Debt vs. Equity: The Balancing Game
Is it better to fund your business with debt or equity? As it’s often the case in a world of trade-offs, the answer lies somewhere in the middle. Nobel Prize-winning economists Franco Modigliani and Merton Miller (M&M) noted that in a perfect world with perfect capital markets, a business’s capital structure does not matter.
As every entrepreneur eventually learns, however, we don’t live in a perfect world. The real world is fraught with complications, but that doesn’t mean the principles we learned in our corporate finance class don’t apply to our everyday lives.
When faced with financing decisions, you’re the one who will ultimately need to decide whether it makes more sense to borrow that $50K for that new branch location or raise it from angel investors. We cover the finer points of debt and equity financing in a series of case studies and explore how they might impact your business.
How Much Debt Is Too Much Debt?
To understand the productive benefits of debt financing, you need to understand the concept of leverage in your business, which is analogous to the loan-to-value ratio on your home. Leverage represents the amount of your business funded by debt and can entail the productive use of borrowing to grow your business. In short, it allows you to expand beyond what you can afford with the cash you have on hand.
As an example, governments issue bonds to pay for large-scale infrastructure projects like highways and hospitals, which can cost millions of dollars. This is essentially a form of leveraged borrowing, where governments borrow money to fund their operations with the promise to repay investors over time. By issuing debt, municipalities effectively use leverage to grow. It could otherwise take decades before a government could afford to fund new projects.
While you might not be building a highway, the concept scales down to the level of the entrepreneur. Let’s say your company is faced with above-average demand for goods but doesn’t have the cash available to increase inventory. By borrowing the funds from a business lender, you’re able to meet this demand and grow your business at a faster rate.
Leverage: A Vicious Cycle
Leverage, therefore, allows your business to expand beyond what’s normally possible, which can pay dividends over time. However, accumulating too much debt comes with pitfalls. To illustrate, let’s consider an example from the financial crisis of 2008, where combined household debts reached levels of over $12Tril.
Major Wall Street banks like Bear Stearns and Lehman Brothers Holdings (Lehman Brothers) increased their average financial leverage ratio—a company’s ratio of debt to equity—from 12-to-1 in 2004 to 31-to-1 in 2007. Over that period, Lehman Brothers posted three consecutive years of record profits, and the firm was worth a record $60B in early 2007, thanks to its expert use of leverage in generating earnings.
However, by the end of 2008, Lehman Brothers’ credit quality deteriorated due to highly leveraged investments and general loss of confidence from the financial markets. Moody’s Investors Service Inc., which previously rated Lehman Brothers an A1 low credit risk in late 2003, downgraded Lehman Brothers to B3 junk status.
Lines of credit evaporated as banks pulled back to protect their interests. In the eyes of lenders, Lehman Brothers lacked the cash to fund its operations and was deemed too risky to lend to. Business dried up, and its access to cash disappeared despite a last-minute bail-out attempt. Lehman Brothers filed for bankruptcy shortly afterward, were wiped out almost $639B in assets.
Although extreme, this example illustrates the double-edged sword of debt financing. In a favorable business environment, it can be a remarkably profitable way to generate earnings, but only to the extent that your business can cover its debts.
As the old adage goes, “cash is king.” Assuming your revenues stay constant, the more debt you accrue, the less cash you have left after paying creditors. Even if the borrowed funds are invested in a highly profitable venture, that investment may not pay off for months or even years.
When you’re more leveraged, future creditors are less inclined to lend to you, and may only do so at higher interest rates. If you continually increase your borrowing without paying off existing debts, subsequent rounds of borrowing may become progressively more expensive, and your ability to cover everyday expenses like inventory or payroll may be constrained.
It’s therefore important to plan for potential downturns when deciding how much skin you can afford to risk in the game. It doesn’t matter how much your company is valued at if you can’t afford to cover your monthly payments.
How Much Equity Can I Afford to Sell?
By contrast, equity is the claim to ownership in your business. Much like the equity in your home, the amount of equity you own in your business measures your ownership stake.
