Deciding on Debt vs. Equity

For entrepreneurs with profitable growing businesses, they often have the opportunity of raising debt or equity capital. I have found that most of the time, companies are led to consider equity more so than debt for the following reasons:

1) Entrepreneurs associate business finance with personal finance. As such they look at higher interest debt as risky. This is particularly true if the entrepreneur struggled financially at some point and never wants to go back to that again. Unfortunately, what most entrepreneurs don’t know is that higher interest debt such as asset based loans and subordinated debt are often less risky to the entrepreneur than their existing debt with the local bank. That is because these lesser known types of financing typically come with limited or no personal guarantees leaving the lender little negotiating power to force the borrower to make difficult decisions in the short term. Conversely, local banks which offer low interest loans typically have tighter covenants and full personal guarantees in order to minimize their financial exposure.

2) Most entrepreneurs get their advice from their existing lender who is biased towards financing strategies that keep them from losing the account. For instance, I had a client that was told by their existing bank that they were being irresponsible and growing their business TOO FAST. The ‘responsible’ thing to do was slow down the growth of the business or raise equity capital. Of course, this ‘advice’ was from the point of view of the banker that wanted to keep the account and the only way to do that was to increase equity or cash flow to improve the debt to equity ratio of the business. Doing that though would have slowed down the company or diluted the ownership of a successful family business. Eventually, the company proactively shopped for capital and found another debt provider that offered a borrowing facility (3) three times the size of the existing bank (although at a higher interest rate) but most importantly WITHOUT any additional equity.

3) The industry standard for financial advisors and investment bankers is that they are paid more to raise equity than debt. Within the industry it is generally believed that raising equity is harder than raising debt and they should receive higher compensation for such efforts. It is true that equity investors are more selective and particularly for early stage businesses or companies currently losing money, raising capital can be very challenging. However, a significant percentage of businesses seeking capital are already profitable and growing. Unfortunately, many advisors use the same fee approach and charge twice as much for raising equity and debt even though those companies are much easier to finance. Advisors using this tactic are very likely to recommend and seek equity sources entirely in order to double their fee. Entrepreneurs go along with this because they see the advisor as the expert.

In the end, there is no ‘right answer’ in raising debt or equity capital. Equity can be an attractive form of financing if the valuation is good, dilution is significantly less than 50% and/or there is a likelihood the company may experience a period of time where servicing debt will be difficult. The most important objective is for the entrepreneur to know all their options so that they can make the best decision for their own situation and temperament.