Raising Capital: Equity vs. Debt

In November 2008, Donn Flipse was forced to close one of his three flower superstores in Florida's Broward and Palm Beach Counties. Nine months later, Flipse expanded by acquiring the business of a retiring florist in a wealthy section of South Miami. Those two events normally would have led Flipse to lean on his $500,000 line of credit. But that credit line had been personally guaranteed by a family member who, because of a decline in that person's own finances, was unable to continue the guarantee. Flipse paid off the revolving loan with "the only thing available"—money from two of his grown children, both of whom are shareholders and sit on the company's board. Now, for the first time in its 19-year history, Field of Flowers, which employs 46 people and expects to bring in $6 million in sales this year, doesn't have bank financing.

Like thousands of other small business owners with good credit histories, Flipse also found his credit-card companies lowering his limits. He plans to pay back his kids in early 2010, after the Valentine's Day and Easter rushes bail him out. "There was no choice," he says. He recently had to lay off two of six headquarters employees, leaving the dispatcher running the computer system. "We're not thrilled about any of it. But the company's a part of our lives."

It's not news that small companies are scrambling for credit, or in some cases, for equity investors. Entrepreneurs even appear to have caught a much weaker strain of the same virus—leverage—that helped bring down Lehman Brothers and many individual homeowners. From 2003 to 2008 the liabilities of small companies ballooned from roughly equal to sales to three times sales, according to Sageworks, a financial data company that tracks 1 million small private businesses. "In the crazy times, people were like drunken sailors—they'd project that in two years they'd double their earnings, [so they would] overvalue their companies, and as owners in love with their businesses, take on debt, right or wrong," says William Lenhart, national director of business restructuring at BDO Consulting, which advises companies with $10 million to $15 million in sales. "They got away from the historical debt-to-equity parameters of their industries." Banks and credit-card companies did their part, too, heedlessly throwing offers of credit at entrepreneurs. Some 636 million business credit-card offers went out in 2007, according to Packaged Facts, a research group. That works out to about 27 offers mailed to each company in the U.S.

Now, morning-after realities are prompting a rethinking of the relative merits of debt vs. equity. A rising sense of conservatism says small companies should be far less leveraged than was thought prudent 18 months ago, and should have much more generous debt-service coverage ratios. This measurement is a favorite among bankers because it cuts to the chase: Will they get paid or not? "There's a weeding process going on," says Joseph Harpster, chief credit officer at Herald National Bank, a New York community bank. "Banks have to be more careful." There's also a shift in thinking about a company's optimal debt-to-equity ratio, or its level of debt compared to shareholder equity. Instead of financing to expand, it's now about stashing away cash and trying to stay solvent.

Some business owners say ratios are an accountant's problem. That's not smart, says Dileep Rao, president of Minneapolis' InterFinance Corp, a venture-finance consulting firm, and professor at the University of Minnesota's Carlson School of Management. "Running your business without knowing your numbers is like driving a car without being able to see your direction or speed," says Rao. "It's only a matter of time before you crash."

The terms "debt" and "equity" get tossed around so casually that it's worth reviewing their meanings. Debt financing refers to money raised through some sort of loan, usually for a single purpose over a defined period of time, and usually secured by some sort of collateral. Equity financing can be a founder's money invested in the business or cash from angel investors, venture capital firms, or, rarely, a government-backed community development agency—all in exchange for a portion of ownership, and therefore a share in any profits. Equity typically becomes a source of long-term, general-use funds. The share of any hard assets, such as property and equipment, that you own free and clear also counts as equity.

Striking the right balance between debt and equity financing means weighing the costs and benefits of each, making sure you're not sticking your company with debt you can't afford to repay and minimizing the cost of capital. Choosing debt forces you to manage for cash flow, while, in a perfect world, taking on equity means you're placing a priority on growth. But in today's credit markets, raising equity may simply mean you can't borrow any more.

Until recently, bank credit was a financing mainstay. But experiences like Flipse's underlie a point made by the Federal Reserve Board's quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices, released in November. According to loan officers, small-company borrowers were tapping sources of funding other than banks. They were being driven away for many reasons. Banks "continued to tighten standards and terms...on all major types of loans to businesses," though fewer were doing so than in late 2008, when tightening was nearly universal. Interest rates on small business loans were on the rise at 40% of the banks surveyed, even as the prime rate reached historic lows. One in five banks had reduced small companies' revolving credit lines. One in three had tightened their loan standards, and 40% had tightened collateral requirements. Partly because of the plunging value of the real estate securing many commercial loans, pressure from bank examiners for tighter standards continued to build. Meanwhile, home equity loans, another popular source of small business cash, had evaporated. Many recession-weary business owners knew they had essentially become unbankable: Loan officers surveyed said far fewer firms were seeking to borrow. Those few who could borrow were repelled by higher rates. All of a sudden, equity financing looked better.

