Finance 101 for Small Biz: Debt vs Equity

Small business owners trying to grow their businesses need sufficient capital (i.e., money) to pay for inventory, marketing, equipment, and other vendor-related items. But owners must also have enough capital to pay for operational expenses like rent, utilities, and labor. And let’s not forget about the owner’s salary or draw. After all, most owners rely on the income from their businesses to live on.

So, the question is how to pay for company growth. Basically, you have two funding choices: debt and equity. Here’s how to decide between the two.

Equity

Equity is the money you and investors would have leftover if you liquidated your company and paid off all debts. In other words, it’s the business’ assets minus its liabilities.

Many small businesses have a single owner, meaning that 100% of the equity belongs to the owner. In this case, the owner’s equity is equal to the business’ retained earnings, which is the accumulated profits of your company after you pay all your bills and draw your own income.

Some small businesses have investors. You issue shares of stock to investors and pay them dividends in return for their equity investment. Then, the total equity of the company is money contributed by investors (including yourself) plus retained earnings.

Unlike debt, equity does not have to be repaid. Equity investors are willing to risk their money in return for a return on their investment. You can use equity capital to pay for the growth of your company, but you need to know the cost of doing so.

The cost of equity is equal to the return demanded by investors (including yourself) for investing in your company. Because small businesses are risky, equity investors usually require a higher rate of return than lenders do. The reason is that lenders have the first claim on the business’ assets if it goes bankrupt. For instance, you might be able to get a commercial loan at, say 10%, but have investors requiring a 15% return to justify their investments.

Dividends and owner’s draw are not tax-deductible to your business.

If you want to grow your company without debt, then the amount available for you to pay yourself and perhaps pay dividends to investors is decreased by the money you spend on growth.

Debt

Debt is the capital you borrow. The cost of debt is the interest rate, but since business interest is deductible, you must adjust the interest rate by your tax bracket.

For instance, suppose you take a 10% commercial loan and you are in the 20% tax bracket. Then, your after-tax cost of debt is 0.10 x (1 -0.20), or 8%.

Unlike equity, you have to repay debt. If you are taking a loan to finance growth, then you expect that the increased revenues from growth will allow you to pay the loan interest and repay the loan principal.

Owners looking for financing often prefer debt to equity because they don’t want partners. Lenders have no say about how you run your business, whereas equity investors may want to have input on your decisions. If you don’t want investors questioning or disputing your decisions, you will prefer debt financing.

Weighted Average Cost of Capital (WACC)

If you use both debt and equity to finance your company, then WACC is the percentage of each times the cost of each. For example, if your capital structure consists of 50% equity with a cost of 14% and 50% debt costing 8%, then WACC is 11%.

Preferred Shares

Sometimes, a business will issue preferred shares to equity investors. Preferred stock is a hybrid of equity and debt because it pays a relatively high dividend that must be paid before common stock dividends. The cost of preferred shares is, therefore, a complex calculation.

Conclusion

For many reasons, business owners turn to debt rather than using their own money or that of investors to fund their business’ growth. We at IOU Financial provide small businesses affordable loans of up to $ 500,000 with instant pre-approval and funding within a day or two. We invite you to contact us today to arrange financing that will help you grow your company and increase your revenues.

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Author: Kaitlyn Hammond

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