Debt vs Equity: Financing Your Business

Transcript

Hello, I'm Rick Dennen, founder and CEO of Oak Street Funding. Today I want to talk about an important topic for business owners, debt and equity financing. Some things I'll be covering today are differences between the two, when one might be a better option over the other, some common misconceptions, and more.

What is the difference between debt financing and equity financing?

Debt financing is a fixed payment. There's a fixed pay period, there's a rate that has to be paid, and the timeline in which that debt is repaid is defined up front as you sign the agreement. On the equity side, there can be many more forms of equity that exist, many different forms. There could be a carry that goes along with that equity, or there could be no payments and it's pure common stock that would result in a repayment at a point of a liquidity event or a buyout or something along those lines. There is no requirement to repay that equity, unless it's specified in the agreement though.

When is debt typically the better option, and when might equity make more sense?

Debt is a better option when you're at a high growth period, the business can support the debt, and you have all the resources you need to run the business. Equity may be a better option if you're already leveraged and you need some equity to somewhat eliminate the risk of the ability to repay some of that debt and keep you levered at the right point in time. Debt is a way to build wealth easier and quicker. If you're giving up too much of the business from an equity standpoint at a high growth period before you need to, then you're going to give away a lot of the equity and a lot of the upside potential. But if you can't get there without the equity, then you've got to weigh the alternatives of getting there and diluting yourself or not getting there at all.

What common misconceptions do some owners have about taking on debt?

A common misconception is that all debt is bad, or debt must be repaid immediately, or you know different things about debt, that the debt is going to start running your business. I think a lot of these misconceptions come about from consumers that might have and what they read about credit card debt and high interest consumer debt and it just plagues people and they're not able to grow the business. I will contend that debt could be one of the greatest wealth contributors to an individual. If they can use debt to grow their business instead of equity and retain all the ownership, it's probably one of the greatest things you can do to build your business. But there's a balance between taking on too much debt and having too much leverage versus, you know, taking on a lot of equity and simply diluting yourself way down before you get an increase in enterprise value.

How should someone evaluate the cost of debt versus the cost of equity beyond just interest rates?

It's very easy to evaluate the cost of debt when you're simply looking at an interest rate, even if it's variable, baking in some assumptions as to how that interest rate may change and what that can do for the business. The cost of equity is a little bit more difficult. You're going to have to weigh in the change in the value of those shares, what those shares are being purchased at, the amount of dilution you're given up, and what that equity is going to be able to do by creating accretive value to the business. So that one's a little bit harder. You're going to have to bake into that some more assumptions. But it is very important that you're doing, you know, mathematical calculations on each to determine what is best for you.

If you could give one piece of advisor to a business owner considering their first major financing, what would it be?

My piece of advice here for raising debt is, you know, having raised close to a billion dollars with probably eight to 10 different lenders is don't get frustrated. If you walk into meetings to the first lender and they don't want to just give you all the debt that you need. You're very passionate about your business, you understand your business very well. But the bankers don't always have the same vision, they don't have the same understanding, the same passion for it as you. What I would recommend as a piece of advice is you're talking to lenders that truly understand your industry, they understand your business, they understand the upsides, the downsides, they understand how things can work, what the potential risks are, what the mitigants are, and from that they'll be able to generate a term sheet or, you know, a letter of interest, letter of intent. And I think at that point in time it's very, very, very important that you understand all of the terms in that term sheet and that's very detailed. I remember a term sheet that was over five pages long that went through about every detail of how the facility was going to work. And by the time we got to legal documents and got that facility closed, there were really not a whole lot of discussions because we spent that time up front. So the piece of advice is don't get frustrated. You know, if you have to talk to many, talk to the ones that know your industry and be very detailed upfront before you sign on the dotted line.

I hope this gives you a clearer picture of the differences between debt and equity and how to think about what's right for your business. Stay tuned for the next video in this three-part series when I will be covering mergers and acquisitions. Thanks again.