Insights
Debt Financing: Why Incurring Debt Could Be a Smart Thing
By Ellen Chang
When and why to incur more debt and retain more control over your business.
As businesses gain traction and obtain more market share, entrepreneurs debate the challenging question of whether to give up equity to investors, apply for bank loans, or look toward other kinds of debt. Entrepreneurs should not be fearful of taking on debt because it signifies that their business has strong revenue and cash flow, experts say.
While some founders believe that incurring more debt is risky, the opposite is actually true, says Thompson Aderinkomi, co-founder and CEO of Nice Healthcare, a Minneapolis-based primary healthcare service provider, which conducts online video and in-home patient visits. Giving up equity to a venture capital or private equity firm often signals that owners are giving up some control on how to manage their business, he said.
Aderinkomi—who has co-founded three other companies, raised $8 million from venture capital (VC) firms, and has also started businesses by taking on personal and credit card debt—said he firmly believes that seeking debt is the best strategy if the business has a track record for strong cash flow.
“I always go for the debt if my business’s cash flow could sustain it and if I don’t need to grow at VC speed,” he said.
Whenever businesses are able to generate sustainable, positive cash flow, utilizing debt poses less of a risk, so long as there are no issues in making the payments.
“I would advise small business owners to consider borrowing than to acquire investors,” says Wai-Chun Li, senior vice president and manager of East West Bank’s SBA lending department. “The advantage of borrowing rather than getting an equity injection by investors is that the original owner will not lose the controlling interest of the company,” Li said. “When you get a bank loan, you don’t need to give up a part of the ownership of the company.”
Why giving up equity poses risks
“The most valuable asset that founders possess in the early stages of a startup is the equity in their business,” said Matt Barbieri, CPA and partner-in-charge of the media, technologies and life sciences group at Wiss and Company, an accounting and consulting firm headquartered in Livingston, N.J.
“Your equity is valueless without your intellectual property, and so many founders do not contemplate this factor,” he said.
According to Barbieri, one major mistake that founders make early on is either giving away large stakes or shares to people beyond investors.
“You only have so much equity to give away, since you’re constrained by that one pie,” Barbieri said. “They’re very quick to give away pieces of their company without enough consideration. Being too relaxed with equity is problematic because it is nearly impossible to undo that.”
“Giving up a percentage of your company in a round of financing can be riskier because sometimes founders do not retain control of the company.”
Giving up a percentage of your company in a round of financing can be riskier because sometimes founders do not retain control of the company, said Aderinkomi.
“You are letting other people into your business,” he said. “You have to be ok with a bunch of people sitting around the table telling you what to do.”
While it partly depends on what industry the business is in, after a company has raised capital multiple times, the concern is how much dilution has occurred over those rounds, said Aderinkomi. One obstacle is that a new round of investors will want the same equity as the previous round of investors.
“We’re innovating and breaking rules,” he said. “When it comes to raising capital, founders think there are all these rules, but there are no rules. If you’re confident and believe you can do it, do not give up control and seats on your board.”
Companies often adopt a hybrid model, where they have already taken on debt and are accepting equity from venture capital firms, said Min Choe, co-founder and CEO of Tso Chinese Delivery, an Austin-based Chinese food delivery service that launched in 2017.
“We’re pretty experienced on both fronts,” Choe said. “It depends on what your growth strategy is.”
Some VC firms have taken a new approach where they are more “founder-friendly” and allow owners to retain more control.
“We are currently talking to a couple of venture capital firms, and it is important to find one that wants to be a partner by letting us grow and are not looking to come in and change how we do business,” Choe said. “For us, the true value of a VC is letting our company grow and network with other investors.”
Brendan Sweet, co-founder of Dream Forward, a New York-based low-cost 401(k) plan provider, said their philosophy is to try and give up “as little equity as possible because it’s an affirmation that your company is doing well.” While there are always circumstances where giving up equity makes sense, founders need to do their due diligence and give it to the right investors, he said.
“Some investors bring contacts and experience, things that are way more valuable than a dollar amount,” Sweet said.
While all industries have different metrics, and valuations for startups can vary widely, many companies aim to raise $3 million to $10 million in their Series A round, and another $20 million or more during their Series B round, he said.
Equity also has to be shared among the founders, which means if you have more than one founder and the first round of investors demand 15-30 percent, control of the company can be diluted quickly, said Choe.
Why debt can be viewed positively
Choe, who also co-owns an upscale restaurant called Jenna's Asian Kitchen in addition to Tso, raised capital in his seed round from friends and family members. Tso is now seeking a low-interest rate loan from financial institutions to help consolidate the debt acquired from borrowing from their friends and family and their loan from NextSeed, a Houston-based investment crowdfunding platform for small businesses.
He was able to launch his company by bootstrapping in the beginning and was cash flow positive within a few months. Initially, he was not planning to bring on equity partners, but in order for the company to accelerate its growth strategy, he needed a large injection of cash.
If the company slows down its expansion plans and adds only one store per year after having established strong financials for a couple of years, it would be easy to go to a bank or SBA preferred lender, to get conventional bank loans.
While incurring debt presents a certain amount of risk, like giving up shares of your company, many founders do not comprehend the full magnitude of not being able to make payments, Barbieri said. Some business owners put debt on the back burner and view debt holders with less priority compared to their investors.
"If the return is greater than the interest rate incurred on the debt, then borrowing can be seen as a positive."
“I wouldn’t advise people to leverage too much debt,” says Li. “But if the return is greater than the interest rate incurred on the debt, then borrowing can be seen as a positive.”
Once businesses are established and generating a healthy profit, they are in a good position to accrue loans for expansion, acquire equipment and additional working capital.
Business owners should consider SBA loans since personal loans and credit cards usually charge higher interest rates in the double digits. The current rate of an SBA loan is an average of 5.5 percent to 7.5 percent. Li said. “SBA loans require lower down payments, longer repayment terms and can be used for a variety of loan purposes, such as real estate purchase, working capital, business expansion, partner acquisition, etc.”
The catch is that if the business goes “sideways,” e.g. the company fails to meet sales projections and their cash flow dries up, depending on the structure of the debt deal, “debt holders will end up owning both your company and your intellectual property,” said Barbieri.
Utilizing debt can pose fewer problems for businesses that can secure market-rate debt with reasonable payments, said Aderinkomi. “Those companies should never pursue giving up equity because it wouldn’t make logical or business sense,” he said.
Having to fulfill debt obligations also instills discipline in the management team because they have to be able to generate enough revenue to support these payments for several years. “Debt is much simpler and more straightforward, since you focus on the amount of cash flow the company is producing,” said Aderinkomi. “If you can help it, grow the cash flow and don't take money out of the company.”