BWSmallBiz -- Cover Story December 4, 2009, 5:00PM EST

Raising Capital: Equity vs. Debt

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They run lean, with just two full-time employees besides the family. "If you've left enough equity in the business and have financial discipline in your life, you have that backup," Pilar says. "We have our back against the wall, and it gets scary" every spring, she explains, during and after a $1 million conference for a client that takes 60 days to pay. She pushes hard on receivables and uses a factor, but the equity is the emergency fund: "It's something that will pull you through." The bank says the Peñas may only approach their line's limit once a year, when they're bankrolling that huge event.

YOUR GOALS

"The real question may not be how much you raise or borrow, but where are you putting that money? There's good debt and bad," says James Montgomery, a small business lawyer. "Borrowing money to generate more money—that's good debt. Borrowing just to stay alive is not."

One goal might be to stay ahead of rivals. If you keep expenses low and raise only a minimal amount, a better-funded rival may pass you. It's a calculation Michael Kirban made with Vita Coco, the coconut water company he co-founded with Ira Liran in 2004 . On vacation in Brazil, they were struck by the popularity of coconut water. With $80,000 in savings and a $100,000 credit line, they began importing small quantities, which Kirban sold to Manhattan grocers and delis, making the rounds on in-line skates. Rivals were on the scene, but Kirban was ahead in sales and distribution and wanted to stay that way. In 2007, he won $7 million in equity funding, for a 20% stake, from Verlinvest, a fund created by the three founding families of European beer conglomerate Anheuser-Busch InBev. That allowed him to build a factory in Brazil that employs 30 and to raise sales to $20 million.

WHEN AN EQUITY INVESTOR OFFERS MORE THAN CASH

Some venture capital firms can help a business gain credibility by supplying advice, access to customers, and a stamp of approval. Kirban says his investor does this, too. Verlinvest "is a perfect fit," Kirban says. "We wanted an investor-partner with in-depth knowledge of the beverage business on a global scale." It seems to be working: Verlinvest has given guidance to Vita Coco's marketing team, which has allowed the young company to start selling in the United Kingdom. Verlinvest also suggested a set of quantitative benchmarks that Vita Coco uses to gauge its progress.

But at the beginning, Kirban was reluctant to part with a majority of his company, which Verlinvest originally wanted. Now, although Verlinvest has a 30% stake, it also has a significant say on all employee remuneration and the ability to replace Kirban at any time. Kirban, for his part, is thrilled to have such a big player in his corner.

SIZE OF MONTHLY LOAN PAYMENTS

Just a few years ago, you may have heard this praise sung in favor of debt: You can deduct the interest payments at tax time. That's still true. But now, burned by the downturn, bankers and entrepreneurs are turning their attention to a different issue: Can you safely project that you'll have enough free cash flow to service that debt without spiraling downward, especially if interest rates rise? Credit analysts use a figure called the debt-service coverage ratio, which measures whether you've borrowed more than you can make monthly payments on. Ray Silverstein, a board member of Devon Bank in Chicago, says he's looking for $1.50 of free cash flow to be available each month for every dollar of debt-service payments that come due. Others seek $1.20. That compares with just $1 a few years ago—and that $1 was often based on cash-flow assumptions that were, shall we say, highly optimistic. Do this calculation not only at current interest rates but at higher rates as well, in anticipation of increases. Then consider possible fluctuations in revenue and in your ability to collect on time from your customers.

Still, some people just don't like to owe money. When Kirban was funding Vita Coco with his line of credit, he had nightmares. "Every time I'd open up our Citibank account and see how much debt we had, I'd freak out," he says. "When we were maxed out and had very little in the bank, you believe in your business, but still—it's scary to be personally liable for it." He paid it down as soon as he found an equity partner.

Where does that leave us? Prevailing wisdom today holds that debt and equity should be equal (1:1)—or that equity financing should be twice that of debt (1:2). Compare that with 2007, when the acceptable level of debt, relative to equity, was twice or even four times what's acceptable today, says Steve Romaniello, managing director of Atlanta private equity firm Roark Capital Group.

In the end, a ratio is only an analytical tool, not a magic wand. Important pieces of the puzzle, such as interest rates or sales, can move in unpredictable directions. Or as Rao says: "An optimally financed business may be obvious only in hindsight."

To listen to a podcast interview on increasing your chances of landing a loan, go to businessweek.com/go/sb/loan

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Jill Hamburg Coplan writes about topics including finance, family, and religion, and teaches journalism at New York University. She has been a regular freelance contributor to BusinessWeek since 2000.