAGES OF DEBT COMPARED TO EQUITY Unlike equity, debt must at some point be repaid. Interest is a fixed cost which raises the company's break-even point. High interest costs during difficult financial periods can increase the risk of insolvency. Companies that are too highly leveraged (that have large amounts of debt as compared to equity) often find it difficult to grow because of the high cost of servicing the debt. Cash flow is required for both principal and interest payments and must be budgeted for. Most loans are not repayable in varying amounts over time based on the business cycles of the company. Debt instruments often contain restrictions on the company's activities, preventing management from pursuing alternative financing options and non-core business opportunities. The larger a company's debt-equity ratio, the more risky the company is considered by lenders and investors. Accordingly, a business is limited as to the amount of debt it can carry or bear. The company is usually required to pledge assets of the company to the lender as collateral, and owners of the company are in some cases required to personally guarantee repayment of the loan specialy if the company is partnership (unlimited responsibility). What to Choose Free money, without interest or repayment. There is, however, an opportunity cost. In return for sharing the risks equity providers also share all the profits. The choice, therefore, depends on the balance between interest rates on debt and profits on equity. In a static environment this choice becomes easy. If the after-tax cost of debt is lower than the company's Net Return On Assets (ROA) you should take on as much debt as you can. This concept is known as leverage. If net profit margins are higher than net interest rates you can maximize your Return On Equity by minimizing equity and maximizing debt. If not, you do the exact opposite. If you cannot afford to pay debt then you have to minimize debt and finance through equity. As a result, a static situation is of no interest to venture capital firms. If the company is doing well there should be no more need for outside equity. If a company is performing so poorly that it cannot pay interest, then an outside equity provider certainly has no incentive to join in. Dynamic Equity Please forgive the commercial, but the name of our firm actually indicates why we exist. Venture capital investment is only feasible in a dynamic environment. This typically means that a company is making some kind of transition in which its long term prospects are better than its short term performance. In fact, a company may even be losing money at the time of investment. Venture capital investors usually do not need short term income and can afford to take the long term view. VC firms make most of their money through capital gains. As a result, VC firms look for those companies that have the best prospects to create the largest long-term increase in shareholder value. Getting the Right Mix While we still cannot give an exact recipe, we can now present an approach for finding the best debt/equity mix. Long-term shareholder value results mostly from bottom- line growth. Therefore, the right mix must maximize the growth in long-term profits. This mix is likely to be different for each individual situation. At one extreme may be start-ups. Because these may lose money in their initial years, and because they have neither cash flow nor much collateral to support debt, start-ups mostly need equity to enable growth. At the other extreme are leveraged buy-outs, where a team of investors takes over an existing company. If that company is profitable already, generates cash and has a healthy asset base, a buy-out can be financed mostly by debt. The optimal mix of debt and equity has to be tailored for each situation. This requires some sophistication (development) in financial modeling. The trick is to prepare financial projections under different scenarios and with different assumptions. The goal is to find the debt/equity mix that provides the highest expected long-term shareholder value. Conclusion Investments into companies usually require both debt and equity. The optimal ratio needs to be carefully determined for each individual situation. It is unlikely that this ratio will consist of 100% equity. If the long-term prospects are so poor that a company can never make sufficient profits to benefit from leverage then the opportunity is probably not worth pursuing. Conversely, relying on 100% debt financing often places a heavy cash drain on companies and leads to sub-optimal growth. Debt and equity financing should not be seen as substitutes for each other. Instead, they are very different in nature and complement each other. Debt needs to be repaid in cash. Equity needs to be rewarded with long-term profits. Depending on individual circumstances and opportunities the trick for each investment is to find the best mix of both.
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