Debt Financing vs. Equity Financing for Scaling Businesses: A Risk-Adjusted Decision Framework
In 2014, I was sitting in a small office space at my startup, looking at a term sheet that would give away 20% of my company just for some quick cash. I was worried about scaling; however, I didn’t realize that cheap money comes with high costs. I came close to signing; however, I had a mentor who showed me the numbers on long-term dilution. That changed my entire outlook on capital.
The Problem:
The issue: You need a lot of money to grow your business, but if you choose the wrong funding source, you could negatively affect your cash flow or give away your ability to make decisions.
The Constraints:
The constraints: You are time-constrained, need to grow quickly, and only have a limited amount of equity to use in the funding process before you run out. You also have to convince your lenders that you will be stable, not just that you have a vision.
The Solution:
The solution: You need a risk-adjusted decision-making framework to balance your Debt Service Coverage Ratio (DSCR) with your long-term dilution goals in order to meet your need to grow and maintain control of your business.
Prerequisites and Context
Before proceeding, you should have a spreadsheet of your last three (3) years of tax returns, a current P&L statement, and 12-month cash flow projections. You do not need a PhD in finance to achieve this; however, you must be familiar with your “burn rate” and current EBITDA. If you do not have your
Understanding the Capital Structure Lifecycle
The Role of Risk-Adjusted Decision Making
Among most startup entrepreneurs, capital is viewed as a commodity, however, capital is an investment tool with its own risk characteristics. When an entrepreneur borrows money, he/she is betting that their future cash flows will be able to support repayment of the loan; conversely, when an entrepreneur raises equity capital, the entrepreneur is betting that their future value will support the return on equity to the investor. There is a correlation between the risks of defaulting on a loan (thereby not being able to repay the loan) and jeopardizing or losing the use of your business due to being unable to make payments on your debt.
Defining the Cost of Capital for Growth
As defined by interest and debt fees associated with obtaining financed growth, the capital costs of growth include debt payment amounts in addition to the amount of equity given up as a percentage of the future profits and the future exit value from the business (e.g., cash flow generated from the business) of the owner; therefore, calculating these costs will be important prior to negotiation with potential stakeholders for financing.
Debt vs Equity Financing for Small Business Expansion
Small business expansion financing decisions are primarily made based on the debt or equity financing option for expansion financing; this financial decision for the entrepreneur probably will be the most important business decision he/she makes. On an average basis, funds borrowed have always been cheaper than funds raised through equity throughout the years; however, borrowed funds must still support the necessary monthly cash flow(s) of the business to cover the entrepreneur’s debt payment obligation as they become due or else the business cannot afford to continue paying back lenders. Conversely, for equity capital, the investment is considered a long term investment by the equity investor.
Evaluating Debt Service Coverage Ratio (DSCR) Requirements
Traditional lender determination of whether a borrower can meet its obligations will be a function of the debt service coverage ratio (DSCR) – DSCR is the result of dividing net operating income by the borrower’s total debt service. Nearly all traditional lenders require a minimum DSCR of 1.25 to consider requesting financing; a borrower with a DSCR below 1.25 will be rejected from traditional financing sources. Regardless of unusual events in your business (e.g., bad month) that may affect your ability to repay a loan, you will need to demonstrate your capacity to repay your lender using residual income.
Analyzing Equity Control Implications and Founder Dilution
When you add equity partners to your business, you’re really getting more than financing, you’re getting a new boss too. Many founders do not understand how the equity control implications of allowing investors into the business can impact them in the long run due to being focused on the “valuation” amount only. Remember, every percent of equity you give an investor is a portion of your future exit and you’ll never be able to buy that back once the conversion occurs.
Navigating Debt Instruments: From SBA Loans to Mezzanine Capital
SBA 7(a) Loan Terms and Eligibility Criteria
SBA 7(a) loan terms are considered the “gold standard” in the small business space, due to their low interest rates and extended amortizations. The only negatives about the SBA 7(a) program are the amount of paperwork required prior to application being submitted and the strict eligibility criteria that applies to your business (size) and personal credit history.
Understanding Venture Debt Cost of Capital
Venture debt (or Growth Capital) is high cost compared to bank debt due to the nature of the venture loan providing investors with a loan to an early-stage (aka start-up) company (or companies) that are currently unprofitable. Venture debt loans are almost always associated with “warrants” (or options to purchase stock in the company later) which adds an element of risk for the lender. Venture debt is more of a bridge than a permanent solution.