But equity has other costs besides giving up some control of your company. Raising equity involves legal, accounting, and investment banking fees, which eat up at least three to five percent of the amount raised. Later, investors will want a regular stream of information. And the lower your company's valuation, the more equity you'll give up to raise the same amount of cash, so raising this type of financing in a company's early stages means selling more of the business.

How much debt, and how much equity, is right for your company? Benchmarks vary by industry. And stripped of context, they don't mean much. Fast-growth fields with potential for blockbuster returns, such as software and biotech, attract equity investors more easily. Those companies also are often unable to borrow because their assets are intangible and their cash flow uncertain. The result: debt-to-equity ratios near zero. Capital-intensive industries with high costs, such as oil and gas development, construction, and mining, tend toward high debt-to-equity ratios—sometimes as high as 10 to 1. The same high ratios can hold for banks and finance companies, as well as troubled industries, such as airlines and autos. Here are some other factors that affect the optimal ratio for an individual company.

THE STAGE YOUR BUSINESS IS INAre you growing? That's hard to do using internal cash flow alone. "If you don't have some debt, you're probably constraining your growth," says John Terry, a business professor at the SMU Cox School of Business. "Most often, a viable business needs cash to grow, unless you choose to grow very slowly." How much debt is too much?

If a company is stable and well-established, tipping toward debt financing makes sense, because the company has both assets to borrow against and the cash flow to service the loans. Fast-growing startups, by contrast, lack the assets and cash flow that would qualify them as borrowers; they must inevitably tilt toward equity financing, which has a downside. "The cost of equity capital, where you're selling off a piece of your business, tends to be double" that of debt financing, says Tom Kinnear, professor of entrepreneurial studies at the University of Michigan's Stephen M. Ross School of Business. From that average, it regularly goes far higher, says Rao. In other words, the profits you're giving up from the portion of the company you no longer own can be expected to be much greater than the interest you would pay on a comparable loan. "That's a reasonably sophisticated calculation that's not widely understood," says Kinnear. The good news about equity is that going bankrupt because of mushrooming debt is not a concern. The bad news is that peace of mind comes at the cost of ownership and control. A demanding investor's desire for a particular exit strategy may not coincide with an entrepreneur's best interest. A newly launched business, however, may have no better choice.

INDUSTRY NORMS FOR ASSETS, INVENTORY, AND RECEIVABLESThese vary, depending on the type of business. If you're a manufacturer and your equipment is valuable, it's relatively easy to secure working capital backed by those assets. Also, banks as well as asset-based lenders will make loans against accounts receivable and certain types of inventory. Typically, they'll lend 60% to 80% of the value of receivables that are less than 90 days old, and sometimes, 30% to 50% of the value of raw or finished inventory. Fair warning: Interest rates at asset-based lenders will typically be at least two or three times the prime rate, and your credit score may play a part, too.

Industry norms also vary when it comes to solvency ratios. Again, asset-rich manufacturers with plants, equipment, and inventory that can be liquidated are well positioned for debt financing, while service or Web companies are less so, says venture investor Michael Gurau, president of Coastal Enterprises Community Ventures, which runs two regional venture funds in Portland, Me. But any company with large receivables, whatever its industry, should seek some debt financing, particularly a working capital line of credit, he believes.

COMPARING DIFFERENT FORMS OF FINANCINGBorrowing isn't cheap right now, but it is at least accessible. The variety of vehicles include subordinated or "junior" debt (so named because it has only a secondary claim on assets in the event of a bankruptcy). These loans come at higher interest rates, but they're available from development agencies and others. Factors and asset-based lenders may be options for distressed companies, where the owner's personal credit rating is below 650 and the company's net worth is negative. Higher-risk or startup borrowers that anticipate a merger or initial public offering within eight years can explore "venture debt" and similar hybrid structures that couple a loan with a "kicker" that converts to equity. But there aren't many venture bankers around, and the most established—Silicon Valley Bank, Western Technology Investment—are in Silicon Valley. Alternative financing may also take the form of a vendor leasing program, which Flipse uses: He leases his delivery fleet from a trucking company that provides financing at 5%.

