This is the third in a series of articles. This was published in Venture Capital Focus magazine in January 2002.

Debt vs. Equity ?

Many people believe they should choose between debt or equity financing for their companies. This is perhaps based on the view that money is money, and it does not matter how you get it. For us as outside equity investors, however, the differences matter a great deal. We want to get the most bang for our buck. When we make investments this usually requires an injection of equity from us as well as additional debt from the company's bankers. This article will review some of the issues and outline an approach for finding the best mix.

Equity and Debt Features

First, it is necessary to understand the differences between debt and equity financing. Some of the key features are listed below.

Debt	Equity
Must be repaid or refinanced.	Can usually be kept permanently.
Requires regular interest payments. Company must generate cash flow to pay.	No payment requirements. May receive dividends, but only out of retained earnings.
Collateral assets must usually be available.	No collateral required.
Debt providers are conservative. They cannot share any upside or profits. Therefore, they want to eliminate all possible loss or downside risks.	Equity providers are aggressive. They can accept downside risks because they fully share the upside as well.
Interest payments are tax deductible.	Dividend payments are not tax deductible.
Debt has little or no impact on control of the company.	Equity requires shared control of the company and may impose restrictions.
Debt allows leverage of company profits.	Shareholders share the company profits.

What to Choose

The table shows why venture capital may first seem like manna from heaven for beleaguered entrepreneurs that are short on financing. Free money, without interest or repayment. There is, however, an opportunity cost. In return for sharing the risks equity providers also share all the profits. The choice, therefore, depends on the balance between interest rates on debt and profits on equity.

In a static environment this choice becomes easy. If the after-tax cost of debt is lower than the company's Net Return On Assets you should take on as much debt as you can. This concept is known as leverage. If net profit margins are higher than net interest rates you can maximize your Return On Equity by minimizing equity and maximizing debt. If not, you do the exact opposite. If you cannot afford to pay debt then you have to minimize debt and finance through equity.

As a result, a static situation is of no interest to venture capital firms. If the company is doing well there should be no more need for outside equity. If a company is performing so poorly that it cannot pay interest, then an outside equity provider certainly has no incentive to join in.

Dynamic Equity

Please forgive the commercial, but the name of our firm actually indicates why we exist. Venture capital investment is only feasible in a dynamic environment. This typically means that a company is making some kind of transition in which its long term prospects are better than its short term performance. In fact, a company may even be losing money at the time of investment. Venture capital investors usually do not need short term income and can afford to take the long term view. VC firms make most of their money through capital gains. As a result, VC firms look for those companies that have the best prospects to create the largest long-term increase in shareholder value.

Getting the Right Mix

While we still cannot give an exact recipe, we can now present an approach for finding the best debt/equity mix. Long-term shareholder value results mostly from bottom-line growth. Therefore, the right mix must maximize the growth in long-term profits.

This mix is likely to be different for each individual situation. At one extreme may be start-ups. Because these may lose money in their initial years, and because they have neither cash flow nor much collateral to support debt, start-ups mostly need equity to enable growth. At the other extreme are leveraged buy-outs, where a team of investors takes over an existing company. If that company is profitable already, generates cash and has a healthy asset base, a buy-out can be financed mostly by debt.

The optimal mix of debt and equity has to be tailored for each situation. This requires some sophistication in financial modeling. The trick is to prepare financial projections under different scenarios and with different assumptions. The goal is to find the debt/equity mix that provides the highest expected long-term shareholder value.

Conclusion

Investments into companies usually require both debt and equity. The optimal ratio needs to be carefully determined for each individual situation. It is unlikely that this ratio will consist of 100% equity. If the long-term prospects are so poor that a company can never make sufficient profits to benefit from leverage then the opportunity is probably not worth pursuing. Conversely, relying on 100% debt financing often places a heavy cash drain on companies and leads to sub-optimal growth.

Debt and equity financing should not be seen as substitutes for each other. Instead, they are very different in nature and complement each other. Debt needs to be repaid in cash. Equity needs to be rewarded with long-term profits. Depending on individual circumstances and opportunities the trick for each investment is to find the best mix of both.

Other Articles: [ How To Impress Your VC ] [ Money for Nothing ] [ Debt vs. Equity ] [ How to Manage a Fund ] [ Some Way Outta Here ] [ Due Diligence ]