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Debt, Equity Financing Question Becoming More Difficult

In the current economic environment companies exploring their options now may soon have a more difficult time choosing between debt or equity financing

In the current economic environment, where the credit markets are taking an extended summer vacation, companies exploring their options now may soon have a more difficult time choosing between debt or equity financing.

“My observation is that in this kind of funny market, where credit issues abound, the cost of both debt and equity are affected. Its hard to choose which to use first, debt or equity financing,” said Jeffrey Kapelman, principal of factoring firm Hilldun Corp.

The apparel industry has a history of being highly leveraged, with firms relying on the support of factors and bankers and trade support from suppliers, according to David Reza, senior vice president, western region, for Milberg Factors.

“The dynamics have not changed that much. Subordinated debt has advantages for principals, depending on their own tax situation, and most want someone else to risk their money,” Reza said.

Richard Kestenbaum, partner at investment banking firm Triangle Capital LLC, pointed out that equity financing represents a higher cost of capital, noting that many entrepreneurs believe equity is free until they have to give up control of the company.

“When you think of a balance sheet, think of an escalating price scale. Bank debt is the cheapest way to finance. If one can’t get senior secured financing, they go to term debt. A term loan costs more than secured debt, and if they can’t get that they go for subordinated mezzanine debt. The most expensive is equity. In the long run, equity costs the most because you are giving up opportunity and that is what you are building the business for. Most companies have a mix of bank financing, longer-term subordinated debt and equity. You always want to use as much bank debt because it is the least expensive, and as little equity as you can,” Kestenbaum said.

As debt becomes less obtainable, equity will play a greater role even if it increases long-term costs. Some companies use equity because there are limited options, or they can instead decide not to hire the next person, not to do a deal or put aside plans to build a new line, the banker said.

“I think there is still a considerable amount of turmoil in the market….I still see lenders wanting to lend, but they are less aggressive. It isn’t so much seeking the most qualified borrowers as it is about them becoming more conservative because banks want to lessen risk,” Kestenbaum observed.

This story first appeared in the September 17, 2007 issue of WWD.  Subscribe Today.

According to Andrew Jassin, managing director of the New York consulting firm Jassin O’Rourke Group, selling equity and cashing out is a compelling option for anyone wishing to walk away from the business as they see a huge payday sooner. “Right now I see many equity purchases involving earn-outs. The earn-out gets the seller a piece of the money at closing, but they have to continue to be successful for a period of time to get the balance. A good equity buyer will want to equitize the seller and keep them in the business for a while.”