In Defense of Debt

By Alek Marfisi

Far too often, I am sitting in our meeting room with clients discussing their businesses and reach the critical point: how much money do you need and where are you going to get it?  Very often, small business founders overlook debt in favor of equity, but this is not always the best option.

If you are starting a business that does not have a high proportion of research and development expenses, or is not depending on a massive marketing campaign to solely generate user traffic, then debt is an option that you should take a closer look at.  First and foremost, the major illusion that business owners must overcome is that debt is expensive; more expensive than equity.  This misconception comes from the fact that debt servicing is a requisite cash outflow while equity distributions are voluntary.  Such a shallow analysis of the true cost of these funding sources is insufficient.  While you do not have to make payments on equity in the immediate term; equity is a far more expensive resource.  Owing to the risk that investors must take when they involve themselves in your business, their limited chances of recuperation in the event the business goes south, and a myriad of other risks that could affect their return, the cost of equity is several times higher than that of debt.  On the other hand; credit is a centuries-old institution that cares only about one thing: being repaid with interest.  Debtors also have the first right to companies’ assets if the business fails.

The negotiation process to acquire equity is equally difficult.  The science of valuing a company only goes so far (it goes an even shorter distance if your company is still in its absolute infancy); and the deal ultimately comes down to negotiation.  In many cases, either the investor feels as though there was money “left on the table” (meaning that they could have bargained for a larger stake in the company for their dollars) or the entrepreneur feels as though they’ve given away too much of their company.

Some of the advantages of debt that you may or may not have considered:

  • It offers a definite schedule for you to transform cash received as debt into owners’ equity (your own equity).
  • Interest expense is tax-deductible.
  • High degree of flexibility: debt can be refinanced, payments can be scaled to match your cash flows, and liquidity can be made available for critical business needs.
  • Ease of transfer – if you sell your company, debt is many times easier to assume than equity.

In summary, if you are starting a business that needs to fund a balanced mix of start-up costs and working capital, take another look at debt as an option.  Don’t be discouraged if you are not immediately approved for financing either; this is a signal that you must spend more time building the business at a smaller scale and building your credit worthiness organically.  A failed loan application may not be a lack of confidence in your concept, but a sign that your business still needs developing before it is ready to move to the next level.

 

Alek Marfisi
MBA Candidate
Field Fellow/Baruch SBDC
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