How to leverage equity and debt finance in your business funding strategy

Mixing debt and equity finance is necessary to find the right mix of business funding instruments for a healthy business. Understanding Leverage, ROE, Costs, Risk, Flexibility and Control issues goes a long way toward to finding the right mix for your company.

When developing your  Business Plan for your business these are some vital areas to consider to develop effective and realistic financial projections. This Debt and Equity analytic thinking and calculations can really help to strengthen your  Loan Packages as well.

Components that Affect Equity and Debt Finance

Leverage: Utilizing a Low Rate of Interest Debt Structure to leveraging into Investing the Loan Proceeds into an opportunity at a projected higher Rate of Return. Compare the relationship of using Debt verses Equity.  Variables would be the Interest on the Debt, the Effect of Taxes and the Economic Reality.  Equity and Debt should not be an either/ or proposition but a proper mix to meet your Financial Modeling Scenarios Goals.

– Calculating Return on Equity:  Earnings divided by Equity. Consider the effect of Harvesting the Asset in an upside and downside market. So while a Debt structure, allows you to leverage Equity, in an Economic Downturn, the Loan Interest can cause the Equity Investment to lose money.

Cost of Debt Finance: Cost of Debt = Interest Rate x (1.00 – the Effective Income Tax Rate).

Cost of Equity Capital: Cost of Equity = Earnings Participation divided by Investment or Earnings per Share divided by Selling Prize per Share.

Debt and Equity Capital Comparisons

– Cost:  Equity Capital is more costly than Debt Capital, as the Investor is open to much Higher Risks than the Lender, and to justify the Risk, the Investor seeks a High Return.

– Lender vs. Investor Risks

1) Interest deducted from earnings prior to distribution to Investors.

2) Legal requirement to repay debt, not equity.

3) Lender has greater access to collateral and liquidity availability.

4) In the event of business failure, Lenders are paid before Investors.

– Understanding Risk:  Equity risk lies with the Investor, yet, Debt Capital Risks are high to the Company:

1) Interest penalties.

2) Repayment demand during low Cash Flow Period.

3) Collateral Claims.

4) Personal Guarantees.

5) Unsuccessful Re-Finance or Expensive Re-Finance Terms.

– Flexibility:

1) Equity Capital much more flexible and efficient.

2) Alternative Debt Sources (Hard Money, Bridge Loans, Factoring, etc.) are Expensive but offer Flexible Debt on a short term acquisition schedule for a short term period (i.e. Rent Money).

3) Equity can limit Debt and vice versa depending on Covenants and Agreement Terms.

4) When combining Equity and Debt, Equity can make Debt much more Flexible, Attainable and Economical.

– Control Considerations:

1) Equity has Board Seat and Share Ownership.

2) Hybrid Debt Products (Hard Money, Mezzanine Finance) can have an Ownership Component.

3) Debt can control a business with a high Loan to Value/ Cost, high interest rate and steep penalty/ default terms.

4) The proper Mix of Debt and Equity is the answer.