Access to capital is one of the biggest barriers businesses face when looking to implement growth strategies. However, an important question always facing companies in need of new finance is whether to raise debt or equity. Despite the continuing theoretical debate on capital structure, there is relatively little empirical evidence on how companies select between financing instruments at a certain point in time. When entrepreneurs think capital, most of them focus more on selling a portion of their company to potential investors; however, they have realized that debt is what helps push the company to the next phase.
There is no reason to be intimidated by the term “debt”. Debt can be beneficial for your business (small or large) in various ways, if managed responsibly. If you look at the large global corporations, you’ll find that most of them have some amount of debt. Debt is what keeps the world economy running and it is also a great way for individuals to gain some return on their investments.
For example, household names such as Uber, Netflix, Airbnb, and WeWork have raised billions of dollars through debt financing over the years, taking advantage of the low-interest rate environment. Alongside equity, these companies are using debt, and lots of it, to grow. Netflix, for instance, has extensively borrowed over the years until it reached a financial milestone in January 2021, where the company no longer needed debt. Since it's inception in 1997, executives have raised more than $20 billion in debt. That figure is 200 times higher than the $103.9 million of equity that the company raised through the end of their Series E round!
Another example is of the tech giant, Apple Inc. Apple’s total debt had climbed from $35 billion in 2014 to $108 billion in 2019, with its debt-to-equity ratio rising from 0.3x to 1.2x. While Apple’s debt increased tremendously, its shareholder’ equity dropped from $112 billion to $90 billion.
Now let’s look at a homegrown brand. Renowned telecom provider Vodafone Idea had the eighth highest debt at Rs 1.26 lakh crore for a listed entity in India. At the end of FY19, Vodafone Idea’s debt increased by a massive 369% in the last four years from Rs 26,859 crore to Rs 1.26 lakh crore.
So, if debt is considered ‘bad’ for growing companies, why do we see a significant number of the large corporations invest in debt? Is debt really a liability or an asset?
When asked Dev Verma, Co-founder, MD and CEO of Swara Fincare, he said “For small NBFCs and start-ups to kickstart and scale up, debt is almost like a lifeline. For the larger players – they need various forms of debt to feed their large distribution and scale up continuously. Start-up firms rely on debt in the form of loans and credit lines from banks/institutions, to generate quick growth. This often becomes the core method to grow, given that equity infusion requires vintage, minimal scale and is a time taking process with several mitigants and timelines in play. Debt on the other hand is simpler and faster. Debt amounts usually tend to be larger and can be raised more frequently compared with other modes. This helps enterprises to plan their growth more efficiently.”
Let’s look at some features of debt to understand what makes it so prevalent and a marker of future success.
Debt helps fuel growth
Some of the uses of long-term debt could include buying inventory or equipment, hiring new staff and expanding the business. Taking the debt route can give your company working capital needed to continue running the business smoothly and profitably year-round. Think of it as the ‘push’ you need to be able to go that extra mile in your business and make additional profits.
Debt lowers financing cost
When compared to equity the cost of raising debt is much lower. In the case of debt, the business owner is contractually liable to make regular interest payments and return debt principal within the said period. On the other hand, equity is where the business owner sells a stake in the company and is expected to share the company’s profit with the equity holder forever.
Debt improves tax savings
The cost of debt is quite less when you take into account the fact that interest is actually tax deductible. Suppose your business tax rate is 20% and your interest rate is 5%, the cost of your debt will come to only around 4%. Thus, debt can contribute to your tax savings significantly.
As per law, interest payments are counted as expense deductions against total revenues before calculating taxable income. A low taxable income is always better for the company, and tax savings help ease a company’s debt financing cost.
Debt helps maintain company ownership
The primary reason why companies choose to finance through debt rather than equity is so they can hold onto company ownership. In equity financing, such as selling common and preferred shares, the investor maintains an equity position in the business. The investor then gains shareholder voting rights, and business owners end up diluting their ownership.
Debt capital is provided by a financial institution, who is only entitled to the repayment of capital plus interest. Hence, business owners can retain maximum ownership of their company and end commitments with the lender once the debt is paid off.
Contrary to popular belief, debt can be a great way to improve your investment returns and grow your business. So then, why not finance a business solely with debt? Because all debt, or even 90% debt, would prove to be risky as well to those providing the financing.
According to Saurabh Marda, Co-founder and MD of Freyr Energy, “Debt is non-dilutive in nature and allows entrepreneurs to fund portions of their operations without giving up stake in their business. As businesses become more stable and reach a certain size of operations, debt might be a much more meaningful instrument to fund growth. The past two years (2020-2021) were extraordinarily stressful from a growth and cash management standpoint for MSMEs. When you combine this with the need to repay debt holders on time, one can understand why companies may view this instrument in a less than positive light.
However, I believe choosing the right lender and right debt instrument can play a very important role in the growth of companies. In general, going forward, I believe companies will definitely consider debt for fueling growth but will do so with a much better understanding of how much debt should be taken and how it has to be structured to suit business needs.”
For a business to grow in the right direction, you need to balance the use of debt and equity to keep the average cost of capital at its minimum. However, we tend to look askance at debt, because it allows individuals and companies to live beyond their means. But debt is not fundamentally ‘bad’ or ‘unhealthy’, rather it’s a complementary source of capital and an effective method of financing that a business needs to scale up.
