The FT neatly describes the difference between Debt and Equity when it argues today, that the tax treatment should be the same for both.
Of course, the fact that it is not has led investors to structure their deals to take advantage of the difference.
And, flavour of the month is convertible debt. But more of that in a minute…
Firstly, why debt rather than equity? Well, because the interest payments that a business makes on debt are tax deductible for the company. Similar returns going to equity investors (in the form of dividends) are not!
Therefore, companies make bigger profits if they leverage up with debt rather than seek equity investment.
And, in this current environment where banks have either withdrawn funding or increased the cost, more start up businesses need to depend on Business Angels for a greater part of the initial investment.
This gives the Business Angels greater power to negotiate convertible debt. That is, a cash sum which earns a particular level of interest each year (and the company can off-set this interest cost against profits) with the magic ability to convert into equity at a pre-defined ratio, should the investor so desire.
However, it isn’t just for tax reasons that convertable debt is popular. It is also because business plans are less clear and timing of exits are less certain that a debt investment structure means that the investor still gets a return on his money whilst waiting for the market to pick up and the company to be sold for a profit.
Hence, it is tax efficient for the company and great for the investors. Now that the business owners have fewer options, it seems that business angels are able to negotiate and agree these structures more easily.