I have the privilege of speaking to a few people who are starting businesses and they do not always have in-depth knowledge or a basic understanding of business concepts. I recently had to answer the question of alternative methods of getting funding or financing for a startup idea and the different effects they would have. Inspired by this we will discuss the use of equity and debt to finance a business, the characteristics of the two, some hybrid ideas and what you should consider when choosing.
Equity is ownership. Shareholders are easy to understand the concept of equity ownership in a business. If you are inviting people to invest in your business and be part of the ownership structure they become equity holders. This has a few repercussions. Owners are liable although except for partnerships that ownership is legally limited to their investment. Equity holders share in profits and losses. In return for this assumption of risk, ownership gets voting rights in company matters. While owners share in profits it is not customary to have mandated profit payouts or dividends. And it is almost unheard of to have any commitment to dividends in growing companies. When companies distribute dividends they are treated as an after-tax item which means they eat out of profit that you can retain in the company.
Debt finance represents any form of finance that is extended to a person or organisation that has a stipulation to return the principal amount and/or interest to compensate. The first and most important thing to remember about debt is that debt holders do not assume ownership responsibilities or voting rights. Business is, however, complex and some situations may warrant debt providers placing holds on assets as a form of collateral. Debt providers are external to the company and as a result, have no liability for the failures of the business or conversely its successes. That means short of insolvency the debt providers must be paid all that is due to them. Payments to service debt finance such as interest are before tax expenses. This means you deduct them before arriving net profit which you are taxed based on. Perhaps the most unattractive thing about debt finance is the mandatory interest payments which accrue regardless of performance.
Some hybrids have emerged over the years which serve to give the best of both worlds. Preference shares are the easiest example to explain. Investors join as equity partners, they are liable to the extent of their investment. However, they do not have voting rights and have a mandated payment that amounts to a percentage of their investment paid on a regular schedule. You can see that this hybrid tries to give the best of both worlds to both parties. Many different combinations are used in the modern world including redeemable preference shares which have a (sometimes) defined date for their buying back from the investors by the company and debt to equity swaps which convert debt to equity. As my first accounting teacher repeatedly hammered in; substance over form. While some arrangements have a legal form that looks like equity, their financial substance is that of debt (usually the commitment to pay something combined with the lack of liability).
What’s best for you?
It is very difficult to give a blanket answer to this, and a lot will depend on your circumstances. There are two main issues which I suppose for business finance are opposing forces. These are control and cash flow. Both debt and equity put money into your company. Equity asks that you give up a little (or a lot of) control while debt asks that you regularly give up cash flow. As a startup business, you will certainly need to control your business as this makes for agility in decision making and quick turnarounds. On the flip side cash flow is critical to small businesses and reinvesting it in the growth of the business is paramount. This creates quite a conundrum. With early-stage businesses it usually wiser to give up control rather than cashflow. 1% of 100 is more than 100% of zero as the adage goes.
With this small discussion of debt and equity as finance options hopefully, you have had an awakening as to some of the issues involved. It is never one size fits all but having information like this at your disposal helps to make an informed decision or as a starting point for research.