Debt vs Equity
Frederic Baud
Hi all. The question is debt or private equity ? If we speak about
Venture or seed money, this means that the scope is to fund an
innovative start-up, requiring money for structuring, for engineering,
for going to the market etc. This type of company is loosing money
during 1 to 3 years (even much longer for biotech cies). After this
"investment period", the company will make profits. As a consequence,
the first period is not a free cash flow positive (not profitable and
even more not FCF positive). So equity looks much better than debt !
On the other hand, the start-up could be funded thanks to debt if this
debt is for instance a loan with an "in fine" reimbursement and with a
"convertible warranty"... -- PatrickLardant
I think one the basic difference from an investor point of view
between debt and equity is that debt bears basically the same level of
risk than equity (will the startup work at all, linger for years or
disappear), but liquidity is slightly better (you can possibly
retrieve some level of cash in case of bankruptcy and even can assure
some pay-back if a tradeable asset is offered as a collateral). In
return pay-off is caped. so volatility is bigger on equities - for the
better.
Now from the technical side, debt may be easier to implement
technically for a startup. Equities involve to adopt a certain type of
legal entity (SA or SAS in France) to be able to trade the shares of
the company and involve.
Basically from the investor side, the question is should it adopt the
VC bank model or the Venture Capitalist model. -- FredericBaud
Equity financing is a form of financing without incurring debt;
without having to repay a specific amount of money at any particular
time. The major disadvantage to equity financing is the dilution of
your ownership interests and the possible loss of control that may
accompany a sharing of ownership with additional investors. From the
lender's perspective, the debt-to-equity ratio measures the amount of
available assets or "cushion" available for repayment of a debt in the
case of default. Excessive debt financing may impair your credit
rating and your ability to raise more money in the future, and for a
start up it may be impossible to get any loan unless you can provide a
due collateral. If you have too much debt, your business may be
considered overextended and risky and an unsafe investment. In
addition, you may be unable to weather unanticipated business
downturns. On the other hand, a mature company having a lot of equity
and no debt may be considered as not being very well "leveraged" and
as not having the best profit return on equity.
Lenders will consider the debt-to-equity ratio in assessing whether
the company is being operated in a sensible, creditworthy manner.
Generally speaking, a bank will consider an acceptable debt-to-equity
ratio. For startup businesses in particular, the owners (and lenders)
need to guard against cash flow shortages. Lenders will look at cash
flows, debt/equity ratio and... collateral. -- PatrickLardant
In fact, we have to look at the two sides of the market: investors and
entreprise.
For investors, we have to look if we can find an opportunity to invest
where standard banks or VCs do not want to trade. Or if we can compete
against them on deals they don't handle efficiently.
Typically a bank will not trade if the value of collaterals is not
high for them to cover the risk they are able to compute. In that
case, P2PVenture could offer a mean to better assess the risk through
the knowledge of the peer-investors and accept collaterals with a
lower value than what require banks.
On the other hand, a VC usually is spending significant resources to
assess the upside of a startup and wants to trade in shares which have
potentially a higher return. Competing with VCs would mean being able
to handle the due-dilligence at a lower cost and trade with startup
with a lower upside but liquidity tends to be more difficult because
of insufficient secondary markets on these (e.g. trade on startup with
an end valuation of €10M, something that Business Angels sometimes
do).
For enterprises, even if in theory the ratio of debts and equities
should not matter (see Modigliani-Miller theorem). In practice, it is
true that a high ratio of debts to equities is difficult to handle.
Nevertheless, if the debts are very long term, then they could be
considered more and more equivalent to equities for accounting
purposes. If we deal for a startup where 5 years looks like infinity,
I suppose that a 10 year obligation could be considered as stable as
equity, with lower dilution, but with more rights in case of
bankruptcy.
My feeling is that there is potentially a bigger market on the cases
of deals that standard banks refuse to do. There is also potentially
more distributed knowledge to leverage once we have been able to
somewhat standardize the presentation of the different businesses
beyond the standard financials (what banks heavily rely on).
For the deals Business Angels and VCs don't do, I'm a bit worried that
it requires heavy due-dilligence that may not be much more efficient
thant what BAs and VCs already standardly do. -- FredericBaud