Financing Your Business - Choosing Between Debt And Equity
A business’ capital structure describes how its assets are financed. Generally speaking, businesses are financed from two broad sources – debt and equity. Each of these sources has benefits and drawbacks. How much debt or equity should a business have? What is the appropriate trade off? There is no standard answer, but making deliberate financing choices will improve insight into the risk / reward trade off for business owners and shareholders.
ADVANTAGES OF DEBT FINANCING
Business owners who are loath to share equity may be able to increase personal upside by using the leverage that debt financing provides. The ability of debt capital providers to participate in the economic benefits from a business is typically limited to interest and principal repayment. Loan obligations are predictable and transparent and the relationship with the source of capital can typically be concluded through simple repayment.
The market for debt capital is generally more developed and efficient than that for equity capital.
This broader base of potential capital sources reduces the nominal cost of capital for debt vs. equity and can provide an appropriate fit for different scenarios. Debt providers ‘rent’ their money and with adequate security and a demonstrated capacity to repay the capital, lending decisions can often be made very quickly.
DISADVANTAGES OF DEBT FINANCING
Business owners often give personal guarantees in order to get traditional bank loans. Even if the business fails, the obligation to repay the borrowed capital remains. Without an operating business, you may be unable to satisfy your loan obligations – even if you are able to find a well paying job.
Obligations to debt capital traditionally take precedence over obligations to equity capital. It is not uncommon to see lending provisions that restrict dividend distributions, salaries, the pursuit of new projects and lines of business, and the taking of additional debt until the lender has been fully repaid. While these restrictions are intended to reduce repayment risk, they can make it more difficult for a business to respond to opportunities and changes in the operating environment.
Interest rates can vary depending on factors including the lending source, macroeconomic conditions, the business and sometimes business owner’s credit history and other factors. Whatever the rate, interest repayments reduce the distributions that would otherwise be available to shareholders.
The process of debt financing may require disclosure of sensitive information to the lending source. While business owners can recognize the importance of providing transparency to other shareholders, there may be concern about providing full transparency to external parties whose interests are not wholly aligned with those of the other shareholders.
ADVANTAGES OF EQUITY FINANCING
Alignment of Interests
Equity capital providers desire a return, but recognize that this return is dependent on the economic success of the business. There is reduced personal financial risk for the business owner vs. debt financing, because personal guarantees are not needed. Equity capital sources typically want to maximize shareholder value and create opportunities for exit or liquidity events.
Sophisticated equity providers will seek to mitigate ownership risk by requiring transparency around the business’ operations, strategy and decision-making. This can include requirements for timely and accurate financial reporting, confirmation of compliance with government and other obligations, diligent record keeping, assessment of performance vs. targets, the use of director meetings and other corporate governance elements that increase the professionalism of the business.
DISADVANTAGES OF EQUITY FINANCING
Closely held businesses, particularly those helmed by the self-made founder may be hesitant about giving up some element of control. While control issues can be mitigated through the creation of different classes of shares and other mechanisms, it is likely that any equity provider will desire some level of input vis-à-vis the business’ operations.
Sharing the benefits from equity can be ‘expensive’, particularly in hindsight when a business may be yielding significant economic distributions.
ASSESSING YOUR BUSINESS’ CAPITAL STRUCTURE
To assess your business’ capital structure, take a look at your most current financial statements (specifically your balance sheet and financial notes). All sources of debt and equity should be considered. Common items to look for include loans from shareholders, bank and other debt financing, retained earnings, common shares and various types of equity capital contributions. The percentage contribution of each component to overall capital structure can be calculated by dividing the value of each component by the total capital. The cost of each source of capital can then be evaluated to compute weighted average cost of capital and determine if you are getting sufficient return for the risk of your ownership (there’s another article about that).
Kumi Bradshaw is President of Firm Advisory Ltd.
T: +441 295 3301 E: email@example.com
Firm Advisory Ltd. helps “business owners measure, grow and harvest the value in their companies”
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