Debt and Equity: A Functional Definition

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Sharing the Fruit of Your Labor

Consider the time, money, and know-how you contribute to your business as “seeds.” External financing is “fertilizer” that accelerates growth. How is the fruit of your collective inputs shared? The ordering of the queue lined up to take a bite out of your cash apple is what distinguishes debt and equity.

Cash Claim Queue
Their place in line to take a bite out of your cash apple distinguishes holders of debt and equity claims.

Debt and equity financing provide cash today in anticipation of the return of cash (including a profit) in the future. The functional difference between debt and equity is the priority and frequency with which the lender or investor can lay claim to their share of your cash flow.

Debt holders get the first bite of your cash apple. Equity holders are last in line. They get what’s left. Equity holders have a residual claim to cash and value. As a result, dollar for dollar, lenders face less uncertainty and risk than do equity holders.

Some Key Differences Between Debt and Equity

Borrowers pay debt holders early and often. You will usually pay interest and principal payments monthly (sometimes even daily). In contrast, payments to equity holders are often restricted by loan agreements.

Key Differences Between Debt and Equity
Some Broad Distinctions Between Debt and Equity

In broad terms, debt is rigid and unyielding. Consequently, debt tends to be less expensive than equity. Comparatively speaking, equity offers flexibility. However, flexibility comes at a price.

Businesses have “debt capacity” when they can generate free cash flow reliably. That’s why bankers usually want to see several years of historical financial statements from prospective borrowers. Historical performance is often the most compelling evidence of future performance.

Collateral increases debt capacity. Collateral gives lenders a bite at a second apple if the first is insufficient. Good collateral is an asset that has value independent of the performance of the borrowing business. So, lenders tend to consider general purpose real estate and equipment to be good collateral.

Equity may be more suitable for businesses that face less certain prospects but have the potential to create a lot of value. That’s why equity investors seek evidence of a big potential market. They also prefer businesses that enjoy a defensible competitive advantage and can scale rapidly with minimal additional financing needs. Like you, outside equity holders don’t want to share with others any more than is absolutely necessary.

Questions to Ask Yourself

Your answers to the following questions will help determine whether debt or equity is the right fit for your business:

  • At what stage is your business? How certain are its prospects? How much flexibility do you need?
  • Do you or your business own assets that represent good collateral? What happens to the value of those assets if your business fails?
  • Who is your core customer? Who is most likely to find your product dramatically different from alternatives? As a result, how large of a potential market does that core customer represent?