Fund your business with a mix of debt and equity

Ever since childhood, Mumuli aspired to build and operate a lodge and conference centre in rural Kenya. When he graduated with his undergraduate degree, he embarked on his goal. He traversed the country searching for the perfect location to construct his inn.

Mumuli explored the Western, Nyanza, Rift Valley, Central, Eastern, and Coast regions of Kenya. He finally settled on Lake Elementaita in Nakuru County.

Mumuli envisioned a large lodge and conference centre all built out of traditional wooden material, thus ensuring a rustic safari feel.

Mumuli petitioned his friends and family and raised enough funds to buy 10 acres on a hill overlooking the entire lake. Pleased with his progress, Mumuli began meetings with architects to finalise his construction plans.

Armed with the architectural plans, his title deed, and his business plan, Mumuli set out to solicit funds from bankers and investors to put up the structure.

However, every banker and investor first asked him the same question: how much do you want? Mumuli told the first bankers that he desired 100 per cent debt financing for the project. The bankers scoffed at his request.

Next, Mumuli met with investors. Adjusting his pitch from the earlier bankers meeting, he declared that he sought 80 per cent equity from the investors and 20 per cent debt financing from a bank.

The investors reacted unfavourably and hinted that much more debt financing should accompany any equity injection. When Mumuli then revised his numbers, the same group of investors did not take him seriously and denied his request.

Perplexed, Mumuli telephoned his former finance professor. The academic told him an incorrect theory taught widely in universities across East Africa. The misinformation entailed: “The theory of debt”.

Many teachings emanating from lecture halls spew forth the notion that firms should optimally hold two-thirds equity and one-third debt. However, a simple assessment of Nairobi Securities Exchange listed firms shows the theory inaccurate and ineffective for most industries.

Armed with the new, albeit incorrect, knowledge, Mumuli set up another meeting with new bankers and investors. He proposed a one-third debt and two-thirds equity scenario to fund his lodge construction. While the bankers showed great interest in the project, the prospective equity investors balked. So, no deal concluded.

Discouraged, Mumuli met with one of his university buddies who worked in a private equity firm. His friend Mboya explained the reality of the outdated academic theory and the nature of debt versus equity.

New information

Mboya advised Mumuli that he should try and get as much debt as possible. European and North American banks often fund “highly levered transactions” leading to over 80 per cent debt financing.

Mboya indicated that Kenyan banks often get wary over such high proportions of debt financing unless the project involves real estate and the owner of the land possess no mortgages against the land itself, like in Mumuli’s situation.

Then, Mboya explained, banks might fund high amounts if they believe in a variety of factors, but especially the cash they expect the business to make in the future and whether the collateral or security could repay the loan if the business cash fails.

Surprised, Mumuli initially resisted Mboya’s advice. He feared getting locked into too much debt. So, Mboya continued that debt funders take on a lot of risk, but receive very little return in exchange.

Whether Mumuli’s project earns him an eight per cent return or 40 per cent per year, the bank only receives its predetermined interest rate regardless of how well the project performs.

Since Mumuli’s business plan reasonably predicted 30 per cent returns per year, Mboya implored Mumuli not to share the whole 30 per cent with investors and instead only give 15 per cent back to the bank in interest payments.

So, armed with the new information, Mumuli convened yet another meeting with a new set of investors and bankers.

He put forth a conservative 70 per cent debt and 30 per cent equity proposal. Much to Mumuli’s surprise, the bankers and investors agreed on the deal that very day.

By way of celebrating the new deal, Mumuli invited the bankers and investors out to dinner. Following the meal, Mumuli asked what made his Lake Elementaita project worthwhile enough to fund.

The lead equity investor spoke first. He indicated that he appreciated that the risk would get shared between Mumuli by owning the land free and clear, the bankers through their 70 per cent, and the investors with their 30 per cent.

He further explained that he appreciated deals when entrepreneurs desired high proportions of debt. He indicated that debt requires a certain amount of discipline every month to make principal and interest payments. Such discipline should keep entrepreneurs in line and focus on earning cash flows more consistently.

Other investors chimed in and stated that they appreciated debt comprising 70 per cent of the deal, leaving the equity holders to enjoy the higher returns among a smaller group of them. So, the equity players did not dilute too much ownership since bank debt does not receive any ownership rights.

Financing

Mumuli understood, but then perplexed, he turned to the bankers and asked what they saw good in the deal from their side. The bankers described that they thought it unlikely that the value of land in a resort area would ever depreciate 30 per cent.

So, they explained, the equity holders retaining 30 per cent of the financing provided them with a good cushion to recapture their loan if the business itself ever flopped.

In essence, the bankers could sell the property in a crisis and surely get all of their 70 per cent back.

The group finished their time at the restaurant and went to their respective homes.

Would you in your own business feel comfortable about such high levels of debt financing like Mumuli?

Would you rather own a larger portion of your business, but take more debt with locked in repayment schedules or would you rather avoid debt, but have to share ownership in your business with other investors?

Share your opinion and debate ideas at #KenyaEconomics on Twitter.

Prof Bellows serves as the director of the New Economy Venture Accelerator (NEVA) at USIU’s Chandaria School of Business and Colorado State University, [email protected]
Twitter: @ScottProfessor.