Debt vs Equity - A Balance

Should a business seek to fund itself primarily with debt or equity as part of the business funding process

Well, let's look first at the different forms of debt and equity that exist

Debt can come in the form of money owed by the business venture to the founders

That is, the founders make a loan to the business. This isn't as common because generally founders are donating money to the business in exchange for an ownership interest rather than simply lending money

But when you have one founder contributing a lot of work and the other one contributing money, in order to avoid tax consequences for the individual contributing work

it is kind of common for the individual contributing money to do so under a loan and payback type of relationship rather than just a simple purchase of equity

So that's an important thing to consider. But another form of debt is when you take out a business loan, an SBA approved loan of sorts that the individual founders have personally guaranteed

And it probably has SBA backing, that type of thing. You may even sign a promissory note or take on a loan from third parties that you know, friends, family, or third party lenders, that type of thing

So these are the forms of debt you'll see. Equity is generally an ownership interest from the founders, obviously for contributing time, effort, resources like equipment as well as cash

and then you have friends family investors who will buy an ownership interest or just have some level of profits interest or something like that for money that they put into the business And then you have more formalized

relationships like investment from angel investors or venture capital firms at later stages of the

venture's life. So that's where the equity debt balance is going to come in. And as you become a

mature company, you also take out oftentimes lines of credit to fund operational cycles

you know, the pay payroll and things like that as part of business operations. So the debt equity balance is a trade-off

There are advantages and disadvantages to each. One, if a business takes out debt, it has to be repaid

Okay, it's going to come with principal payments and interest payments. And oftentimes business debt can be quite expensive, particularly based on the risky

nature of the business. Equity, on the other hand, does not have to be repaid

If the business fails, the equity obligation goes away. Now, there's two sides of this coin, too

Because the equity obligation goes away if the business fails, that means that anyone

purchasing equity has to have a higher potential return if the business is successful, which

which means you typically have to give away a larger percentage of your business up front

to equate the same amount of money you could get from a loan

And ultimately, if the business is successful, the amount you'll pay back to the investor for giving that amount of money

would far exceed what you'd pay back in a loan in interest

So that one thing the consideration of what it going to cost the business to sell equity versus taking on debt Another one is with debt it can be very procedurally handcuffing if you will That is

you have to get a, especially if you go through a bank that approves the loan, then you really

have to present a picture where you're going to spend most of the money on things that constitute

collateral rather than on things that help the business grow like marketing and things of that

nature. Where if you get money from investors, they primarily want to see that you're going to

spend the money on growth factors. Perhaps equipment if you need to level up to the level

of demand you have for production, but primarily they want to see it spent on marketing. Okay

you're going to put the money where it's going to have the most immediate impact on growth. So

once again, how you use the money is going to be a strong consideration as to whether you go

with debt or equity. And lastly, just whether you can get it. If you are a growth-based venture that

needs the money to achieve its potential, and if you don't get the money, honestly, the business

could fail, even though there's tons of market potential because you're moving too slow and

you're not grabbing enough of the value that's out there to be grabbed, well, you're going to

look towards equity in that scenario. If you're a more slow growth business, long term, you're

looking to turn the corner and make a profit as soon as possible, well that type of business

generally called mom and pop or small business or sometimes a larger but mature business

they tend to look instead towards debt as a means of funding because they going to have constant and stable revenue to pay off that debt and it just going to be like I say another cost line item that they can easily cover with operational revenue

Now, when evaluating a company, the debt to equity ratio is an important metric. Extreme

or heavy debt can be a liability. Extreme equity dispersion, that is lots of diverse

owners can create internal governance issues because, again, the founders have less control

there type scenario. And it could mean, once again, that the business is not as attractive to other investors because

the wide dispersion of equity owners there might mean that it's difficult to purchase

a controlling interest or to have a substantial stake or interest in the business

So once again, debt versus equity is always a balance. It will depend on whether the business is a slow growth or a startup, what type of funding is out there and available to them, and what are the overall objectives of the business

If it is a primary objective to retain ownership, not to disperse ownership among a wide number of owners, then debt's going to be a better option

And if debt is not available or there isn't enough capital there in debt form to take advantage of the potential growth or you wouldn't be able to service the debt payments based upon the nature of the business and when it will become revenue positive, then equity is the primary option

So that's the balance and breakdown of the equity versus debt consideration in funding a business