Which Is Better for Your Business: Debt or Equity?

By Ken Kaufman on 4 October 2010 (Updated 5 January 2011) 0 comments
Photo: PhotoEuphoria

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.

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