Debt vs. Equity ?

Many people believe they should choose between debt or equity financing for their
companies. This is perhaps based on the view that money is money, and it does not
matter how you get it. For us as outside equity investors, however, the differences
matter a great deal. We want to get the most bang for our buck. When we make
investments this usually requires an injection of equity from us as well as
additional debt from the company's bankers. This article will review some of the
issues and outline an approach for finding the best mix.

Equity and Debt Features

First, it is necessary to understand the differences between debt and equity

financing. Some of the key features are listed below.

Debt
Must be repaid or refinanced.
Requires regular interest payments.
Company must generate cash flow to pay.
Collateral assets must usually be available.
Debt providers are conservative. They
cannot share any upside or profits.
Therefore, they want to eliminate all
possible loss or downside risks.
Interest payments are tax deductible.
Debt has little or no impact on control of
the company.
Debt allows leverage of company profits.
Equity
Can usually be kept permanently.
No payment requirements. May receive
dividends, but only out of retained
earnings.
No collateral required.
Equity providers are aggressive. They can
accept downside risks because they fully
share the upside as well.
Dividend payments are not tax deductible.
Equity requires shared control of the
company and may impose restrictions.
Shareholders share the company profits.

What to Choose

The table shows why venture capital may first seem like manna from heaven for
beleaguered entrepreneurs that are short on financing. Free money, without interest
or repayment. There is, however, an opportunity cost. In return for sharing the risks
equity providers also share all the profits. The choice, therefore, depends on the
balance between interest rates on debt and profits on equity.

In a static environment this choice becomes easy. If the after-tax cost of debt is
lower than the company's Net Return On Assets you should take on as much debt
as you can. This concept is known as leverage. If net profit margins are higher than
net interest rates you can maximize your Return On Equity by minimizing equity
and maximizing debt. If not, you do the exact opposite. If you cannot afford to pay
debt then you have to minimize debt and finance through equity.

As a result, a static situation is of no interest to venture capital firms. If the

company is doing well there should be no more need for outside equity. If a
company is performing so poorly that it cannot pay interest, then an outside equity
provider certainly has no incentive to join in.

Dynamic Equity

Please forgive the commercial, but the name of our firm actually indicates why we
exist. Venture capital investment is only feasible in a dynamic environment. This
typically means that a company is making some kind of transition in which its long
term prospects are better than its short term performance. In fact, a company may
even be losing money at the time of investment. Venture capital investors usually
do not need short term income and can afford to take the long term view. VC firms
make most of their money through capital gains. As a result, VC firms look for
those companies that have the best prospects to create the largest long-term
increase in shareholder value.

Getting the Right Mix

While we still cannot give an exact recipe, we can now present an approach for
finding the best debt/equity mix. Long-term shareholder value results mostly from
bottom-line growth. Therefore, the right mix must maximize the growth in long-
term profits.

This mix is likely to be different for each individual situation. At one extreme may
be start-ups. Because these may lose money in their initial years, and because they
have neither cash flow nor much collateral to support debt, start-ups mostly need
equity to enable growth. At the other extreme are leveraged buy-outs, where a team
of investors takes over an existing company. If that company is profitable already,
generates cash and has a healthy asset base, a buy-out can be financed mostly by
debt.

The optimal mix of debt and equity has to be tailored for each situation. This
requires some sophistication in financial modeling. The trick is to prepare financial
projections under different scenarios and with different assumptions. The goal is to
find the debt/equity mix that provides the highest expected long-term shareholder
value.
Conclusion

Investments into companies usually require both debt and equity. The optimal ratio
needs to be carefully determined for each individual situation. It is unlikely that
this ratio will consist of 100% equity. If the long-term prospects are so poor that a
company can never make sufficient profits to benefit from leverage then the
opportunity is probably not worth pursuing. Conversely, relying on 100% debt
financing often places a heavy cash drain on companies and leads to sub-optimal
growth.

Debt and equity financing should not be seen as substitutes for each other. Instead,
they are very different in nature and complement each other. Debt needs to be
repaid in cash. Equity needs to be rewarded with long-term profits. Depending on
individual circumstances and opportunities the trick for each investment is to find
the best mix of both.

Equity Share Capital:-

The proportion of the issued share capital (normally referred to as ordinary share
capital) of a company carrying an unrestricted right to participate in any
distributable profits.