When Is Debt More Dilutive Than Equity?

Lately in the Private Equity world, I’ve been working on some deals where a company has a choice between a (relatively) expensive debt type product (be it a convertible loan, venture debt type instrument) and equity at a price they are maybe not quite happy with; along with some terms they don’t quite like either, such as liquidation prefs. The obvious choice is to go with the debt – its less dilutive hence protecting equity on the upside. However, surprisingly, it is not always the case though - what it comes down to basic maths and crossover points in valuation. Also, control elements, covenants and vetoes associated with each financial product come into play and may be more important in the end.

Here we look just at some basic financial maths.

Let’s take a live example:

Company GrowFast needs £5m in equity. They have a business plan ready to be financed which they believe can boost their sales and bottom line to allow them to be valued at £30m in 2 years – and a ready buyer is in the wing if they prove themselves.  They believe current valuation to be anywhere between £7.5 and 15m depending on what view/ metrics you use.

1: They have an offer of Debt with (for the sake of simplicity) no current cashpay coupon and an all-encompassing 1.75X return in 2 years. 

2: Or they can take preferred equity - non–participating(no double dipping) however senior on a payout to common. Valuation as of yet unccertain.

Now some maths: 

To explain – Debt is giving a guaranteed return to the provider but is not sharing the upside, hence it is non-dilutive – apparently better. However, if you can raise equity (even preferred) at a high enough valuation – the dilution effect on a cash-basis is less than the cash loss effect of paying back the redemption on the debt. See the charts below – original equity holders are better taking equity, not debt as the payback on the debt is more on a cash basis than the equity dilution effect at THAT valuation (a higher exit valuation – debt would become more attractive):

Running a goal-seek on the above shows that in this very particular scenario:

• Need £5m
• Exit £30m

The cross over point on valuation on whether you should take equity of debt is as below – below this valuation take debt – above take equity (all else such as exit valuation being equal) :

This does not take into account the terms – control, rights, etc. associated with each product – especially on defaulting on the debt. Again, the devil is in the details but a good place to start is with a model to know where you stand. (I can share this basic excel with anyone who wishes--email hello@whitelake-group.com)

By John Rowland, Managing Director