Financing: Debt or Equity

September 25, 2014

Financing: Debt or Equity

Overview
Inevitably strong business growth has led many businesses to ponder how to access more capital. Is debt the optimal way to access capital or should privately held companies consider accessing the equity markets. Companies can spend several months analyzing and negotiating deals to access capital whether private placement or an initial public offering (IPO). IPOs are certainly the most complex and difficult to accomplish. Avoiding financial markets and finding private (or angel) investors may allow for a lot less regulatory scrutiny, though come with potential headaches as well.

In this article we only discuss a few cost / cash flow considerations when financing with debt or equity.

The Cost of Equity Vs. Debt Financing
Financing with equity requires that business sell ownership interest in exchange for capital. Many business owners struggle with giving part of the control of their company to someone else. The trade off can result in much more capital to work with, but the ability to develop and implement a strategy that is purely yours may become more challenging.

Furthermore, the type of business ownership will come into consideration. An LLC is not a structure that easily allows for the selling of shares. An S-Corporation is much better, though allows for a limited number of investors. A C-Corporation is the easiest structure to sell equity shares. When considering finding equity investors, this should be considered.

Attorney and consulting fees can be high when issuing equity. If a business issues private debt, attorney and consulting fees could also come into play. Debt financing through a bank is much less costly, as most of the fees are bank fees, which can be relatively low. (fees in this context do not include interest)

The Ongoing Consideration
Debt financing is ultimately less costly than equity financing whether you find private companies to provide debt or finance through a bank. Several chapters of a book can be written on the reasons for this. We will discuss this at a relatively high level.

The ongoing primary cost for equity is issuing dividends. Investors may expect dividends or a large payback (return of capital including dividends) after a period of time. Dividend payments are not tax deductible to the company.

For example, if you pay a 5% annual dividend on $1,000,000 of equity, the cost would be $50,000 per year. If you pay 5% interest on $1,000,000 of debt, the cost would be $50,000 per year, which is tax deductible to the business. In essence, with debt, your income goes down by $50,000. The equity payment does not lower your income, and would not lower your taxes.

Large corporations try to manage the optimal amount of debt versus equity partly for this reason. There are other reasons as well, though this is a big driver. Debt financing is generally less costly than equity financing.

As cash is king, both of these payments (dividend or interest) decrease cash flow by $50,000. Though, one alternative ultimately allows a business to keep more cash during tax time. This is a very simplistic way of explaining the difference, as the result to a business’ actual cash flow statement is more involved.

The point is that at the end of the day, debt financing can be a less costly option, though there are many of factors to consider. Some of these will be business specific. An example is that there are some companies that need a tremendous amount of capital and a large amount of debt on the balance sheet could negatively impact the company’s perceived solvency. There are several other considerations besides cost when making a debt versus equity decision, and businesses should be thorough in analyzing the alternatives.

If you would like assistance, please contact A. L. BEAN & Company at 512-244-4912 or email us at admin@albeancompany.com

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