Debt vs. Equity: Capital-Raising Primer

Posted: 04/1999

Debt vs. Equity: Capital-Raising Primer
By Bryan Mitchell and Salman Tajuddin

As any telecom insider would tell you, telecommunications is a capital-intensive
business. The ability to execute on a business plan is predicated not only on raising the
appropriate amount of capital, but also on raising the appropriate type of capital from
the appropriate financing source.

The capital markets offer a range of financing sources, each one corresponding to a
unique risk-and-cost profile. This article is the first in a three-part series that will
cover capital-raising options available to telecommunications companies. This month, in
Part One, we’ll discuss the general difference between debt and equity solutions. Next
month, in Part Two, we’ll take a look at raising private debt. Then, in June, we’ll take a
look at when to raise equity from venture capital (VC) firms and the public.

Whatever your business plan calls for–acquisitions, direct marketing, sales-force
development or network builds–the choices for financing boil down to essentially two
categories: equity and debt. If your intent is to raise private equity, you can expect to
give up a significant share of the equity and possibly control of the business. By
comparison, raising debt allows you to maximize the upside of your invested equity by
avoiding dilution and allowing you to maintain control of your company as long as you
perform within the confines of the debt contracts. The choice between debt and equity
ultimately depends on the answers to three questions: What are you going to do with the
money? What is the likelihood of success? And what you are willing to give up for the
money?

The Equity Solution

If you need capital for a startup, clearly you are going to need equity. If you solicit
outside private equity, the likely use of proceeds will be to build a business
infrastructure that will support the execution of the business plan. Typical uses of
proceeds at this stage include organizational costs, operating losses associated with
front- and back-office development, marketing and sales expenses and network expenditures.
Private- equity investors expect returns in excess of 30 percent and ultimate return
requirements are dependent upon the risks of the plan.

Graph: Telecommunications Capital Markets Activity

Once your business has demonstrated the ability to sell a product or service in a
scaleable fashion, you will need additional capital to fund the expansion of marketing,
customer support and network buildout. At that point, the value in your enterprise opens
up several options for raising money, including going public.

For many reasons, the completion of a public offering is a highly sought-after goal. A
public offering will mark-to-market the value of the firm, give you and your investors
liquidity in your investments and allow the company to use its stock as currency for
acquisitions and employee recruitment and retention. Most importantly, having access to
public capital gives the company the utmost flexibility in managing its operations.
Companies that are public face additional cost related to Securites and Exchange
Commission (SEC)-mandated reporting requirements and shareholder relations expenses.
Additionally, public company in-vestors expect public companies to provide annual returns
of 15 percent to 20 percent.

Potential equity investors always will seek to maximize the pricing spread between what
they pay for their investment (the premoney valuation) and what they hope the firm will be
worth upon deploying the new capital into the business. The lower the premoney valuation,
the greater the dilution current shareholders will face. One of private equity’s greatest
risks is the opportunity cost of choosing one investment over another. To minimize this
risk and enhance prospects for a greater-than-30 percent rate of return, venture
capitalists seek to lower the buy-in price. An investment banker, seeking to appease
institutional buyers of your equity in a public offering, will try to price a new issue so
it will appreciate quickly in the after-market. The key difference between the
public-equity investor and the private-equity investor is the required rate of return.
This translates into the public’s willingness to pay a higher price for your equity.

The Debt Solution

If you need capital, but believe raising equity would dilute your ownership position
unnecessarily, the alternative is to seek out debt financing. Debt adds an element of risk
that should not be taken lightly: the contractual obligation to deliver a lower rate of
return to your lender, even at the expense of your own equity.

As much as debt increases the risks to equity, it also enhances its rewards. Securing
an appropriate debt investor will enable your telecommunications company to execute a
business plan without excessive dilution, maximizing valuation and preserving ownership.

Choosing the right form of debt also requires a consideration of your needs and the
market realities. Just as there is public and private equity, there is public and private
debt. Public debt, including nonregistered 144A offerings, allows for a diversified use of
proceeds such as acquisition financing, network expenditures and, on rare occasions,
funding of operating losses. Repayment of this form of debt is dependent upon the
generation of future cash flows from the execution of a carefully constructed business
plan.

The drawback to this form of financing is the cost. The legal documentation,
underwriting, pricing and registration requirements make this type of financing extremely
unwieldy and expensive for transactions less than $75 million. There are, however, other
debt financing sources, each with different parameters, advantages and disadvantages.

Vendors, commercial banks, commercial credit companies and specialty finance companies
all have secured financing available for telecommunications services providers. These
investors emphasize collateral value and cash flow. Vendors, banks and commercial credit
companies look to equipment and receivables for principal protection. Specialty finance
companies look to enterprise value for their security.

As any provider of telecommunications services is aware, vendor financing can be
attractive. The financing either can be of a short-term nature for working capital, or
long-term nature for equipment acquisition. These restrictive uses of proceeds may meet a
singular need of the service provider but ultimately add to the cost of doing business by
locking the service provider into one vendor. Vendors’ primary profit engine is the sale
of equipment or carrier services. They use the strategy of increasing the price on each
sale through product pricing muscle associated with financing. The vendors are not focused
on providing sustainable standalone corporate finance solutions.

Commercial banks often offer the cheapest capital with the least flexibility and
strictest credit standards. Commercial banks will finance working capital and, in certain
large market transactions, acquisitions and network buildout. The big negative to
commercial bank financing is the inflexible structure and restrictive covenants that
reflect a lack of understanding of the business and institutionalized conservatism due to
the banks’ federally regulated credit policies and hierarchical organizational structures.

Commercial finance companies offer an alternative to banks. Their primary advantage is
their higher levels of risk tolerance. But these lenders frequently lack the
specialization necessary to structure a capital investment that meets the service
provider’s needs.

An emerging market participant in corporate finance is the specialty finance company.
Consolidation in the banking and investment-banking businesses has created megafirms that
do not focus on small to mid-sized companies. Specialty finance companies, however, offer
another corporate finance alternative. Specialty finance companies are merging the
commercial-banking and investment-banking models. These lenders develop expertise and
perform the role of adviser as well as investor. The customized structures offered by
these lenders reflect the particular business needs of the telecom company by increasing
access to capital by factoring in items that mitigate risk, such as customer-base value,
industry trends, regulatory issues and business-plan quality. While having highly
knowledgeable lenders can be a tremendous benefit to the owner-operator, it also can work
against those business plans that are ill-conceived and lack the credibility to withstand
a more thorough analysis and underwriting.

Telecommunications service pro-viders have a range of options for financing their
business. Issues that must be considered when weighing financing options include
flexibility with respect to use of proceeds, timing for repayment (in the case of debt) or
liquidity (in the case of equity), cost of capital and the nature of the relationship
beyond just money. Careful analysis should be made as to how much equity dilution is
tolerable given the risk associated with the use of proceeds. If you believe the financial
condition and potential for your business merits debt financing, carefully review all your
options and consider the role that your financier can play in the long-term success of
your business.

Bryan Mitchell is CEO and president of and Salman Tajuddin (pictured) is an associate with MCG Credit Corp., Arlington, Va., a specialty finance company majority controlled by affiliates of Goldman Sachs & Co. Tajuddin can be reached at +1 703 247 7520, or via e-mail at [email protected].