Choosing debt over equity for business capitalization offers advantages like tax deductions and lower financing costs, but requires careful consideration of repayment obligations and potential financial risks.

Primary Implication

Use other people’s money wisely!  Understand the obligations to lenders and investors to achieve success when financing your business.

Anytime you use other people’s money to capitalize your business, you enter into financial and management obligations to those who provide you money.  The obligations to a lender differ from an equity investor’s, yet the results are the same.

You must do something more with their money than the cost of the money, or you will be the loser.

Overview

A profitable business model will lead a business to grow through self-funded reinvestments from their high margins and the surplus cash they generate through their operations.  The challenge is that very few business models start in this position.  They get there as they dial in their business model through disciplined management practices.

For those businesses not fortunate to start with high gross margins and surplus cash, there are times when you need to access capital beyond what your business operations can provide.  The two options that exist for doing this involve bringing on investors or taking on debt.

Below are five reasons why a company should use debt to capitalize a business versus equity:

1. Interest on the debt is deducted from corporate income taxes.  Tax rules allow using interest payments as expense deductions against revenues.  It is not uncommon for a company’s cost of debt to be below five percent after considering the tax break associated with interest.
2. Debt requires lower financing costs as compared to equity.  Debt, unlike equity, is finite.  This means you are required to make periodic payments for a specified amount of time until the debt is repaid.
3. Equity is riskier than debt.  Because a company typically has no legal obligation to pay dividends to common shareholders, those shareholders want a specified rate of return.  Debt is much less risky for the lender because the business is legally obligated to pay it.
4. Equity partners are hard to get rid of.  Getting rid of a loan payment is much easier than a business partner.  Getting rid of a partner can get nasty and turn into a legal mess, so be careful.
5. Debt is better than equity when the return on investment (ROI) will bring in a higher profit than the cost of the debt.  Plus, dealing with equity partners is always more complex than dealing with lenders.

Understanding and utilizing business debt is foundational to running and growing a successful business.  Business debt is not evil.  When a business owner uses debt to secure additional capital, equity owners can keep the extra profits generated by the debt capital.  Debt is neutral as long as you use the debt to make more money.  Fall behind on your debt repayments, and you will experience some ruthless tactics by those you owe money.

What makes debt a problem?

1. Repayment.  Despite the benefits, the debt must be repaid in full.
2. High-interest rates.  Debts are associated with interest.  Often, the interest rates for your debt are higher than fully realized, putting unnecessary strains on your operating cash flow.
3. Credit rating.  Too much debt will affect your credit rating until the debt has been paid off.
4. Cash flow.  Having too much debt will adversely affect your cash flow.  This is because your lenders require the debt to be repaid in equal installments regardless of your business income.

The appeal of debt over equity is proportionate to how successful you expect your business to be and whether you like the idea of sharing control with other investors.  If you think you can do better on your own, debt is the best way to go.  The downside is that if your company isn’t successful, you still have to make those debt payments.  And if you can’t, lenders will be first in line in a bankruptcy proceeding to collect what is owed them.

Debt is fundamentally more risky than equity.  A debt-financed company will bring in higher rewards for its founder than if the founder decides to share profits among many owners, but a high debt load also increases the chance that a company will fail.  Below are three reasons why you might choose to raise money by selling an ownership stake in the company:

1. You have burned through your personal funds and can’t secure additional capital through outside financing.
2. You would prefer not to be tied down by debt. You would rather owe your investors money when you realize a profit, not have to make fixed payments to them, and are prepared to reward them large amounts in exchange for their taking the risk that there may be no profits.
3. You want investors to have a say in managing the company because you see value in multiple people helping you decide what to do.

The problem with equity investors is their relentless focus on return on equity.  The business challenge with ROE is how tied up it is in stock appreciation.  Put another way, a business with many investors must always grow revenue, profit, and cash flow.  Fail to generate acceptable returns on an investor’s investment, and you are likely to get pushed out of your business.

The bottom-line is anytime you use other people’s money to capitalize your business, you enter into financial and management obligations to those who provide you money.  The obligations to a lender are different than to an equity investor, yet the results are the same.  You must do something more with their money than the cost of the money, or you will be the loser.