Differences Between Debt and Equity Structures

Once an investor and an entrepreneur have decided that they want to integrate a structured liquidity mechanism into their deal, they need to decide whether to implement it in the form of debt or equity. There are a number of factors to consider, including tax implications, potential regulatory restrictions and economic considerations – such as whether uncapped upside or stronger downside protection is desired. The table below summarizes some of the main differences between the two forms based on U.S. law.

  • Below are some rules of thumb:

Characteristic

Debt

Equity

Preserve option for sale / IPO upside

No

Yes

Downside protection

Creditors are paid first in downside scenario and loan amount can be secured by collateral

Liquidation preference possible, but debt is paid first.  Generally, no dividend or redemption payments will be allowed if the company is insolvent (see below under Board of Director approval)

Annual payment amounts limited by usury laws

 Yes

No

Board of director approval

Generally, required once to approve the loan agreement.

Required for each payment.  The board will need to ensure that state law governing the amount of distributions to shareholders permits each dividend and redemption payment.  Generally, payments will be allowed unless the company is insolvent.

Company tax implications

Interest payments are tax deductible, but IRS reporting is complicated

No tax deduction for dividend and redemption payments

Investor tax implications  (gains)

Interest taxed at ordinary income rate (up to 43.4% federal)

Qualified dividends taxed at special rate (up to 23.8% federal)

Capital gains taxed at maximum rate of 23.8%, but could be as low as 0% effective rate in certain situations

Investor tax implications  (losses)

$3,000 per year deductible against all income, remainder only against qualified investment income

Amount of losses deductible against all income could be as high as $100,000 in certain situations

Transaction cost/complexity

Generally lower up- front cost, but complicated IRS reporting

Generally higher up-front cost, but usually simpler IRS reporting

  • When Equity is Preferred
  • Early-stage company on conventional financing track, and the company’s stakeholders would prefer, or are at least open to, an IPO or Sale. Here, a redemption provision is used as a hedge against an IPO or Sale not occurring, rather than as the primary means of achieving liquidity.
  • Investors are willing to defer most if not all of repayment and return on investment for 8 or more years post investment. Investors may agree to defer payments because they believe it is important to reinvest profits to accelerate growth. If investors defer repayment, they will also benefit from the lowest available federal tax rates on gains, and, in some cases, they may not be required to pay federal tax at all.
  • The parties want to avoid the complications and unusual tax treatmentassociated with variable payments for debt instruments.
  • When debt is preferred
  • For PRI investments. Although a growing number of foundations will consider equity PRI investments, debt continues to be the predominate form of investment.
  • For some investors, investments into a limited liability company or other entity with “flow through” tax treatment. Tax-exempt entities will often avoid direct equity investments in these entities because of concerns related to unrelated business taxable income. Foreign investors will typically avoid direct equity investments in LLCs because these investments would likely subject them to US federal and state taxation. Other investors may want to avoid direct equity investments in LLCs because these investments may require them to file tax returns in all of the states in which the LLC operates.
  • When the parties desire a shorter investment period (less than 8 years) and seek regular payments that commence relatively quickly after investment.
  • Variable Payment (Debt)

Most people view debt as a rigid financing option best suited for investments in mature companies with predictable cashflow. Most debt instruments offer fixed annual returns that are commensurate with their inherently lower levels of risk relative to equity investments. To make debt a more flexible option better-suited to early-stage impact transactions, pioneers have introduced three innovations.

Variable repayment

Repayment amounts are linked to an agreed-upon measure of the company’s financial performance, such as revenue or EBITDA.

Initial payment deferral

The repayment of principal and interest is deferred for a specified period of time.

Higher return profile

This variable payment structure provides for a risk-adjusted return if company performance meets or exceeds expectations. Deal examples show investors targeting 2-4x returns in 5-7 year periods using these instruments.

  • Repayment Amounts

The parties to a variable payment debt transaction will first need to determine how the repayment amounts will be calculated. Learn more about variable payment debt repayment amounts.

  • Timing of Initial Repayment

Based on the company’s stage of development, the parties may agree in advance to defer initial repayment for a predetermined period of time (e.g. one or two years). Learn more about variable payment debt and initial repayment timing.

  • Accrual Rules during deferral periods

If the parties choose to defer initial repayment, they will need to decide whether interest or other obligations will be assessed or “accrue” during the deferral period or if repayment of those amounts will be waived (no accrual). Learn more about variable payment debt and accrual rules during deferral periods.

  • Caps of Variable Payment Amounts

If the total repayment amount under the loan will vary based on the company’s financial performance, the parties may choose to cap the total return to the lender. Learn more about variable payment debt and caps on variable payment amounts.

  • Prepayment Options

The parties may agree to allow the company to prepay the loan at the company’s option but with a prepayment premium, or the parties could require the lender’s consent for prepayment. Learn more about variable payment debt and prepayment options.