Debt vs equity: leverage, dilution and risk

A loan has an obvious price: the interest. An equity offer hides its price in a percentage, so turn it into money first.

If an investor pays an amount for a share of the company, that implies a value for the whole company once the money is in, the post-money valuation:

Post-money valuation = investment ÷ share bought

Klasna's investor offers 6,000,000 UAH for 12.5%: 6,000,000 ÷ 0.125 = 48,000,000 UAH.

Subtract the new money and you get the pre-money valuation, what the investor thinks the company is worth today: 48,000,000 − 6,000,000 = 42,000,000 UAH.

These numbers make offers comparable. A second investor offering 6 million for 15% values Klasna at 40 million post-money, a worse deal for the current owners. And they remind everyone that the founders aren't receiving the 6 million: the company is, in exchange for a permanent slice of everything it will ever earn.

When a company sells new shares, the existing owners don't sell anything, but they end up owning a smaller percentage. That's dilution.

Everyone who owned the company before the round now shares what is left after the new investor's slice, in the same proportions as before:

New share = old share × (1 − share sold)

Klasna sells 12.5%, so the old owners keep 87.5% between them. Founders: 80% × 0.875 = 70%. Early investors: 20% × 0.875 = 17.5%. Check: 70% + 17.5% + 12.5% = 100%.

Dilution isn't automatically bad. The company now has 6 million more, and if that money grows it, 70% of a bigger company can be worth more than 80% of the old one. But the slice is permanent: the founders get 70%, not 80%, of every future profit and of the price if Klasna is ever sold.

The common slip is subtracting points: 80% − 12.5% = 67.5%. That would mean the founders alone paid for the whole new slice, and the early investors gave up nothing.

Both bring the same 6 million into Klasna. What differs is what the company gives in return.

Debt financing (the bank loan, 6 million at 20% a year, interest only, repaid in three years):

• nobody new owns anything: the founders keep 80%;
• interest is due every month, 100,000 UAH, in a bad year as in a good one;
• the full amount comes back on a fixed date, whatever happens;
• the lender's claim ends when it is repaid; banks often add conditions, such as a minimum cash balance.

Equity financing (the investor, 6 million for 12.5%):

• no interest and no repayment date;
• the investor shares the bad years: if profit falls, so does their part;
• but the cost is permanent: 12.5% of every future profit and of any future sale, plus a voice, often a board seat.

Neither is "cheap" in general. Debt costs a fixed amount and leaves the upside to the owners; equity costs a share of the upside and takes some of the downside off them.

The fair way to compare debt and equity is from the owners' side: in a given year, how much of the result belongs to the founders under each option?

• With the loan: (operating profit − interest) × founders' share before the round.
• With the investor: operating profit × founders' share after the round.

Klasna's strong year, 5,000,000 UAH of operating profit, taxes left out:

• loan: (5,000,000 − 1,200,000) × 80% = 3,040,000;
• investor: 5,000,000 × 70% = 3,500,000.

Even in a good year the investor wins here, because 20% interest on 6 million is a lot next to 10 points of a 5 million profit. The loan wins only above the profit where both give the same:

0.80 × (X − 1,200,000) = 0.70 × X → X = 0.80 × 1,200,000 ÷ 0.10 = 9,600,000 UAH,

almost twice Klasna's best case. "Debt is the cheap option" is a rule of thumb that depends on the rate and on how much profit the money really produces.

Interest is due whatever the year looks like. That makes debt an amplifier for the owners: financial leverage.

Klasna's weak year after the expansion, 800,000 UAH of operating profit, taxes left out:

• with the loan: 800,000 − 1,200,000 = −400,000; the founders' 80% is −320,000 UAH;
• with the investor: 70% × 800,000 = +560,000 UAH.

Put next to the strong year (3,040,000 with the loan, 3,500,000 with the investor), the pattern is clear: the loan widens the range of outcomes for the owners, and at a 20% rate it doesn't even win the good year.

The −320,000 isn't only a number on paper. The bank wants 100,000 every month in cash, profit or not. A useful check is interest coverage, operating profit ÷ interest: here 800,000 ÷ 1,200,000 = 0.67. Below 1 the business doesn't earn its interest, and the payments come out of cash reserves. Lenders usually want profit to cover interest several times over.

Funding conversations use a handful of terms that are easy to mix up. Anchor each one to a number.

• Pre-money valuation: what the company is worth before the new money, in the investor's eyes. Klasna: 42 million UAH.
• Post-money valuation: pre-money plus the new money, the value right after the round. Klasna: 42 + 6 = 48 million; equivalently, 6 million ÷ 12.5%.
• Dilution: existing owners own a smaller percentage after new shares are sold, although they sold nothing themselves. Klasna's founders: 80% → 70%; early investors: 20% → 17.5%.
• Financial leverage: fixed interest makes the owners' good years better and bad years worse. With the loan, the founders get −320,000 in a weak year (800,000 of profit) instead of +560,000 with the investor.

The first three describe the equity route, the last one the debt route. A funding recommendation usually needs all four: what the company is valued at, what the owners give up, and how far the results can swing.

Once the loan is signed, its interest behaves like any other fixed cost: it is due every month and doesn't care how many lessons Klasna delivers.

6,000,000 UAH at 20% a year is 1,200,000 a year, 100,000 UAH a month. To pay it from operations, Klasna needs extra contribution of 100,000 every month. Last year an average lesson left 173.44 UAH of contribution, so:

Extra lessons per month = monthly interest ÷ contribution per lesson = 100,000 ÷ 173.44 = 576.6, about 577 lessons.

That's in July, when families take a break, as much as in May. The loan raises the break-even point of every month, which is why a seasonal business should check its weakest months, not its average, before taking on debt.

The same logic turns any fixed commitment into units of the business: a new hire, a bigger office or a loan each costs "this many lessons a month". It's a quick way to make a financing choice concrete for people who don't think in interest rates.

The choice between debt and equity is less about which is cheaper in general and more about how predictable the money the project produces is.

Debt suits projects with steady, well-known cash flows that cover interest several times: bridging a known seasonal gap in a profitable business, buying equipment that pays for itself. The interest is fixed, the upside stays with the owners, and leverage works in their favour.

Equity suits projects whose results are a guess: entering a new country, launching a product without proven demand, an expansion that could lose money in a weak year. The investor shares the downside, and there is no monthly bill to pay when things go badly.

Klasna's EU plan is the second kind. In a weak year it makes 800,000 of operating profit against 1,200,000 of interest, a coverage of 0.67, and the founders would lose 320,000 while still owing the bank. With the investor they keep 560,000. At a 20% rate, the loan only wins above 9.6 million of profit.

Ask first: "If this goes badly, can we still pay a fixed bill every month?"