[MUSIC] Early stage ventures rarely raise money via debt, except convertible notes maybe. Consider what is debt. Borrowed money which is paid back over time with interest. Consider what is equity. The guarantee provided to creditors. If you have no equity, you cannot have debt. Debt financing increases redundant equity, but it also increases risk. This is what we call the leverage effect. Suppose an investor who plans to buy an apartment in a neighborhood that is becoming fashionable. The apartment is on sale for $1 million, and the investor thinks it will be worth $1.3 million in a year time, resulting in a capital gain of 300,000 euros. If the investor has the money, the profitability of his investment, his return on equity, will be 30% in one year. If he borrows 500,000 at 10%, the profitability jumps to 50%. Indeed, it must deduct interest expenses of 50,000 from its capital gain of 300,000, resulting in a net gain of 250,000. But he only invested 500,000, and the net gain of 250,000, it wasn't 50% on his investment. Debt financing increases return on equity. But there is no free lunch in finance in that financing increases risk as well. Suppose our investor was mistaken and that he could sell the apartment at the purchase price a year later. His return on equity is 0 if he hadn't used any borrowing. But the return on equity if he had borrowed half of the money would be a -10% since he will have to pay 50,000€ in interest expenses. For your venture, the leverage effect is the difference between return on equity and return on operating assets. The leverage effect explains how it is possible for a company to deliver a return an equity exceeding the return on operating assets. But the leverage effect work both ways. It can deliver a negative ROE. More precisely, the leverage effect increases the volatility of ROE. Please watch the following video. Let us dream that we live in a world without taxes. By the way, it may be a nightmare at the societal level. In this simplified world, there are two companies exactly the same except for their capital structure. One is leveraged, the other not. Both companies have the same amount of operating assets and the same EBIT The unleveraged company has 8000 kiloeuros of equity divided into 400,000 shares of 20 euros each. The formula for earnings per share, EPS, of the unleveraged company is EPS = EBIT/400,000. The leveraged company has 4 million of equity divided into 200,000 shares of 20 euros each. And the total of net debt of 4 million bearing interest at 10%, which represents a yearly interest charge of 400,000 euros. The formula for earnings per share, EPS, of the leveraged company is EPS = EBIT- 400,000/200,000. To illustrate the way in which earnings per share responds to change in EBIT, we are going to plot the variations of EPS in function of the changes in EBIT for the two companies. The solid line shows the way in which EPS responds to changing EBIT for the company without debt. It starts from 0 since EPS is 0 when the EBIT is 0, and it passes through a point EBIT = 800 EPS = 2, since EPS = EBIT divided by 400. The dotted line shows the way in which EPS responds to change in EBIT for the leveraged company. It starts at 400 on the horizontal axis as EPS is 0 when EBIT is 400,000 euros. It passes through a point EBIT = 800,000, EPS = 2. Since EPS = (EBIT- 400,000)/200,000. When EBIT equals 800,000, the two lines intersect since EPS equals 2 euros for both companies. Let us change EBIT from 400,000 euros to 800,000 euros. When EBIT is smaller than 800,000 euros, EPS is higher for the un-leveraged company. Let us move EBIT from 800,000 euros to 1,200,000 euros. When EBIT is higher than 800,000, EPS is higher for the leveraged company. That increased return on equity as long as the cost of debt remains lower than the increase in profits obtained through that. Otherwise, it decreases return on equity. Financial leverage can boost the company's returns, but it increases risk as well. >> The difficulty of debt financing for a young enterprise is precisely that it increases its risk of the VDO short. A new venture may not have a well-developed business model. We call business model the manner by which the enterprise delivers value to customers. Will customer buy your product? Entices customers to pay full value. How do I attract customers and convert those payments to profit? It is hardly useful to multiply each business risk by the leverage effect. It is only in special cases that your venture will resort to borrowing. Banks will only lend with a guarantee on identifiable assets, such as vehicles or equipment which have value on a secondhand market, or on good will linked to a location. The terms of any loan should match or be shorter than the expected life of the assets you are requiring. And if you want to finance your venture with bank loans rather than with specific assets, you will need to give collateral or a personal guarantee. Financial public institutions like the French banque publique may provide such guarantees. And it also distributes participating loans with no guarantee, which can be use to finance intangible. In addition, there are very marginal funding sources such as local authority schemes and startups. Or less marginal sources as the research tax credit to finance your research and development. Two banks will lend short term. And an overdraft is often the best way of funding working capital requirement. But the only reasonable way to finance your venture over the long-term is through equity. Histories of successful ventures show that they have raised equity in several realms of financing. One can draw a general principle. Equity financing is normally raised in stages because your venture will go through several stages. If all goes well, when your venture goes through the next stage of development, it will find new funding with investors from the previous one or from new investors which gave it the means to take the next step in case of difficulty during your phase of development. Investors will decide if the plan you have in place seems to them to justify continuing. There will be equity dilution if subsequent rounds of financing at lower values take place. But not if all goes well. Good luck and goodbye. [MUSIC]