If you own a sole proprietorship, this consists of any money you sink into the business. On the corporate level, this can also include any invested capital from investors purchased in exchange for shares of stock. In either case, equity holders lay claim to a portion of your business and are entitled to share in its profits.
Initial invested equity may be all that you need to fund a small startup, but as your business grows, you’ll likely need access to more money to scale your operations. It may be tempting to keep your operations small, but forgoing profitable opportunities will restrict your ability to grow in the long run.
In some cases, you may lack expertise in key areas. A budding retail store may require a marketing expert, while an e-commerce site may need a dedicated web developer. New partners can free up your time to focus on other things. Not only does having partners buy into your business provide a welcome capital infusion, but it can also mean a boost in manpower, connections, and expertise.
Equity funding is not without its drawbacks, as many viewers of “Shark Tank” know all too well. Startup investments may take years to pay off, and some “Activist” investors can take a personal interest in your operations. Some may have their own opinions on how your business should be run, and this can lead to a number of ideological clashes or even an all-out struggle for control. It’s not uncommon for equity financing to come with strings attached, as we describe below.
Ownership: Having Your Cake and Eating it Too
When considering equity financing, you’ll need to decide whether you’re ready to give up a portion of your business in exchange for funding and expertise. Equity financing is a popular method of funding among many startups. According to the National Venture Capital Association, U.S. venture capitalists invested $84B across over 8K unicorn financings in 2017 alone.
Ownership can be viewed as a cake that can only be sliced in so many ways. A sole proprietor typically owns 100% of the cake while partnerships may cut it up into proportionate slices. After you already have a few partners, on-boarding more will result in a smaller share of profits for each member. Additionally, removing investor interests can require expensive buyouts, which can often tally up to significantly more than the original funds invested.
After factoring in all of these costs, one can see why repeated equity financing is an expensive way to raise capital. On the corporate level, equity investors can demand dividend payouts when those funds might be better reinvested in the business. This is common among private equity investors of medium-sized firms.
Allowing investment firms to buy into your company runs the risk of adding a partner who may not always have your business’s long-term strategic interests in mind. They may prefer short-term profits to long-term growth, and their views may clash with your own.
In summary, unless your business is in dire need of assistance, taking on too many equity investors in a short period of time will dilute your profits. This can be particularly distressing for businesses that have difficulty scaling. Before accepting new offers of financing, remember to balance their benefits against their costs, both implicit and explicit.
Being Mindful of Bad Actors
On the one hand, new partners can provide expertise and insight into areas where you’re not well-versed. On the other hand, you may invite too many cooks into the kitchen. New partners may have a vision that differs from your own, and if you give away enough equity, you lose control.
A well-known example is the story of Richard and Maurice McDonald, founders of the original McDonald’s restaurant. Beginning in 1953, the McDonald’s brothers franchised their wildly successful restaurant to six separate locations across California. The McDonald’s model of the fast food assembly line quickly caught fire and became the basis of all modern burger joints today.
Their original view was to keep the McDonald’s franchise limited to a small but manageable number of restaurants. This all changed when the brothers partnered with Ray Kroc, a traveling salesman and entrepreneur who wanted to franchise his own McDonald’s location.
In a span of fewer than 5 years, Ray Kroc expanded the franchise to more than 200 restaurants, contrary to the McDonald brothers’ original vision.
To push his vision of what the McDonald’s franchise should look like, Ray Kroc eventually bought the McDonald brothers out of their ownership stake for a paltry sum of $2.7M ($22.3M in today’s value) under the condition that the brothers be allowed to keep their original location. However, even this fell through.
In the years following the buyout, the original San Bernardino McDonald’s was forced to change its name due to copyright restrictions encountered during the buyout agreement. However, it didn’t end there, as Ray Kroc eventually opened a competing McDonald’s restaurant across the street from the original location, eventually running the original founding branch out of business.
It’s obvious here that the McDonald brothers quickly lost control of a franchise that they had staked their lives on. While this is an extraordinary example, it’s a classic illustration of how strategic views on business may diverge when multiple owners enter the fray.
Introducing partners to your business will require you to consult with them before you make major business decisions. If you’re not the type of person who likes to share decision-making authority, you may wish to limit how much your equity you extend to future partners.