Small Business Financing
Capital or Debt, What to Choose
General Business News
Small Business Financing
Capital or Debt, What to Choose
Last month, we discussed creating a business plan for your business, regardless of whether it is a startup or an established company. We also briefly mentioned financing the business through equity capital (shareholder, member or partner funds) or some form of debt. This month, we want to talk about the differences in these two types of financing.
Equity financing will have different names depending on the form in which you do business (i.e. common stock, partners capital, or member equity), but in the final analysis, it all comes from the same place - the pocketbook of the owner(s). There is generally no requirement for the capital to be paid back to the owner(s), unless there is some side agreement. Instead, the owner is paid back through distributions from the profits of the company.
So if all the above is true, how could equity financing ever be more expensive than debt financing? There are several ways equity financing can be more expensive. The corporate tax structure plays a part in this and so do human desires.
Lets look at the corporate tax structure. Assuming your company is a C Corporation, it will pay taxes on the income it generates. Whats left over after taxes is the net profit of your company. Lets suppose that you put $1 million into the company and your borrowing rate is 6%. Now, assume you have paid yourself just about as much as the IRS will allow on audit (called "reasonable compensation" in tax circles), but you still have taxable income of $100,000. If you pay only federal tax, your tax bill will be $22,250, leaving you a net of $77,750, $60,000 of which you pay out to yourself in the form of a dividend. The dividend is taxed at 15%, so you pay another $9,000 in tax on that portion of your income. The overall tax bill is approximately $31,000.
Lets turn things around and say you borrowed the $1 million. Now, instead of making $100,000, after deducting interest at 6%, your net profit is $40,000. On that net income, you will pay $6,000 in tax. Although you wont have any income to distribute after principle payments, the net effective tax is only 15% and you still have your $1 million to invest elsewhere.
Obviously, we could also look at the preceding example on the basis of cash remaining after taxes, ignoring your initial $1 million investment, and make a case for equity financing. After all, you wind up with $69,000 under the equity scenario and nothing under the debt scenario, but this assumes you are the only equity owner. What if you got that $1 million from 50 other investors? This is where you are really going to find out the expense of equity financing. In most cases, a single owner business can control finances in a way to minimize double taxation, but its not that easy when you have more than a few shareholders. While company founders are operating with the business partly as a labor of love, most other investors are looking for a return. That return will come either from increased value of the business or dividends.
Weve already discussed dividends to some extent, but what happens if your company increases in value? How will that cost you? Lets say that you start a business and need $100,000. You sell 25% of the company to a friend who will be a "silent" investor. The company grows, makes a bundle and five years down the road, its worth $10 million - mainly because of your hard work - and you have a buyer. How will you feel about giving up $2.5 million to your friend? Since your friend gave you the seed money, hopefully, you will both be happy, but still, a $2.4 million gain on $100,000 is pretty hefty, especially if you had the ability to borrow the money for 6%. Unlike the dividend, this difference in cost will hit you regardless of your form of business.
While there are various twists on equity financing, lets drop that subject for the moment and turn to another traditional method of financing your business - debt. While we took pains in the foregoing section to point out the pitfalls of equity financing, we werent really being fair to that financing vehicle.
For one thing, we didnt point out that every business has to start out with some level of owners capital, regardless of the amount. Sometimes this is dictated by legal considerations, sometimes by owner comfort level and sometimes, by lender requirements. You see, there are many lenders out there who think it wise that you have something to lose if a business goes under. Lenders are generally not willing to finance 100% of anything because if you dont pay them back, whatever you bought with their depositors money may not be worth what you owe on it.
So what should you expect when you set out to get a loan. If your company is a startup, you should expect to be required to put up plenty of collateral, prove you are putting adequate capital into the business and sign the note personally as well as on behalf of the company. All of this is in addition to convincing the lender you will produce adequate income to pay the principal and interest on the loan.
There are several reasons for this. First and foremost, the bank wants to be repaid and the best way to make sure that happens is to give you the incentive to do all you can to make the business a go. If all of your worldly assets are tied up inside the company as capital or pledged as collateral on a loan, you have a powerful incentive to work, be successful and pay the loan back.
Second, a new business has no track record, just "what ifs." Given that, about all the lender can really count on is the collateral you give and your personal guarantee, which essentially puts all of your assets, except qualified retirement accounts, on the line.
Ok, now that weve talked about the easy stuff (borrowing when you have collateral to provide), lets talk for a moment about what happens when you dont have a ton of assets to pledge as collateral on a loan. In other words, lets talk about real life.
Many states have a department of economic development, the mission of which is to provide assistance to businesses to grow the employment base in the state. Sometimes, these states provide some financing in the form of very low interest loans, either direct or by giving a bank a guarantee. Some financing may also be available through a local program in larger cities. Many times, these loans are directed toward disadvantaged borrowers in an effort to help them overcome a lack of adequate collateral or other defined disadvantage, but dont expect them to be a free ride. These programs still require some level of equity investment, however minimal.
Another source of assistance is the Small Business Administration of the United States Government. The SBA has several different programs that help the small business owner, but again, you will have to show a reasonable amount of equity for your type business; often times, the SBA requires equity to equal approximately 20% of your companys assets, after you receive your loan and spend it for the purposes you state in your loan application. Sometimes, a strong showing on other credit indicators may overcome a low equity level, but a company with no equity will likely fail to get a loan guaranteed by the SBA.
Make sure you get the right kind of loan for your purposes. A cardinal rule is do not use short-term money (annually renewing line of credit, demand note, etc.) to buy long-lived assets. By their very nature, long-lived assets are not expected to produce the kind of return needed to pay a short-term loan back. You may want to break your loan request down into a short- and a long-term component. Short-term money should be used for financing receivables and inventory while the long-term money can be used to buy the necessary property and equipment.
While we are talking about loans, you should know that banks generally do not lend for the long term. It is uncommon to see even building loans extend much beyond 5 years. This is another good reason for the SBA. Because of an SBA guarantee, your banker may be willing to go for a much longer term than normal.
We started this article out telling you all the reasons why equity capital may be more expensive than simply borrowing the money you need to start your business. We did this for a reason - to show you that there is a time and a place for both equity and debt financing in business. If your new or established business needs financing, give us a call and let us help you look at all your options. Were not a bank, but we know how to work with lenders to help you get the best possible outcome. We are here to serve you and help you with the financing decisions so you can concentrate on what makes your company profitable.
Have a great March and please remember to keep our troops in your hearts and prayers.
These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.