The EQ Journal Blog

I have always believed that (most) debt is less expensive than equity but many of my students view equity as ‘free’.

Let’s suppose you start a computer consulting business or a herb garden business or whatever and you need some micro capital to start the new enterprise. I have done quite a bit of thinking about how to start a new business without much capital and what sources one might turn to in the absence of a big balance in your personal savings account. I wrote a bit about it on my blog to. See:

More about Self Capitalization.

I even wrote about how one might colonize the moon using bootstrap capital!

Let’s return to your mini farm business where, in the example I use, you need $7,500 to start it. The mini herb garden business, under certain assumptions produces cashflow of $4,500 per year and a return of 58% p.a. (This is an IRR.)

Now let’s say you are like me and know nothing about farming so you decide to bring in a partner who does and you are going to give her, say, 1/3 of the business and she is going to put up 1/3 of the startup capital or $2,500. You can not only use the extra expertise but also the extra dough and since it is equity, there are no interest or monthly repayments. Phew, you say.

Maybe she is a great partner but let’s assume as in many partnerships, this is your idea, your baby and you are the one with the most enthusiasm. So after giving you a few tips that you probably could have found on the Internet yourself (like how to grow herbs organically, without pesticides, and not let the bugs eat them all either), she kind of loses interest and you end up doing most of the planning, planting, weeding harvesting and sales.

You become a bit resentful because you have to give her 1/3 of the annual profits ($1,500) and it is bugging you that she is getting a heck of a return ($1,500 each and every year on her $2,500 investment) and not putting in her fair share of the work.

Her ROI is obviously the same as yours: 58% p.a. (Don’t make the mistake of thinking the ROI is $1,500/$2,500 or 60% p.a. Be a bit more rigorous and use the IRR as a lifecycle approach to analyzing projects. Click here to get the spreadsheet in .xls format and you can fool around with it on your PC.)

Now let’s say you had to borrow this extra amount on a credit card instead of getting it for ‘free’ from your partner. Many credit cards charge you 14% to 28% p.a. depending on your creditworthiness (which is what Banks determine using your beacon score). Even at 28%, you are borrowing for much less than the cost of your equity which is 58%!

So the advantages of debt are:

1. It is usually cheaper than equity.

2. You don’t have to put up with a partner.

3. Decision making is fast: your Board of Directors meets in a closet (i.e., you meet with yourself).

The advantages of a partner are:

1. If there is a problem in the business, you may have an extra pair of hands around to help you deal with it (if the partner doesn’t throw up her hands and bug out on you).

2. You have access to what you hope will be patient capital.

3. You hope she brings expertise that you don’t have to the table.

Most partnerships end up badly and you will have to buy her out, let her buy you out, sell the business or shut it down. Now if in the above example, your partner likes the returns she is getting and say she puts a 11 cap rate (capitalization rate) on her share of the annual profits, then it will cost you a LOT to buy her out. Here is how it works:

Cap Rate = NOI/S.P.

where, NOI is Net Operating Income and S.P. is Selling Price.

Obviously,

S.P. = NOI/Cap Rate.

Therefore you are going to have to pay her:

S.P.(your partner’s share of the business) = $1,500/0.11 or $13,636.36.

You have turned a $2,500 problem into a $13,636.36 problem in a hurry.

So:

a) don’t have a partner to begin with if you can avoid it;

b) use debt or bootstrap capital to fund your business because it will probably be cheaper in the end;

c) understand that there is a higher risk with debt.

Debt is like the hare and the tortoise running around a track. Debt is the hare. You are the tortoise. If you take on debt (especially bad debt like credit card debt), your tortoise better be relentless and get around the track because he is working all the time to pay off the debt as soon as he can. Once the hare catches you (in a foreclosure or power of sale or bankruptcy), you are probably dead.

Maybe instead of ending up borrowing the extra $2,500 from a credit card, you could have got a loan from Farmers Credit or a government grant program to grow more food locally or even got a pre-order from Whole Foods or a high end Natural Food shop in your area that included a downpayment on the first herb order that just happened to equal $2,500. The latter has an interest cost equal to zero and also gives you a secure feeling that once you start producing herbs, you will have customers!

Dr. Bruce