Video: Module 7 – Dept and Equity
Presenter: Andrew Earnshaw
Let's look a little bit more at debt and equity as possible sources of business financing. When you borrow money from somebody when you're starting a small business, you're generally taking quite a risk, because whether the business succeeds or not, you're going to have to pay that money back. Fairly self explanatory.
When you get equity, either using your own money, which of course you don't have to pay back if you lose it in your business, or getting shares from somebody else, you don't have to pay that money back if things don't work out. So there's less risk for you. The nice thing about debt is that all you have to do is pay the money back, pay a little bit of interest, and you get to keep all the profits from your business.
With equity, that's a little bit different. You likely entered into some arrangement where a certain percentage of the profits are going to go to that person who gave you that equity, and probably because that person is taking more risk, they're going to require a lot more profits than they would get if they were just loaning you the money in terms of an interest arrangement.
So those two things have to be balanced off. You can think of this there's a term they use in business called "leverage." The more debt you have, the more leveraged you are. Imagine you buy a house one year for $100,000; you sell it next year for $110,000; you have a $90,000 mortgage; you had $10,000 down. Ignoring all the other complicated factors like mortgage payments and rents and things, simplistically speaking, you see in this case, if I sell that house a year later, I have $20,000 after I pay off the bank. I only put 10,000 in. My profits in one year were a hundred per cent. That's leverage because I borrowed money.
If I found a private investor to go in as a partner with me on that house purchase, they would have taken 90 per cent of all the money we got for selling the house, and I only would have got to keep 10 per cent. So remember, I put in 10,000; the private investor put 90,000. If we sold the house for 110, there is a 10 per cent profit. We'd share the profits equally. I'd end up with 11,000 in my pocket, and they'd end up with 99,000 in their pocket. So you see, not as much leverage, not as much return.
So risk and reward. We've talked about that in terms of debt and equity, how that impacts your business. But probably the most important impact is cash flow.
The trouble with debt is that businesses that get started with too much debt and not enough equity historical fail, and then they have nothing to do with the management ability of the people that started the business, nothing to do with whether they have a product or service that there is a market for. It's simply that they're committing so much financial energy to their business to make their debt payments, that they can't do things like an aggressive marketing campaign that should be happening at month 6, or going to a trade show at month 12 and negotiating really good deals with their wholesaler to get better prices for their raw materials.
Equity, on the other hand, remember, we have an investor here who is not expecting anything but profits. So there doesn't have to be cash flow running out of the business, going away from the expenses to pay off that investor. They're probably going to expect to be waiting for a few years before they start seeing some of the profits. In fact, they probably want you to plough your profits back into your business. So equity is a much more attractive option when it comes to cash flow and therefore is required for getting for businesses to succeed in the start up phase.
The final issue that I think about in terms of debt and equity is the relationship you have with the investor. The nice thing about debt relationships is they're simple: Someone gave you money; you made a promise to pay them back, certain amount of payments per month. As long as you do that, they're probably not going to be involved in your business. Equity investments can be a little more complicated. If I'm an equity investor and you're starting up a small restaurant, and I'm willing to put $50,000 in the start up of your restaurant, and my return is based on you being profitable in three years, until then, not much is happening. I'm probably going to be on top of you, I'm probably going to want to come in for lunch every Thursday and have a little discussion of your numbers, and make sure your food costs are under control, talk about whether your advertising campaigns are working properly. I'm going to be a lot more involved. That can be a really good thing. Lots of people who are starting small businesses tend to get equity investments from people that are experts in what they're doing as a start up. That kind of mentoring can be absolutely invaluable. It, however, can also be the close words of mentoring I guess would be meddling. So you want to be really clear, when you have a relationship with an equity investor, about what the terms of the contact are going to be, how much information are you going to provide about what you're doing, when do you want their help and when do you not want their help, when is it your business, not there's? These are things that are really important to clarify when going into an equity relationship with an investor.