If we’re saying that entrepreneurs use combinations, how do we distinguish which and when? The use of debt almost always requires that some equity has come in first. A rough rule of thumb is that a dollar of early stage equity can support a dollar of debt, if there is some additional security to further back the debt.
Lenders feel that a start-up has little ability to generate sales or profits. Consequently, the lender wants to have their debt secured, and even then, they feel that the asset value will be decreasing with time and there’s always the possibility that management may not be up to the company-building challenge at hand.
This debt will most likely be short-term debt (one year or less) to be paid back from sales. Short-term debt is traditionally used for working capital and small equipment purchases. Long-term borrowing (one year or maybe up to five) can be used for some working capital needs, but usually is assigned to finance property or equipment that serves as collateral for the debt.
While commercial banks are the most common source of short-term debt, there are more choices for long-term financing. Equipment manufacturers provide some, as does the Small Business Administration (SBA), various state agencies, and leasing companies. More examples are given in the following section.
It’s true, entrepreneurs can finance start-ups with more debt than equity, but there are some distinct disadvantages. As an example; if they negotiate extended credit terms with several suppliers, this restricts their flexibility to negotiate prices. Heavily leveraged (i.e., debt-financed) companies are constantly undercapitalized and will experience continuing cashflow problems as they grow. Paying close attention to strained cashflow requires a that lot of management time be diverted from company operations. It also affects the balance sheet, making it difficult to obtain additional equity or debt.
On the other hand, there is one big positive in using debt. Debt does not decrease or dilute the entrepreneur’s equity position and it provides nice returns on invested capital. However, if credit costs go up, or sales don’t meet projections, cashflows really get pinched and bankruptcy can become reality.
Top entrepreneurial companies use varying combinations of debt and equity. They determine which is the most advantageous for the particular stage of growth they’re financing. Their aim is to create increasingly higher valuations or profit structures.