This is such a wide ranging topic that it makes it hard to find a great starting point. So I am going to begin by making sure that we are clear on Debt and Equity. I am going to use an example later to show how they compare in a real situation. In some businesses, it may be difficult to get one or the other or both. And we will get to that.
Debt is pretty simple. It is borrowing money. Many people are clear on this today as Credit Cards, Auto Loans, Student Loans and Home Mortgages are commonly used and widely available. Business Debt is available in a variety of forms such as Corporate Bonds, Business Loans, SBA Loans, and Lines of Credit. Each of these has their different place in the life cycle and size of company. But the basics are still the same. The borrower gets an amount of money that will be paid back over time with interest. Terms and Conditions on these loans vary widely and so have a lot to do with who can get what kind of loan. In the Banking world, the process of evaluating the loan request is called Underwriting. So when you hear of a Bank talk about their Underwriting Guidelines, they are talking about what they will need to have from the company to be able to give it a loan. You should talk to a Banker before you apply for a loan and they will give you an idea of what they want. This may be a lot more than you think it is.
Equity is also simple. You are selling a portion of your Business to someone (or many someones). You will know Equity transactions from the Stock Market where Public Companies are bought and sold (or at least parts of them are) every week. But Private Companies have equity investments of many forms as well, where firms sell part or all of themselves. The difference between a Public Company and Private Company is the availability of Stock for sale on the Public Markets. There are some forms that need to be filed and a whole mechanism to distribute that Initial Public Offering (IPO) happens. But at the time of an IPO, there is already Equity in the company and shareholders who own it. All that is happening is that some percentage of the ownership is for sale in a public marketplace and average people can buy or sell that stock in a marketplace.
There are also mixed Debt and Equity Instruments like Convertible Debt that I will cover in the future.
My example is a company that has $250,000 ($250K) in profit and has an opportunity to expand by spending $500K to buy a competitor. There are plenty of middle grounds here (and I will cover this a lot more in another post) but we are going to examine both scenarios at a very top level. For a Loan, the company takes in the $500K and pays off the loan with the profit that it generates in the future. For Equity, somebody gives the company $500K. If we assume the company was worth $1M at the time (aka pre-money), then the company (after the Equity Sale) is now worth $1.5M (aka post-money). This is shown on the Balance Sheet first with an increase in cash and then an increased Liability in Shareholder Equity.
The value of each of these is different as we have to look at how the Investment gets its Return. For Debt, it is pretty simple. It is the payback of the Principal ($500K) plus the value of all the Interest. For Equity, it is more complex. The Investor may want to be paid a percentage of the profits. The reason is that the Investor will want to “get liquid” or get his money back from the Investment at some point. So will the owner buy out this minority partner or will the investor sell his/her stock to a 3rd person? You can see how this can make the Equity more expensive than the Debt. But we will examine this throughout our series.
Have a great day!
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