Debt or Equity in Small Business – Fundamentals
Small business books and manuals explain the formula used to determine whether additional debt increases the return for investors commonly known as return on investment (ROI). I find this laughable in our modern economic times given the low cost of financing. For well qualified individuals, money can be borrowed at less than 8% interest for business loans.
The best answer for small business related to debt or equity is the structure of both. As an owner of a small business you should use debt at the appropriate time and for certain purchases. On the other hand having no debt and no corresponding interest or debt service allows for faster wealth accumulation via optimum reinvestment of earnings.
To fully explain all that is involved, I’ve decided to write a series of articles related to return on investment in small business. This article explains the basic fundamentals and the formula because it is used frequently in the follow up articles and woefully misapplied by entrepreneurs.
To define the basic formula let’s assume the owners of a small business have invested $60,000 as equity in the business. At the end of the current year, earnings before interest and taxes is $20,000. Assume there are no taxes as this is a pass-through entity for tax purposes. For the formula of return on investment the resulting formula is simple. Take the earnings and divide by the investment, in this case:
Return on Investment = $20,0000 of Earnings Net of Taxes
$60,000 of Investment .
This pretty good. Now the owners want to expand into the next county at a cost of $100,000. The question is ‘Should they borrow the money or sell stock?’
To answer this, more information is needed. This includes:
- Issuing stock requires the existing investors give up 30% of the ownership interest in the company.
- The bank has provided a commitment letter indicating a 6% annual interest rate for a loan.
- Expansion into the next county will generate an additional $15,000 of net income before interest.
Let’s see what happens with both scenarios (sell stock to pay for the expansion or borrow money).
Total investment in the company is now $180,000 comprised of three components:
Long-Term Debt $100,000
Initial Capital $60,000
Retained Earnings 20,000
Sub-Total Equity 80,000
Total Liabilities and Equity $180,000
In the second year the business meets its goal and operating income is now $35,000 ($20,000 as in year one plus the additional $15,000). Interest on the debt is $6,000 so the net income adjusted after paying the interest on the debt is $29,000. What is the return on the investment (total equity position)?
Return on Investment = $29,000 Net Income
Return on Investment = 36.35% .
This is a significant increase in return on investment over the prior year. It is actually a 10.9% increase over the prior year’s return of 33.3%.
Now let’s find out the return on investment if the owner’s sell 30% of the company to raise the necessary $100,000.
After selling the stock the original owners now control 70% of the company. After completing the second year net income is $35,000. The original shareholders get 70% and the new owners are assigned 30%.
For the original shareholders their assigned earnings is $24,500 (70% of $35,000). For the original shareholders (owners) their investment is still $80,000 comprised of the original $60,000 investment plus retained earnings of $20,000 from the prior year. The return on investment is:
Return on Investment = $24,500 Earnings
Return on Investment = 30.6%
Wow, this is less than the return on investment if debt is used to expand into the next county. It would appear that borrowing money would benefit the existing owners over selling additional stock.
Or does it?
Primary Drawback of Borrowing Money
There are several different types of bank loans available when borrowing money. In almost every bank loan to a small business the bank requires security (Secured Notes). Since collateral is used to secure the debt, bankers prefer the loan’s amortization (payback period) not exceed 75% of the expected life of the asset.
As an example, the business purchases a truck and the truck’s expected life is 8 years. The bank will want their loan paid back in 6 years (75% of the expected life). Think of it like this, 6 years is 72 months, so the bank is going to want between 1 and 1.33% of their principle lent out paid back each month plus interest.
To simplify this I’ll use 1% during the first year. Using the $100,000 loan from the prior example the bank will want $1,500 per month as payment comprising $1,000 of principle and $500 of interest.
The annual cash payment is $18,000, $12,000 of principle and $6,000 of interest.
The net income before interest is $35,000 (Year 2). Of this $35,000, $18,000 must be paid out for principle and interest. This means the real value (cash value) earned by the original investors is actually $17,000. Now let’s restate the return on investment as:
Cash Return on Investment = $17,000 Net Cash
Cash Return on Investment = 21.25%
The drawback to borrowing money is that is must be paid back with cash plus cash for the interest. Whereas selling stock to raise money actually allows for more cash available to reward the shareholders. With the sale of stock as noted in the example used earlier, $24,500 is available for dividends. With borrowing money only $17,000 is available for dividends. Remember the return on investment from above after selling stock to raise the necessary capital was 30.6%. The return associated with borrowing money is actually 21.25% because cash is needed to pay back the principle.
With this situation, the cash return on investment equals total return on investment because there is no debt service (principle and interest) to reduce cash earnings.
IN REALITY, BORROWING MONEY REDUCES THE ABILITY OF OWNERS TO TAKE DIVIDENDS FOR THEIR INVESTMENT.
As an owner of a small business one of your decision criteria with choosing between debt and equity is the question related to taking dividends in the future. In the next article with this series I will complicate the decision model further by expanding into the issues of comparative returns between the two counties and the relationship to their respective sources of funding.
Summary – Debt or Equity in Business
When faced with the decision to fund growth with either debt or equity as the source of capital, the first step is to use the return on investment formula for both options. Compare the returns and then address the cash return on investment. If dividend payouts are of primary value to you as the owner make sure you evaluate the cash return on investment for both debt and equity in small business. Act on Knowledge.
© 2017 – 2022, David J Hoare MSA. All rights reserved.