As for possibilities on the equity side, it's sometimes feasible for companies or owners to create their own nest eggs. Pilar Peña is co-owner, with her twin sister, Ali, and her mother, Alex, of 10-year-old Forums Event Design & Production, a $2.5 million, five-person Miami company that uses a network of freelancers to put on expos, conferences, and other bilingual sales and training meetings across Latin America and the Caribbean. Recently the Peñas' credit-card company canceled the business' revolving credit, claiming their $150,000 balance was too close to the limit. But when the bank conducts its annual scrutiny of Forums' $200,000 credit line, the Peñas are prepared. Besides owning residential property, they build capital by keeping half the company's net income in the business each year. They run lean, with just two full-time employees besides the family. "If you've left enough equity in the business and have financial discipline in your life, you have that backup," Pilar says. "We have our back against the wall, and it gets scary" every spring, she explains, during and after a $1 million conference for a client that takes 60 days to pay. She pushes hard on receivables and uses a factor, but the equity is the emergency fund: "It's something that will pull you through." The bank says the Peñas may only approach their line's limit once a year, when they're bankrolling that huge event.

YOUR GOALS"The real question may not be how much you raise or borrow, but where are you putting that money? There's good debt and bad," says James Montgomery, a small business lawyer. "Borrowing money to generate more money—that's good debt. Borrowing just to stay alive is not."

One goal might be to stay ahead of rivals. If you keep expenses low and raise only a minimal amount, a better-funded rival may pass you. It's a calculation Michael Kirban made with Vita Coco, the coconut water company he co-founded with Ira Liran in 2004 . On vacation in Brazil, they were struck by the popularity of coconut water. With $80,000 in savings and a $100,000 credit line, they began importing small quantities, which Kirban sold to Manhattan grocers and delis, making the rounds on in-line skates. Rivals were on the scene, but Kirban was ahead in sales and distribution and wanted to stay that way. In 2007, he won $7 million in equity funding, for a 20% stake, from Verlinvest, a fund created by the three founding families of European beer conglomerate Anheuser-Busch InBev. That allowed him to build a factory in Brazil that employs 30 and to raise sales to $20 million.

WHEN AN EQUITY INVESTOR OFFERS MORE THAN CASHSome venture capital firms can help a business gain credibility by supplying advice, access to customers, and a stamp of approval. Kirban says his investor does this, too. Verlinvest "is a perfect fit," Kirban says. "We wanted an investor-partner with in-depth knowledge of the beverage business on a global scale." It seems to be working: Verlinvest has given guidance to Vita Coco's marketing team, which has allowed the young company to start selling in the United Kingdom. Verlinvest also suggested a set of quantitative benchmarks that Vita Coco uses to gauge its progress.

But at the beginning, Kirban was reluctant to part with a majority of his company, which Verlinvest originally wanted. Now, although Verlinvest has a 30% stake, it also has a significant say on all employee remuneration and the ability to replace Kirban at any time. Kirban, for his part, is thrilled to have such a big player in his corner.

SIZE OF MONTHLY LOAN PAYMENTSJust a few years ago, you may have heard this praise sung in favor of debt: You can deduct the interest payments at tax time. That's still true. But now, burned by the downturn, bankers and entrepreneurs are turning their attention to a different issue: Can you safely project that you'll have enough free cash flow to service that debt without spiraling downward, especially if interest rates rise? Credit analysts use a figure called the debt-service coverage ratio, which measures whether you've borrowed more than you can make monthly payments on. Ray Silverstein, a board member of Devon Bank in Chicago, says he's looking for $1.50 of free cash flow to be available each month for every dollar of debt-service payments that come due. Others seek $1.20. That compares with just $1 a few years ago—and that $1 was often based on cash-flow assumptions that were, shall we say, highly optimistic. Do this calculation not only at current interest rates but at higher rates as well, in anticipation of increases. Then consider possible fluctuations in revenue and in your ability to collect on time from your customers.

Still, some people just don't like to owe money. When Kirban was funding Vita Coco with his line of credit, he had nightmares. "Every time I'd open up our Citibank account and see how much debt we had, I'd freak out," he says. "When we were maxed out and had very little in the bank, you believe in your business, but still—it's scary to be personally liable for it." He paid it down as soon as he found an equity partner.

Where does that leave us? Prevailing wisdom today holds that debt and equity should be equal (1:1)—or that equity financing should be twice that of debt (1:2). Compare that with 2007, when the acceptable level of debt, relative to equity, was twice or even four times what's acceptable today, says Steve Romaniello, managing director of Atlanta private equity firm Roark Capital Group.

In the end, a ratio is only an analytical tool, not a magic wand. Important pieces of the puzzle, such as interest rates or sales, can move in unpredictable directions. Or as Rao says: "An optimally financed business may be obvious only in hindsight."

To listen to a podcast interview on increasing your chances of landing a loan, go to businessweek.com/go/sb/loan

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