Friday, April 29, 2011

Debt Can Be a Great Thing When Raising Money

With President Obama and the Small Business Administration’s push to lend Money, now may be a great time to raise money via Debt (instead of Equity). Below are 5 reasons why:

1 – The SBA Debt is Cheap.
We have seen a few SBA deals recently and the loans appear to be priced inexpensively relative to an equity finance cost of capital. This means that there exists a potential to benefit greatly from the gains due to the leverage. (Note: There is an MM Theorem in traditional finance which states that Leverage is irrelevant, meaning that a company’s cost of capital will not change with leverage, because as a firm increases its leverage the cost of equity will increase to offset gains on leverage. The current SBA deals seem to indicate that this theorem does not apply).

2 – Tax Benefit. Interest on debt is tax deductible, whereas, dividends on equity is not deductible (and actually can be taxable). In fact, the higher the marginal tax rate of the company, the higher the amount of debt a company should have in its tax structure.

3 – Discipline to Owners/Management. Debt adds an element of discipline to an organization. The old adage “Equity is a cushion; Debt is a Sword” certainly applies. In fact, the management teams of firms with high cash flows left over each year are more likely to be complacent and inefficient.

4 – Ownership Stays the Same. Although most likely creating financial covenants, financing through debt keeps the control of an organization intact. Owners/Managers value control.

5 – Creditors Are Not in Your Business. One of the biggest downsides to debt is the possibility of being forced into bankruptcy and/or being taken over by a lending institution. Although this is possible and has been happening more frequently than ever, we have seen that banks have no intention to take over a company that has fallen behind in interest payments (or broken a financial covenant). Banks would much rather work with a company than take it over.