October 1, 2010

Is debt or equity better for your business? The answer depends on several criteria, although the stage of the business and the use of the funds are usually the best determining factors.

Pre-Revenue

This is the stage of a business before you have paying customers. Equity is almost always the better way to fund a business in this stage because debt causes three main problems. Consider this example: Let's assume you receive a $100,000 SBA loan to start your business. You receive terms that include a 6 percent interest rate, a monthly payment of $1,933 for five years, and you have to put the equity in your home up as collateral to secure the loan.

Problem #1 — Since the business has no cash inflow, you will have to use the proceeds from the loan to service your debt facility at a rate of almost $2,000 per month. Getting a loan and then using it to pay back the same loan is risky since you got the money in the first place to build your business. With equity, on the other hand, you can use the entire $100,000, minus any acquisition costs, to grow your startup.

Problem #2 — Many finance experts, who will usually tout debt over equity because it is "cheaper" to get, use the argument that the tax-deductibility of the interest portion of your loan payments makes debt even cheaper to obtain than equity. However, a pre-revenue company operates with losses, meaning the tax benefit is usually very small, or even non-existent, and may be deferred far into the future. This narrows the gap between the cost of debt and equity.

Problem #3 — The business has no collateral, so the bank is going to tie up your personal assets. This is not all bad, but we need to consider the risk. Pre-revenue companies are the highest risk for failure. You have taken a severe pay-cut to launch your new venture, meaning you have a real opportunity cost associated with your current income. In addition, your personal assets are now at risk if the business fails. Add all this up and you are maximally exposed to a great deal of risk. Raising equity at this stage of your business can help offset your overall risk, possibly without negatively impacting your potential for return. In fact, it may improve it.

Debt is not bad, but it is often more costly than equity for pre-revenue businesses. If, however, you are buying equipment or other fixed assets, financing those transactions with debt may make some sense based on the terms of the financing. Please note that raising equity for a pre-revenue venture is not without disadvantages, like dealing with partners — but it is often the better option.

In-Revenue, Negative Cash Flow

You have customers but you are still spending more cash than you are bringing in each month. This means you have operating losses, but you are hopefully on the path to profit. Funding operating losses with debt can still be costly because of the three reasons mentioned above, but a business case for doing so can more often be justified. The closer the company is to operating profitably, the more justifiable this option becomes. Financing equipment and other fixed asset purchases with debt is also more palatable at this stage.

In-Revenue, Positive Cash Flow

The better option once positive cash flow is reached is debt. You have the cash flow to service it, and you can get the tax benefit for paying interest on it. You will not, however, avoid exposure of risk to your personal assets. Even if the business has assets, like accounts receivable, to secure a loan, most lenders will still require a personal guarantee from you.

The Best Way

So far we have discussed the better of two options (debt or equity) to fund your business, but there is a best way that trumps them all. It is called bootstrapping, and it means you run your business in a lean but mean manner that requires you to only spend what you bring in. With a focus on growing your cash inflows through customer acquisition and managing your cash outflows by controlling your expenses, you get to keep more of your business and not encumber your personal assets with the risk of the business.

The biggest disadvantage to bootstrapping is that growth opportunities will often be constrained by your ability to create free cash flow from your operations. You will be limited to using your retained earnings (which is a form of equity), not outside money, to grow. This is why many profitable companies will still sell equity in their ventures — to accelerate growth. If you plan to do this, you need to carefully consider the costs and benefits of bootstrapping versus raising equity to determine which option will best serve your objectives.

Join the conversation ( 8 )

• Ken Kaufman 1 year 4 months and 15 days ago

  

  Great discussion on factoring. Here is my take...
  
  In some circumstances, factoring is actually the best solution to working capital shortages. Ultimately every company would hope to graduate from factoring to other forms of financing, but it can solve a real need that no one or nothing else can solve. Gary, I agree it needs to be considered in some situations.
  
  On the other hand, I somewhat agree with George's point. There are many situations where it just does not make sense. The bottom line is that is really depends on the situation.

• Gary Honig 1 year 4 months and 15 days ago

  

  Oh that same old saw gets brought out every time receivables factoring is mentioned. Head for hills Mable them factor people are out to rob you blind.
  
  Unfortunately the facts don't agree with that perception, factoring is a billion dollar industry. There is one reason the rates are "relatively higher" than bank lines of credit. The borrower cannot qualify for a bank loan and as such are in fact a higher risk. The borrower cannot get annualized capital and has to settle for short term capital. In tandem, factoring companies have a short lease and heavy transaction load attached to their funding - each account debtor must be credit checked, each invoice must be verified and later collected. Advances must be wired, reserves tracked etc. A bank makes a loan and a computer keeps track, a factoring company is in constant contact with their client with a direct hands on approach due to the risk involved.
  
