How to Survive a Recession

LESSON 34: Debt Not Equity Financing

In order for a business to grow it must have adequate capital and investment to build its customer base and serve those customers.

There are two main ways to finance a company’s growth: Equity or debt. Equity financing means selling shares of stock or similar ownership interest in exchange for cash or services. Debt financing means borrowing cash funds to be used for various purposes, such as investing in a fleet or trucks or a marketing campaign.

Equity and debt financing are different in a number of respects:

Investor Ownership: Equity financing means selling off a portion of the company in return for future share of the profits. This introduces new ownership into the company’s capital structure, with no set ownership term, and all of the rights and responsibilities of stock ownership. Debt financing uses somebody else’s money for a set period of time in exchange for interest payments and (typically) a claim on some of the company’s assets as security in the event of default.

Payment Schedule: Equity financing typically does not require any sort of cash payments by the company in the short term. A company’s existing shareholders give up the right to a future portion of the company’s cash flow for an immediate cash infusion with no associated near-term cash outflows. Equity purchasers are simply buying the right to future cash flows or company value with no expectation of near-term cash returns. (We are ignoring dividends here since very few small companies pay them.) Debt typically requires cash payments throughout the life of the loan, with a repayment of the original principal amount at the end of the term or upon some triggering event such as a default or refinancing.

Accounting treatment: The portion of the company sold in an equity financing is not considered a cost from an accounting standpoint. While there is definitely a cost of capital associated with equity financing, that cost cannot be expensed. In comparison, interest paid on loans is an expense item which reduces taxable income, and thus reduces taxes paid.

There are multiple reasons to opt for debt over equity financing in a recession. The latter stages of a recession are the optimum time to make long term investments in land, buildings, heavy equipment, computer hardware, software, and marketing and advertising campaigns to capture market share. Interest rates drop significantly during recessions, making loan payments cheaper. Lenders typically offer very flexible terms – an ideal time to get low rates, zero-payment loans, or minimal collateral requirements (notwithstanding the current credit crisis). By purchasing big-ticket items with borrowed money, this allows you to keep your cash in the bank and pay out small portions in the form of loan payments.

Debt interest payments reduce taxable business income, reducing taxes paid. If the business is operating close to or in the red, interest payments can potentially create a buildup of Net Operating Losses (NOLs) that can be used as tax credits when the economy improves and the company becomes profitable again. This allows the business owners to keep more of their profits instead of paying them out in taxes.

Debt financing also allows the owners to retain 100% ownership of the company unless the company defaults and there is a bankruptcy settlement awarding the lender ownership of the company in lieu of repayment. Financing a company with equity sales dilutes the existing owners’ interest. Introducing new equity owners into the control structure adds complexity and reduces management freedom to operate and sell the company as the owners wish. The owners are “locked in” to the relationship, and the cost of capital is fixed until the next equity sale. Debt financing can be refinanced or retired as the owners see fit, which provides a significant amount of flexibility. As long as interest rates remain low, it is therefore better to use debt financing.