Equity vs. Debt Financing : When to Use Either (or Both)

By Eric Hall

At FLG Partners, we work with many high growth clients and one of our clear areas of expertise is fundraising. Companies today have several options to finance growth at their companies; cash flow, debt and equity. Established players can often use the cash flow they generate from sales of their products, services, or advertising to fund growth.  Although generating cash flow from operations is important, today we’re going to focus on equity and debt and when to use them.

The second method of financing growth is equity.  Equity is the sale of stock (ownership) in the company in return for cash.  Equity can be common shares or preferred shares.  Preferred shares have priority for receiving cash distributions and usually convert to common shares once the priority obligations are met.

The third option for financing growth is debt.  Debt is a loan from a bank, venture lender, private equity firm, corporation, or individual.  Debt accrues interest that must be paid on a monthly, quarterly, annually, or at maturity.  The principal must also be repaid on a periodic basis or at maturity.

Uses of Capital: Why Do You Need Equity or Debt Financing?

All companies need working capital to fund daily operations.  Most early-stage companies are consumers of cash.  Later-stage companies also may not generate enough cash to fully fund operations or growth.  Issuing equity or raising debt provides needed working capital to pay salaries, wages, and operating expenses or to purchase inventory.

You may also want to purchase assets – plant and equipment, hardware, software, intellectual property, and other long-term assets – to build the business.  It is important for these types of purchases to match the life of the funding to the life of the asset.  Short-term cash should not be used to finance long-term obligations as this often creates cash flow problems.

You may also need to finance a merger or acquisition.  You don’t need to use cash to acquire a company. Equity, debt, or a combination of both can be used to acquire another company or line of business. Using “OPM” (other people’s money) in the form of equity and debt provides ample merger or acquisition funding in return for a future return on investment for shareholders and lenders.

You might want access to multiple sources of capital.  Diversity in your capital structure strengthens a company from the point of view of lenders and investors.  Capital markets are fickle.  Availability of equity and debt changes based on economic conditions and/or the performance and condition of the company.  You may find yourself without funding if you rely on one type of financing.  Access to capital is also based on the relationships you build between your company and your investors or lenders.  A good history and track record are essential for raising additional funding from either source.

When Should You Use Equity to Finance Growth?

Equity should be used for financing when the risk of not being able to service debt (payment of principal and interest) is high.  If you can’t repay, don’t borrow!  The greater business risk makes equity the better choice for financing.  This is the reason why start-ups are typically financed with equity.  Lenders, by nature, are risk averse.

Equity can also provide a base to support debt and increase the company’s ability to raise additional funding.  This is what we call leverage.  Creating a capital structure that includes a mix of equity and debt improves a company’s financial strength.

Equity is also long-term capital.  Equity also does not need to be repaid by the company and  shareholders have a longer time horizon to realize a return on their investment.  An IPO transfers this obligation to the stock exchange.  Sellers get their money from buyers who want to own the stock.

When Should You Use Debt Financing?

Debt financing is a sound financing option when you know can pay back both interest and principal.  You don’t need to have positive cash flow, just enough cash available to pay the interest and amortize the principal over the life of the loan.  But note, lenders will want to see cash flow improving over the life of the loan.  Forecasts of revenue, EBITDA, net income and other KPIs (key performance indicators) should show improvement over time.

Debt can also be used to lower a company’s cost of capital.  Equity is expensive!  The cost of equity can range from 30% to 80% for start-ups depending on the stage of the company.  Equity demands a higher cost of capital because the risk associated with equity is higher.  The cost of capital for debt is usually based on a return in excess of the risk-free interest rate.  Today, that spread is in the range of 1% to 20%, still less than the cost of equity.  Without going into a lot of financial theory, in general, debt tends to improve ROI for investors so long as the amount of debt is not excessive. Debt raises necessary funding without diluting shareholders.

Debt, when used in an acquisition, also conserves the cash necessary for working capital.  Again, this matches a longer-term liability with a longer-term asset.  Leverage provides additional capital, if used properly.  Debt-to-equity or debt-to-total-asset ratios in excess of 50% are not recommended.  The recent failures of Toys-R-Us and Remington were caused by debt in excess of 50%.  Neither company could meet their debt service requirements and had to file for bankruptcy.

Understanding the Key Characteristics of Debt

Debt is associated with a number of important characteristics which need to be well understood when evaluating specific lender options:

• Principal amount
• Interest rate
• Loan term
• Type (revolving or term)
• Security interest
• Senior or subordinate
• Interest payment schedule
• Principal payment schedule
• Warrant coverage

Principal Amount

The principal amount of debt is determined by several factors: the amount of financing needed, use of funds, key leverage ratios (debt-to-total-assets, debt-to-total-equity, current ratio, quick ratio, etc.), and credit limits of the lender.  Lenders are willing to provide an amount that is equal to your funding needs.  Overfunding increases the borrower’s cost for funds they do not need.  Underfunding is also bad for the borrower and lender.  Underfunding will not get the company to where they need to be financially and increases the risk of default.  Default is an outcome that everyone wants to avoid.

Interest Rates

Interest rates for debt are based on the Prime rate or LIBOR plus a spread.  Loans from a bank usually have a spread from ½% to 4% over Prime or LIBOR.  Venture lenders usually have a spread of 5%-12% over the cost of funds.  Yield is usually 9 ½% to 16 ½% for venture loans.  It seems high but it is still a lot less than the cost of equity.  Interest can be simple or compounded on a monthly, quarterly, or annual basis.  No compounding or annual compounding are the preferred methods to reduce the cost to the company.

