Ever since the recent financial crisis introduced the general public to the pitfalls of excessive leverage within the financial system, there’s been a common misconception that “leveragability” for corporate borrowers may have been fundamentally altered. However, lending in today’s environment remains robust and is driven by the same fundamental analysis that occurs across financing cycles – stability and predictability of a company’s cash flow, coupled with the market value of core assets, remain paramount to any lender’s underwriting. So, with a relatively more stable market environment, companies that have survived and thrived in the post-crisis environment are well positioned to access the vast amount of underutilized debt financing that’s available.
Nonetheless, equity financing remains a very appealing option for many. Why is it so appealing? To many entrepreneurs, at first blush it seems like "free" money – with no repayment obligations and no interest payments. And they can often retain some say in determining stock price, dividend payments and the role investors will assume in their company.
What many business owners overlook, however, is that while equity financing doesn’t have to be repaid like a bank loan, the long-term costs of equity financing (in the form of relinquished ownership and control) can be significantly higher than debt. This is especially true in light of today's low interest rate environment, where the relative cost of debt is near an all-time low. Keep in mind that each share of equity you divest to investors is not only an ownership share out of your pocket that has an unknown future value, but also dilutes your control over both the long-term vision and day-to-day operations of your business.
The preferential tax treatment on debt financing
One of the major attractions of debt financing is the potential tax benefit. In most cases, the interest payments on a business loan are classified as business expenses, and thus can be deducted from your business income taxes. But while the interest on debt is paid before taxation, dividends paid to equity holders in most cases are paid from after-tax profits. As a result, the cost of debt is often significantly less and therefore more attractive than the cost of equity due to its tax-deductible interest.
While an optimal capital structure will typically involve a mix of both debt financing and equity financing, a greater dependence on debt finance may be advisable given the preferential treatment of debt relative to equity in the federal tax code.
Equity financing – high transactional costs and diminished control
In addition to the tax considerations, there are transaction costs associated with raising capital, whether through debt or equity financing. Your company must pay fees and outside expenses when issuing stock or corporate loans. But equity financing transactions generally require a greater time commitment from senior management, potentially at the cost of diverting their focus from more pressing business matters.
Raising debt capital may prove a less complicated endeavor, because with bank loans your company isn’t required to comply with complex and arduous state and federal securities laws and regulations. Nor does such financing require you to distribute periodic mailings to a large number of investors, hold regular shareholder meetings, or seek shareholder approval for certain actions.
And because lenders don’t have an ownership stake in your business, unlike equity investors, they have virtually no say in the business decisions of the company. The dilution of ownership interests that occurs when equity is relinquished often comes with infringements on both your control and decision-making power. Investors expect a return on their investment, and if it’s slow to materialize, they’ll typically insert themselves more actively in the day-to-day running of the business. There’s no shortage of business owners who have found themselves on the outside looking in – having been forced out by their own investors.
Using debt financing to buy back equity
At SunTrust, we often encounter successful, growing companies that have reached a point of stability where they would like to reclaim some of the equity stake they relinquished during their start-up phase. It’s a situation where debt financing can often provide an excellent means to achieve corporate and personal goals. For example, we recently spearheaded a recapitalization strategy for a direct seller and marketer of natural food supplements by securing the company a $130.0MM senior credit facility. Proceeds from the transaction enabled the company to repurchase a significant portion of the equity it had previously sold to a private equity firm, while at the same time refinancing its existing credit facility and providing access to additional working capital.
Refinancing higher interest debt
In much the same manner as individuals will refinance their home mortgage as interest rates decrease, business owners too need to remain vigilant as to the various loans and lines of credit they have in place. The current interest rate environment may afford you an opportunity to obtain more favorable rates, terms or covenants which can serve to help lower your overall debt servicing costs and in turn make obtaining additional capital feasible.
Potential drawbacks to debt financing
Of course, there are also inherent disadvantages to debt financing. Unlike equity, debt must at some point be repaid. It’s the reason why many start-ups are drawn to the equity side, sometimes willing to relinquish a majority stake in their fledgling business in order to minimize their personal risk.
Companies that are highly leveraged (have a large debt to equity ratio) are more susceptible to experiencing cash flow issues due to the high cost of debt servicing, and are viewed as riskier investments by potential investors. And corporate loans may also contain certain restrictions on the borrower's activities, such as preventing management from pursuing other financing options or non-core business opportunities.
As a result, businesses are often limited as to the amount of debt they can carry and commonly required to pledge company assets (and in some instances personal repayment guarantees) to the lender as collateral.