240 CHAPTER 10 FUNDING THE BUSINESS
Debt or equity?
Along the way, I have assumed that you will use trade credit as and when it is available.
Your choice for your excess cash requirement is to fund it by borrowing or by increasing
the owners’ capital. The owners might be a sole proprietor, partners or shareholders. The
jargon varies, so from now on I will refer to loan capital as debt and to owners’ capital as
equity. With that out of the way, what difference does it make whether the funding comes
from debt or equity?
COMPARING DEBT AND EQUITY
Debt is repayable
Lenders are very demanding. They are concerned mainly with security and cash flow.
They usually lend to you only if you own more than you owe (so that they can seize your
assets if you default on repayment) and if you can prove that you can definitely afford to
pay it back. The main cost to you is the interest charge.
Equity is not repayable
Shareholders recover their capital in one of two ways. Either the business goes to the
wall and shareholders take the final pickings after all other creditors have been settled.
Or the shareholders unlock value by selling their shares to another investor. We should
assume that you do not want to close your business. The alternative then is to run a suc-
cessful company so that the amount that people are prepared to pay for your shares
increases. Shareholders can then sell their shares at a premium. You usually have to keep
them happy along the way by giving them dividends (sharing out a bit of annual profit as
pseudo interest payments). As shareholders are the owners of the company, those with a
high proportion of the shares usually want a say in how it is run. A shareholder – or group
of shareholders – with a dominant stake can force majority decisions. The cost, then, is
mainly an obligation to be good managers and a loss of ownership and control.
I said that lenders are very demanding. It sounds as if shareholders are worse. The big
difference is in the cash flow.
Debt is a burden – repayments of principle and interest drain your cash
flow. Equity does not necessarily involve parting with any cash – even the
dividends can be deferred until better cash flow days. Moreover, equity
investors accept higher risk in exchange for better returns in the future. This means
that you can persuade backers to swap their cash for your shares when the bankers
are sucking in their breath and shaking their heads. But while the cash flow effect of
equity is far less painful, the overall cost is actually greater than that of debt.