# Debt vs equity: leverage, dilution and risk > What a loan and an investor each do to returns, risk and ownership. - Course: [Finance for Product People: From Unit Economics to Business Cases](https://productovi.com/courses/finance-for-product.md) - Module: Which costs matter for this decision? - Lesson 31/32, ~25 min - Source: https://productovi.com/courses/finance-for-product/debt-vs-equity ## Six million for the EU **Alex Tutor:** Still on Klasna's product team: the company wants to grow in the EU and needs money from outside. **Leo:** We want to grow in the EU: ads in Poland and Germany, partnerships with Ukrainian weekend schools. Hanna's plan needs 6 million UAH from outside. We have two offers. **Hanna:** A bank offers a 6 million loan at 20% a year, interest only, the full amount back in three years. An investor offers 6 million for 12.5% of the company. **Sofia:** The loan is easy to price: 20% of 6 million is 1.2 million a year, 100,000 a month. What does the investor's offer mean in money? **Alex Tutor:** It puts a price on the whole company. If 6 million buys 12.5%, what is 100% worth once the money is in? That's the **post-money valuation**. > **Exercise:** The investor offers 6,000,000 UAH for 12.5% of Klasna. What is the **post-money valuation**: the value of the whole company right after the money comes in? ## Who owns what **Alex Tutor:** Take away the new 6 million and you get the value before the round: 42 million, the **pre-money valuation**. That's what the investor thinks Klasna is worth today. **Hanna:** Today the founders hold 80% and the early investors 20%. A new 12.5% shrinks everyone in proportion. **Alex Tutor:** Work out the founders' new share before Hanna does. > **Exercise:** Klasna's founders own 80% and early investors 20%. A new investor buys 12.5% of the company in a round of new shares. What share do the founders own after the round? **Sofia:** Founders: 80% × 0.875 = 70%. Early investors: 20% × 0.875 = 17.5%. **Alex Tutor:** That's **dilution**: the same company, a smaller slice for every existing owner. In return, **equity financing** has no interest, no repayment date, and the investor shares the bad years with you. **Alex Tutor:** **Debt financing** is the mirror image: nobody new owns anything, but interest is due every month and the money comes back on a fixed date, whatever happens. > **Exercise:** Klasna needs 6 million UAH for its EU expansion. A bank offers a loan at 20% a year, interest only, the full amount back in three years; an investor offers the same money for 12.5% of the company. The founders own 80% today. Which of these are true of the **bank loan**, compared with the investor's offer? Select all that apply. ## A good year and a bad year **Alex Tutor:** Now what each option does for the founders. Take two possible years after the expansion: 5 million of operating profit, or 800,000. Leave taxes out to keep it simple. **Alex Tutor:** Before the numbers: which do you expect to win in the strong year? > **Exercise:** After the EU expansion Klasna has a strong year: 5,000,000 UAH of operating profit (ignore taxes). With the loan (6 million at 20%) the founders keep 80% of the company; with the investor they keep 70% and pay no interest. Which option leaves the founders more that year? **Sofia:** Strong year with the loan: 5,000,000 − 1,200,000 = 3,800,000, and the founders' 80% is 3,040,000. With the investor: 70% of 5,000,000 is 3,500,000. **Leo:** So the investor is better even in the good year? I thought debt was the cheap option. **Alex Tutor:** At 20% interest, not here. The loan wins only when profit is high enough that the fixed interest is small next to the 10 points of the company the founders would give away. The line is where both give the same. $$ 0.80 \times (X - 1\,200\,000) = 0.70 \times X \;\Rightarrow\; X = \frac{0.80 \times 1\,200\,000}{0.10} = 9\,600\,000 $$ *X: operating profit at which the founders get the same from the loan and from the investor, UAH.* **Hanna:** 9.6 million: almost twice our best case. And now the weak year. > **Exercise:** In the weak year Klasna makes 800,000 UAH of operating profit. With the loan (1,200,000 of interest a year), what is the founders' 80% part of the result? Ignore taxes; enter a loss as a negative number. **Hanna:** And −320,000 isn't just a number on paper. The bank wants 100,000 every month, in cash, profit or not. **Alex Tutor:** That's **financial leverage**: debt makes the owners' good years better and their bad years worse, because interest is due either way. Here the weak year covers the interest only 0.67 times: 800,000 ÷ 1,200,000. **Alex Tutor:** Four new terms in one conversation. Pin them to Klasna's numbers before we go on. > **Exercise:** Klasna needs 6 million UAH: a bank loan at 20% a year, or an investor buying 12.5% of the company (founders own 80% today). Match each term with what it means here. **Sofia:** And the interest is one more fixed cost, so it raises the break-even of every month. > **Exercise:** **True or false:** last year an average Klasna lesson left 173.44 UAH of contribution. With the loan (6,000,000 UAH at 20% a year, interest only), Klasna needs about 577 more lessons every month just to cover the interest. ## Not only the numbers **Leo:** The investor also wants a seat on the board. **Alex Tutor:** Equity buys more than cash: a partner who can help, and who can also say no. Debt keeps control with you, but banks add conditions, such as a minimum cash balance, and a fixed bill. **Hanna:** And the 12.5% is forever. If Klasna is ever sold, the investor takes 12.5% of that too. The loan ends when it's repaid. **Sofia:** So debt is cheaper when results are predictable, and equity is safer when they aren't. > **Exercise:** For which project would a loan usually make more sense than selling shares? ## Your turn: which money for the EU? **Leo:** I need to answer both of them this week. Loan or investor? **Alex Tutor:** Use the numbers: what each costs the founders in both years, what happens to cash in the weak one, and what you give up. **Sofia:** A recommendation first, then the numbers behind it. > **Exercise:** Recommend to Leo, in 3–5 sentences, whether to fund the 6 million EU expansion with the loan or the investor. The facts: loan at 20% a year, 1,200,000 UAH of interest, repaid in three years; investor buys 12.5% (founders go from 80% to 70%, post-money valuation 48 million) and wants a board seat. Strong year (5,000,000 of operating profit): founders get 3,040,000 with the loan, 3,500,000 with the investor. Weak year (800,000): −320,000 with the loan, +560,000 with the investor. Taxes ignored. Use the numbers for both years and say what Klasna gives up. > **Key ideas** > > - **Debt financing** costs interest whatever the results (6 million at 20%: 1.2 million a year) and must be repaid; owners keep their shares. > - **Equity financing** has no interest or repayment but costs a share of every future profit and sale: 6 million for 12.5% means a post-money valuation of 48 million, pre-money 42 million, founders diluted from 80% to 70%. > - **Financial leverage** amplifies: with the loan the founders get 3,040,000 in a strong year and −320,000 in a weak one; with the investor 3,500,000 and 560,000. > - Debt beats equity only above a profit line (here 9.6 million) and needs profit that covers interest several times; a weak year covering it 0.67 times is a cash problem. > - Interest is a new fixed cost: about 577 more lessons a month just to break even. **Alex Tutor:** Next time we put it all on one page: the case Klasna takes to investors. - Previous lesson: [The allocation trap: should we drop programming?](https://productovi.com/courses/finance-for-product/allocation-trap.md) - Next lesson: [Case: a one-page finance memo for the next round](https://productovi.com/courses/finance-for-product/funding-memo-case.md) --- Productovi Learning. 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