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Leverage, also known as gearing, can play a significant role in financing startups. It involves using debt as part of your startup’s long-term capital structure. This article will explain leverage in more detail, the implications of using it for your startup, and its key stakeholders.
What is Leverage?
Leverage refers to using debt as part of your startup’s long-term funding. Leverage is commonly used in the context of engineering a startup’s balance sheet to boost the value of shareholders’ investments in the startup.
Leveraging your startup’s capital comes with an inherent increase in risk. Before distributing any available earnings to shareholders via dividends or capitalising returns by reinvesting them into the company, your startup must service its debt obligations. If your startup employs excessive leverage, it might struggle to repay its debt. The worst-case scenario is that your startup’s debt obligations exceed its assets. In some cases, this will result in shareholders losing their entire investment.
Understanding Leverage and the Capital Structure
Leverage describes using debt in your startup’s capital structure. Your capital structure is the source of your startup’s long-term capital. It is the funds that your startup uses to acquire assets that are used to generate earnings. These earnings should exceed the required rate of return that investors expect in investing with your company.
The way in which your startup blends the mixture of debt and equity is reflected in the capital structure. To illustrate this, we will look at two fictional startups:
Case Study: EquCo Ltd
EquCo Ltd is a startup that has raised all of its long-term capital through equity financing.
The founders injected £500,000 into the company in exchange for 500,000 x £1 ordinary shares. The equity investors injected £1m into the company in exchange for 500,000 additional ordinary shares. These ordinary shares are issued at a £2, which is a £1 premium.
EquCo Ltd has no long-term borrowings. At the point it raised additional financing, it had £500,000 of retained earnings, which is the product of EquCo Ltd’s first two years of trading profits.
At the point EquCo Ltd allotted the additional shares, it had the following capital structure:
| Source of Capital | Amount (£000) | Notes |
| Share Capital Account | 1,000 | 500,000 shares issued to founders + 500,000 additional shares issued to first-stage equity investors. |
| Share Premium Account | 500 | UK law requires companies to maintain a share premium account. This accounts for any premium value a share is issued for. In this case, it is £500,000, which reflects the fact that 500,000 ordinary shares issued at £2 per share = £500,000 nominal value + £500,000 premium value. |
| Retained Earnings | 500 | Retained earnings form part of your startup’s equity. |
| Total Equity | 2,000 | |
| Total Long-Term Debt | 0 | |
| Total Capital Structure | 2,000 |
Case Study: BlendCo Ltd
BlendCo Ltd also needs £1m in financing. It decides to raise half through equity and half through borrowing under a loan note programme. It manages to secure £500,000 worth of debt financing by issuing loan notes to investors at 10% interest. All other aspects of its financing are the same as EquCo Ltd.
It has the following capital structure.
| Source of Capital | Amount (£000) | Notes |
| Share Capital Account | 750 | 500,000 shares issued to founders + 250,000 additional shares issued to first-stage equity investors. |
| Share Premium Account | 250 | This reflects that 250,000 shares were issued for £2 each. The premium amount is credited here. |
| Retained Earnings | 500 | Retained earnings form part of your startup’s equity. |
| Total Equity | 1,500 | |
| Bank Borrowings | 500 | |
| Total Long-Term Debt | 500 | |
| Total Capital Structure | 2,000 |
EquCo Ltd vs BlendCo Ltd
Both startups’ capital structure is worth £2m.
However, BlendCo Ltd has a leverage ratio of 25%, calculated as follows:
Long Term Debt/Total Capital Structure = Leverage= 500/2,000 = 0.25 x 100 = 25%
EquCo Ltd has no debt, so its portion of leverage is 0%.
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What Are the Advantages of Leverage?
You can use leverage to generate higher shareholder value. This is possible for two primary reasons:
- You can deduct the interest amount from your pre-tax profits. This means that the government effectively pays for your interest payments.
- For every £1 you raise in debt financing rather than equity, you avoid diluting the equity pool by that amount.
To illustrate, let us assume EquCo Ltd and BlendCo Ltd generated £500,000 in operating profits the first year after the financing. Profits here refer to the earnings after sales and operating expenses but before interest and taxation.
We will use the current corporate tax rate of 25%.
Both companies will also issue a dividend to shareholders of 5p per share.
| EquCo Ltd (£) | BlendCo Ltd (£) | Notes | |
| Operating Profit | 550,000 | 550,000 | |
| Interest paid | 0 | 50,000 | 10% interest per year on £500,000 borrowings = £50,000 |
| Profit before tax | 550,000 | 500,000 | |
| Tax (25%) | 137,500 | 125,000 | |
| Net Profits | 412,500 | 375,000 | |
| Number of ordinary shares | 1m | 750,000 | |
| Earnings per share (EPS) | 41.25p | 50p | This is the total amount of earnings available to shareholders (net profits) divided by the number of ordinary shares. |
Unpacking the Effect of Leverage
Earnings per share (EPS) is an important financial metric investors use to assess the value of an equity investment. EPS divides the total earnings available to shareholders, a figure usually equal to net profits, and divides this figure by the total number of shares in the allotment.
As you can see, BlendCo Ltd has a higher EPS. This demonstrates the effect that leverage can have on shareholder wealth.
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What Are the Disadvantages of Leverage?
Leverage can be appealing when looking solely at EPS and forgetting that more debt translates to higher credit risk.
In some respects, this is true, largely because of the tax advantages available to startups that use interest-bearing long-term borrowings to finance their capital structures.
However, leverage increases the risk that your startup cannot service its debt. Therefore, another way to view the increased EPS for a geared company is the risk premium shareholders demand to compensate them for the fact that the startup’s lenders have the first right of repayment ahead of equity investors.
Practical Considerations
Before using leverage for startups, you must consider practical factors. Firstly, you may not have access to debt finance. Therefore, any potential gains are theoretical and therefore irrelevant.
Furthermore, even if you find debt financing, many startup debt investors will expect an option to convert the debt to equity. This will effectively dilute the effect of leverage.
Lastly, it is harder to value private companies than publicly traded companies. Accordingly, valuations used to calculate investor metrics like EPS may not be accurate.
Key Takeaways
Leverage, or gearing, can significantly impact startups’ financing and capital structure. It involves using debt as a component of a startup’s long-term funding. This can offer tax advantages, which can potentially increase shareholder value. However, leveraging also comes with increased risk. When considering leverage for your startup, practical factors may limit your access to debt. This can make any advantages you might obtain from leverage irrelevant.
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Frequently Asked Questions
EPS is a key financial metric investors use to assess the potential returns on their investments.
Debt obligates you to make repayments according to the terms of the debt agreement. This means that you must direct all earnings to repayment before reinvesting the proceeds or paying out dividends to shareholders. If your startup cannot make these payments, you will default.
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