Most companies never seek angel investment or venture capital. This makes a lot of sense when you take a step back. Examples are all around us: the local grocery store, the gas station down the street, and so on.
Still, companies often need external money to fund operations. Where does this money come from? The company has two main options: it issues stock or it takes on debt (i.e. the company gets a loan).
The capital structure of a company is how the company has financed its operations. If the company issues stock to raise additional capital, the company is said to have an equity capital structure. If the company finances activities through assumption of a bank loan or issuance of a bond, the company has a debt capital structure.
Which of these approaches is better? There are several considerations. It is no coincidence that tech startup companies issue a lot of stock at the beginning: they probably couldn’t qualify for a bank loan! Equity, on the other hand, can be created out of thin air to represent percentage-wise the value of your company.
We’re all familiar with the meteoric rise of stock prices like Google and Facebook. As such there is a natural tendency to think of stock as the way to go when we need to raise money for our businesses.
Not necessarily! Taking out a loan or issuing a bond has some very attractive features to the business owner…so much that in his book, Rogers recommends companies fund their operations with debt. The reason is that taking on long-term debt can actually turn out cheaper than issuing stock.
Whereas stock is subject to double taxation (the income is taxed at both the corporate and the personal level), interest expense incurred when borrowing money is tax-deductible. Interest expense incurred on debt lowers taxable income.
Another consideration: while debt may be long-term, equity is forever.
Equity transfers some degree of ownership in your company to the hands of another. Once issued, that equity can be out of the founder’s reach forever, especially if your company is successful. Conversely, debt can be paid off, and if your company is successful, it can be paid off quickly.
Your business structure plays a role too. Issuance of stock in the way we typically envision basically necessitates you run a C-corporation, and that brings with the increased overhead and general greater complexity you see with that structure. Serious investors typically don’t want to deal with LLC “profit sharing” or some flavor of partnership.