“I owe more debts than I can ever pay back …” — from “The Debt I Owe,” as written by Woodie Guthrie
Let’s imagine that we’re business partners and that together we’ve invented a new dog collar. Then let’s say we are fortunate enough to arrange an appearance on “Shark Tank.” We need an infusion of cash to mass produce our product, advertise it and attract more customers.
The day arrives and we make our pitch. Mark Cuban will give us $200,000 in exchange for 40 percent of the company. Lori Greiner will give us $125,000 for 20 percent. And Mr. Wonderful (Kevin O’Leary) offers $100,000 for 15 percent ownership, but wants a dollar on every sale until he gets his investment back.
Obviously, all the offers require us to give up partial ownership if we want to raise money. This is the small businessman’s version of an IPO. Having Mark Cuban on our management team or board is certainly beneficial, but what if we don’t need a celebrity to grow our business? Or what if we aren’t willing to part with shares of our company? Wouldn’t most of us simply prefer to just borrow the money without giving up ownership if we could?
These two options for funding our company, borrowing money or selling ownership, are the same two options faced by just about every company seeking capital. Both sources of funding have costs. Interest payments on borrowed money are obvious and known costs. And selling pieces of our company for cash today has opportunity costs, because we’ll have to share the profits later.
There’s one more major difference between the costs of the two money-raising techniques. One is tax deductible (interest payments) and the other (selling equity) is not.
Currently, interest rates are low and what interest is paid is indeed tax deductible. This combination of factors has encouraged heavy borrowing in corporate America. The deductibility of interest payments tips the scales of fund raising in favor of larger companies. Small companies can also deduct interest on debt, but don’t get to borrow nearly as cheaply as do larger companies. The debt of large multinationals trades publicly and frequently and almost always comes with a credit rating. The mom-and-pop shop around the corner is hard-pressed to find a loan with terms as favorable as America’s biggest companies, even after factoring in differences in credit quality.
A new proposal currently under Congressional consideration would phase out the deductibility of interest on corporate debt. While it’s a long way from becoming law, and while implementation would take time, if approved it has massive implications for the way large and small American companies do business. And, if the proposal passes, it may put smaller American companies on much more equal footing.
Margaret R. McDowell, ChFC, AIF, author of the syndicated economic column "Arbor Outlook," is the founder of Arbor Wealth Management, LLC, (850-608-6121 — www.arborwealth.net), a “fee-only” registered investment advisory firm located near Sandestin.