Structuring Mezzanine Debt for Mid-Market Growth
Mezzanine debt is also considered to be more of a hybrid between senior debt and equity. The lender takes on additional risk in providing mezzanine financing, thus will charge higher interest rates; however, unlike a venture capital company, a mezzanine lender will take only a portion of equity. Mezzanine debt is a great way for mid-market companies that have outgrown their bank to obtain financing without going through a full equity round.
Comparative Funding Table
SBA 7(a) Loan: Interest – 7% to 11% – 10 to 25 year term – High collateral (personal collateral will most likely be required)
Venture Debt: Interest – 10% to 15% – 2 to 4 year term – Low collateral (warrants/equity kickers)
Mezzanine Debt: Interest Rates 12% – 20% | Term of 3 years – 5 years | Collateral subordinated (lower priority)
The Mechanics of Equity and Alternative Funding
Dilution Analysis: Calculating the Long-Term Cost of Ownership
Before you can sign any term sheets you must do a dilution analysis. If you raise $1 million at a $5 million valuation, you have given away 20% of your ownership. If you do that 3 times, you will not be a majority owner anymore. Make sure you use a spreadsheet to model your “post money” ownership after every investor you bring on board.
Revenue-Based Financing Repayments: A Flexible Alternative
With Revenue Based Financing the repayment amount is tied to your sales for that month. If you have a poor month, your payment is less than if you have a great month. This makes it an excellent alternative to traditional bank loans with rigid repayment schedules.
The Hybrid Strategy: An Undocumented Workaround for Scaling
Layering Revenue-Based Financing Over Senior Debt
I have seen many successful founders stack Revenue Based Financing on top of an SBA Senior Loan. The SBA Loan provides the “cheap” base and the Revenue Based Capital provides the “growth” fuel. You just need to ensure your senior lender allows for “subordinated debt” within your contract.
Mitigating Covenant Breaches During Rapid Expansion
When you grow rapidly, your financial ratios will fluctuate. If you breach a covenant, your bank can call your loan.If at all feasible, obtain ‘covenant light’ terms, or establish a cash reserve on hand for paying down debt in the event that your financial ratios begin to decline. More information about maintaining your financial covenants to maintain a good relationship with your banking institution may be found here.
What Didn’t Work For Me
When I first got started, I took out an extremely high-interest bridge loan to cover payroll during my slow business season. I figured I would be able to “outrun” the high-interest cost but I was wrong. The compounding interest on that bridge loan consumed my entire margin for two years. It was a lesson learned the hard way: Use debt only for growth assets (like inventory or equipment), not to pay for day-to-day operating expenses like payroll. If you are borrowing money to pay for your employees’ wages, the issue lies with your business model; not your ability to secure financing.
Best Practices for Maintaining Financial Health
- Balance Cash Flow Liquidity: Maintain Liquidity in Your Cash Flow – Always have at least three months’ worth of business operating expenses in cash, regardless of how much debt your company has at any given time.
- Strategic Timing: Timely Fundraising – Raise funds before you require them, as presently you are not in a position to negotiate with a financial institution because if you wait until you are desperately seeking funds you will have very little negotiating power, however if you wait until you are successfully growing there should be plenty of negotiating power.
Frequently Asked Questions
How does the Debt Service Coverage Ratio impact my ability to secure traditional bank financing?
If your DSCR is below 1.25, banks will view you as a company with a high risk of defaulting on the loan they are considering you for. Banks will either decline your request for a loan altogether or they will require you to personally guarantee the loan with the equivalent of a significant personal asset that will offset the relatively high-risk that the bank sees in lending you that money.
At what stage of business growth should an entrepreneur prioritize equity over debt to avoid over-leveraging?
When your business model is still being proven out, or if you are looking to place a bet on some much larger, high-risk opportunities that may not come to fruition until far into the future, it is better to use equity rather than debt. Debt should be saved for proven models that will produce an adequate cash flow stream.
Can revenue-based financing be used to bridge the gap between SBA loan disbursements?
Yes; however, it is extremely important that your SBA lender is aware of any revenue generated from secondary sources as some of the agreements executed with them prohibit taking on additional debt without prior written consent from the SBA lender.