  But here is the crux of the issue; if you are looking to turn down a contract due to lack of operational capital, and have a 25% profit margin from the work, would you give up 2-3% to have a factor back your action? Fair question.

• George Van Wert 1 year 4 months and 15 days ago

  

  How can anyone recommend invoice factoring with a straight face? From what I was offered numerous times when called by people attempting to sell their factoring service the interest rates were always way out to lunch. Unsecured credit cards offered lower interest rates (not that I am recommending credit cards to finance a business but costs are less than factoring). Pawn shops come to mind when I think about factoring - both are places with no place in a business.

• Ken Kaufman 1 year 4 months and 16 days ago

  

  Gary,
  
  I think you bring up two very good points.
  
  When I refer to "costly debt financing," it has less to do with its alternative equity option and more to do with unsecured, un-collateralized debt with high interest rates attached. Credit cards are the first form that come to mind.
  
  Your second thought on invoice factoring is also valid. The important thing to remember is that it is costlier than almost all forms of debt, with annualized costs ranging from 24-36% on invoices collected in 30 days or less.

• Gary Honig 1 year 4 months and 17 days ago

  

  Ken, Peter,
  
  I'm not following the logic behind "costly debt financing." Have you known an equity investor of any stripe; seed, angel, VC to accept LIBOR rates as a return? When you extract the actual cost of sharing profits with a new "partner" to paying bank rates - there is no comparison.
  
  You leave out an important tool that is available for start-ups and growth spurt (negative net worth even) companies; AR financing. Invoice factoring can be used very effectively as so0n as you get to revenue stage without regard to the borrowers financial condition, without limits to availability and often without signing a personal guarantee.
  
  The cost of funds is always relative to the manner in which it will be employed and the future outcome with or without it.

• Ken Kaufman 1 year 4 months and 17 days ago

  

  Peter,
  
  Thanks for your comments. I agree with both of your points. There are certainly times when raising capital creates the best opportunity for all, but those are actually few and far between. Most can get the most benefit by using debt.
  
  Second, I agree that the cost of debt can be higher for start-up and younger businesses without more significant assets than their IP and people. This is why most startups are using their personal assets to collateralize debt to fund their businesses at this stage.

• PETER LEHRMAN 1 year 4 months and 17 days ago

  

  Ken - thanks for a great article. I had just two comments.
  
  I would make one comment adjustment regarding your assertion that financing a cash-positive business with debt is preferable. In my experience, it really depends on how fast the company is growing and how large the market opportunity is for the business.
  
  If the entrepreneur has a large marketing opportunity for their business, say greater than $50M or $100M in revenue, and the business is generating profits at 5M in revenue, it might serve the entrepreneur to raise equity growth capital to attack the market opportunity.
  
  Yes, the entrepreneur will have to sell more of the company to do this, but the ownership s/he retains will likely be worth more if the company is generating 50-100M in revenue and only generating very modest profits vs remaining a 5M or 10M revenue business that has debt on its books.
  
  The second comment I would make is that debt is usually quite expensive unless the business has significant capital assets to offer the bank as collateral. Many startups count their core assets as their IP and their people, neither of which banks can collateralize. In this case, getting debt financing is very expensive, sometimes impossible, even when you are generating revenues, so the entrepreneur must be prepared to raise equity capital to fuel growth.
  
  Peter
  @axialmarket

• PETER LEHRMAN 1 year 4 months and 17 days ago

  

  Ken - thanks for a great article. I had just two comments.
  
  I would make one comment adjustment regarding your assertion that financing a cash-positive business with debt is preferable. In my experience, it really depends on how fast the company is growing and how large the market opportunity is for the business.
  
  If the entrepreneur has a large marketing opportunity for their business, say greater than $50M or $100M in revenue, and the business is generating profits at 5M in revenue, it might serve the entrepreneur to raise equity growth capital to attack the market opportunity.
  
  Yes, the entrepreneur will have to sell more of the company to do this, but the ownership s/he retains will likely be worth more if the company is generating 50-100M in revenue and only generating very modest profits vs remaining a 5M or 10M revenue business that has debt on its books.
  
  The second comment I would make is that debt is usually quite expensive unless the business has significant capital assets to offer the bank as collateral. Many startups count their core assets as their IP and their people, neither of which banks can collateralize. In this case, getting debt financing is very expensive, sometimes impossible, even when you are generating revenues, so the entrepreneur must be prepared to raise equity capital to fuel growth.
  
  Peter