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Debt vs. equity: Which works best for you?

By Glenn Burkins
Glenn Burkins is editor and publisher of Qcitymetro.com, an online news site targeting CharlotteĀ’s African American community. He is a former Wall Street Journal reporter and Charlotte Observer business editor.

So you’re looking to launch (or grow) a business. It’s going to take some cash, and plenty of it, perhaps.

You could try getting a bank loan, but bankers aren’t too eager to lend these days, especially for startups. Family and friends may agree to help, but borrowing from loved ones isn’t always a great idea. And even if you are lucky enough to find an angel investor – someone willing to back your venture – that, too, carries its own set of risks.

So what’s an entrepreneur to do?

Start by knowing and understanding the various options, says Paul Solitario, a longtime mover on the Charlotte-area entrepreneurial scene. Solitario also is managing partner at Cerium Capital, which provides various consulting services to midmarket companies (those with $10 million to $100 million in annual sales).

Entrepreneurs looking to raise cash, he said, have two broad options: Debt vs. equity.

If you ever bought a car or got a home mortgage, then you understand the principle of debt borrowing: A lender floats a loan and the borrower agrees to pay it back, over time and with interest.

Generally, Solitario said, this is the simplest and cheapest way to raise capital.

Unlike debt, equity funding is not repaid on a set schedule. In essence, the lender becomes your co-owner and business partner. The loan eventually is repaid, but typically when the business is later sold or recapitalized.

Which route is right for you?

Depending on your business, your options will be limited, Solitario said. Equity investors typically look for fast-growing companies (“gazelles”) that hold out the promise of a big payday – at least 30 to 40 percent per year internal rate of return.

“If I’m investing in your company and it’s high-risk, I’m really rolling the dice on you,” he said. “The probabilities are that you’re going to fail.”

Most startups aren’t “gazelles” but “lifestyle businesses” – owner-operated with limited potential for sale or major recapitalization, Solitario said.

As for banks, he said, entrepreneurs should not expect them to fund startups because the rate of return is not sufficient to cover the risks.

Debt: Pros and cons

The biggest drawback is that debt must be repaid, and that can put pressure on small companies, especially those in the startup phase. In addition, Solitario said, most lenders will require a personal guarantee from the borrower, in addition to collateral.

Lenders also frequently impose “covenant” agreements that limit the borrowers’ financial options. For example, a covenant might require the business to generate a minimum amount of cash flow, restrict the owner’s ability to take on additional debt or buy competitors, or even block the owner from making capital distributions to investors or co-owners.

“You may be paying your loan back just fine, but you can trip a covenant and be in technical default,” he said.

Equity: Pros and cons

When it comes to equity investors, there’s no avoiding a simple fact: “You’re giving up a percentage of the company, and you may be giving up some of the control also,” Solitario said.

In other words, the founder may find himself being second-guessed on major decisions. And in some cases, Solitario said, equity lenders may be on par with founders, or even in a preferred position, if the business is sold or recapitalized.

On the positive side, the equity route carries fewer immediate risks. No collateral is demanded, no covenants are required, and the debt is repaid only after the business is sold or recapitalized – presumably years later.

Glenn Burkins is editor and publisher of Qcitymetro.com, a news site for Charlotte’s African-American community. He is a former Wall Street Journal reporter and Observer business editor.
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