Financing: Debt vs. Equity

Many top players, especially tournament players, have backers, and depending on their skill level, cut different deals. One arrangement is that the backer puts up all the money and takes all the losses, and in return receives half of the player's winnings. That's a great deal for the player, it seems – no risk and half the profits. It's no surprise, then, that very few players get "staked." The question you should be asking is: "If a player is so good, why should he or she need to be staked in the first place?"

As a businessperson, you can ask a similar question: Is it better to give up a stake in your business by giving away equity (issuing stock), or are you better off taking on debt (issuing bonds or simply taking out a loan)? Several years ago, my friend Haley was running low on cash and desperately wanted to play in the World Series of Poker $2,000 buy-in seven-card stud tournament. As an experienced player with a great track record, there was funding available, and after talking to different investors, he had two choices: He could borrow the $2,000, which he would have to pay back, plus $1,000 juice, within a month. Or, he could sell 50 percent of the equity in his winnings for the $2,000 buy-in. What would you have done?

This dilemma points to the two ways that you can finance a business – through debt or equity. Debt is riskier, although cheaper. It would seem that equity should be cheaper, since you don't have to pay any interest. But what you do have to pay is part of your profits, and if you run a solid business, giving up a percentage of your profits will end up costing you more than servicing your debt.

In addition, debt payments are tax deductible, so when you borrow at 15 percent, the real rate (after taxes) is closer to 10 percent. The tax deductibility of debt payments is a big reason for the junk bond boom that Michael Milken created in the '80s. Milken realized that a company would prefer borrowing money to giving up a stake in its business, even if it meant paying extremely high rates of interest. Had it not been for this type of financing, it's unlikely that Steve Wynn would have been able to raise enough capital to build the Golden Nugget in Atlantic City and, ultimately, The Mirage in Las Vegas.

The nice thing about equity is that if you go broke, you don't owe anything. The bad part is that if you make it big, you give up a piece of the pie. The reality is that most investors, particularly for risky ventures, demand equity for their investment.

Back to Haley. He knew that he couldn't pay back the $2,000 if he didn't place in the tournament, so he decided to get "staked" and gave up 50 percent of his equity. When he won the tournament, he received $70,000 and promptly paid $35,000 to his investor. Had he taken on the debt instead, he would have owed only $3,000. Mind you, $35,000 isn't a bad score, but his decision to sell equity instead of debt cost him severely – $32,000, to be exact.

It's easy to play Monday morning quarterback and say that Haley made a poor decision. But just because he won the tournament doesn't mean that he made the wrong decision. Had he taken on the debt and not won, he would have owed $3,000 that he didn't have. Not only would that have led to stress, it also may have threatened his ability to get staked again.

Back to your business. The old adage about banks definitely holds true: They'll only loan you money when you don't need it. Bankers detest risk, and rarely will fund a start-up venture. It's no accident that investors who back start-up ventures, whether it's Haley playing in a poker tournament or Jerry Yang starting Yahoo!, want equity. If they're going to take on a big risk, they want to hit a home run, too.

In my eyes, entrepreneurs spend an inordinate amount of time on getting funded. They seem to think the order is: (1) Write a business plan. (2) Get money. (3) Get to work. The problem is, when you are asking for money and have nothing but a business plan, you are going to end up giving up too much equity in your business (early-stage investors can be ruthless). Therefore, what I recommend is to start out by taking on a little debt to start your business. Even if it's a few thousand dollars on a low-interest credit card, at least you are executing your business plan, generating revenue, and building a client base. Then, when you have to turn to the equity markets, your company will command a fair valuation (you can sell stock for a fair price).

I have often seen high-limit poker players standing on the rail begging to get staked in a high-limit game. They're willing to give up 50 percent of their equity just to put themselves in the game. What they could be doing, and should be doing, is taking what they have and playing in a lower-limit game to build their stake. That way, when they have the capital to play in the bigger game, all of the profits will be theirs.

In poker and in business, debt is cheaper than equity, but also riskier. First, determine your tolerance for risk. Then, give up as little of your business as possible. If you think it's not such a big deal to give up equity, ask Haley.

Greg Dinkin is the author of The Finance Doctor. He is also the co-founder of Venture Literary, where he works with authors to find publishers for their books and producers for their films. He can be reached via E-mail at [email protected].