Loan Terms

Loan terms are usually 1 year to 5 years.  The higher the risk, the shorter the term.  Venture lenders, however, are not that sensitive to the term of the loan.  Their objective is to have you never repay the loan.  They would prefer you to refinance the principal plus accrued interest or increase the principal.  The economics are simple – why would any lender want to give up a 15% return?

Loan Types

Loan types are either revolving or term.  Revolving means that repaid principal can be borrowed again during the term of the loan.  Revolving loans are usually used for working capital.  They can be asset-backed using receivables or inventory.  A borrowing base calculation can also be used to determine the amount of available revolving credit.  A borrowing base can be a percentage of current assets or current assets less current liabilities.  It all depends on what you can negotiate.

Loan Terms

Term means that principal borrowed is for the term of the loan.  You can borrow all the principal at once or in tranches for a term loan.  Repaid amounts cannot be reborrowed.  It is possible to have a loan facility that provides both revolving and term features.  You may also be able to convert a revolving facility to a term facility to lock in the financing.

Security Interest

Loans can be secured or unsecured.  Secured loans have assets, tangible and intangible, pledged (assigned) to the lender.  A blanket UCC-1 lien is filed by the lender to perfect their interest in the security.  Other pledges or restrictions on assets and liabilities may also be required by the lender and included in the terms of the loan agreement.  Unsecured loans are based on the credit worthiness of the borrower.  Although the company’s assets may not be tied up by a security interest, lenders may require a personal guarantee from the borrower.  Try to avoid personal guarantees as a rule.  You don’t want to be personally liable to repay the loan should the company fail.

Senior vs Subordinate

Debt can also be senior or subordinate.  Senior notes have priority in repayment.  Subordinate loans are paid after the senior loans.  Subordinate loans can, however, force senior notes into default if the borrower is not careful.  Senior lenders usually do not allow subordinate debt, except from themselves, for this reason.

Interest Payment Schedule

Interest payments can be monthly, quarterly, annually, or accrued and paid at maturity.  You can also have a “rent holiday” where no interest is paid for the first 6, 12, or 18 months.  Interest can also be accrued and added to the principal balance for repayment at maturity.  The choice should be based on the cash flow which is available to service the debt.  Remember that deferring interest repayment will increase the cost of financing.

Principal Payment Schedule

Principal payments can be deferred to maturity (bullet loans) or amortized over the life of the loan on a monthly, quarterly, or annual basis.  The principal payment’s start date can be delayed through negotiation of terms to reduce the impact on the company’s cash flow.

Warrant Coverage

Warrant coverage (equity) is added to the terms of the loan to increase the ROI to the lender.  A good rule of thumb is that 2% of warrant coverage is equal to 1% of interest.  For example, a 12% interest rate plus 6% warrant coverage would translate into an ROI of 15% to the lender.  Warrant coverage may be a non-cash kicker but warrants do have a financial cost and impact on ROI to your equity investors.

What Are Issues to Watch Out for with Debt Financing?

There are several terms, conditions, and covenants companies should watch out for when using debt financing.

Default Conditions and Cure Requirements

Events of default and cure requirements are at the top of the list of issues of concern with debt.  If things go wrong, do you have the ability to fix them without having the loan called?  Can you get a waiver for a covenant if you are not able to comply?  You should be able to fix a default within 15-30 days of the default, except for bankruptcy.  No lender is going to let you off the hook for bankruptcy.

Deposit Account Control Agreement (DACA)

Be very careful when deposit account control agreements (DACAs) are required.  DACAs assign control over all your bank accounts to your lender.  Why?  If things go wrong, they can pull cash from your bank accounts without having to go through legal proceedings or notification.  DACAs are never good for the borrower.  Combined with Material Adverse Change (MAC) clauses, DACAs can be used to pull funds from your accounts even though you’re in compliance with your covenants, interest, and principal payments.  You should try and restrict the terms where a lender can use their DACA powers.

Material Adverse Change (MAC)

MAC clauses give the lender the ability to call your loan and demand repayment should something occur that could jeopardize the company’s ability to remain a going concern.  MACs are broad and can cover financial covenants to economic conditions to industry or market conditions.  The lender has broad discretion when to exercise these unless limited by the loan’s terms and conditions.  I have seen lenders call loans using MAC clauses even though the company is current with their payments and there are no events of default.  You should try and eliminate or restrict MAC clauses.  Using a monetary test with materiality clearly defined should be included in the loan terms.  Monetary test limits for materiality should be in hundreds of thousands of dollars.  A good starting point is $250,000.  A lender getting nervous because the industry outlook has changed or a recession has occurred are never good reasons to call a loan, in my opinion.  As a CFO, I expect lenders to support the company in good times or bad.  Lenders who only want to be there for the good times may find themselves excluded from future financing opportunities.  Lenders that have a proclivity for calling loans should be avoided at all costs.  There is a new class of lender that will lend money in order to force a default by borrower to gain control of the company’s assets including intellectual property.  Unfortunately, this is a cheap albeit deceptive way to acquire a company.

Summary

Equity and debt, alone or in combination, are useful means to provide funding for working capital, growth, and mergers and acquisitions.  Which one to use depends on the company’s ability to service the debt.  If the company can service the debt, the decision comes down to minimizing the cost of capital while maintaining a capital structure that reduces risk and maximizes return to the company and its shareholders.  A CEO and CFO should have access to multiple capital markets and sources of financing.  You can’t rely on one source like equity.    A healthy capital structure includes multiple types of funding.  Ultimately, your goal should be to ensure that your company has the cash it needs to survive and grow over both the short and longer term.  Remember, companies can survive with negative Net Income.  They can’t survive without cash.