Relative Value Of Cash Investment vs. Loan Guarantees For Receipt Of
Shares In Business Venture

My question is in regards to a start-up business.  For simplicity,
assume that no venture capital or going public madness will ever
happen.  Pretend it's something like a roller skating rink.  Assume
that there are two parties who will be contributing both financial
assets and sweat equity, the latter of which is irrelevant for the
current question.  Assume that $200,000 is needed, and will be split
in some manner between the two parties. Assume that both parties own
separate houses that they will be using to provide cash investments
(by refinancing to get the cash they'll fork over) and possibly loans
to the business based upon home equity loans on their respective
property.  Assume that they plan to issue shares to themselves, with 1
share equivalent to $1 in cash put into the business.

Here's the question/problem.  If each put in JUST cash, then there
would be a total of 200,000 shares, and they would be split between
the two investors/partners based upon the amount of cash which they
give to the business.  However, what equivalent value in shares does a
loan count for?  I'm going to guess that I am not the first person to
face this dilemma, and there is either a hard, well accepted financial
equation out there, or at least a general rule of thumb that is
commonly used in business ventures.

To impress upon why this is important, look at it from the standpoint
of the survivability (and profitability) of the business.  If someone
gives say $50k in cash, the business gets the cash, uses it as it sees
fit, and everything is easy.  If however $50k in the form of a loan is
given to the business where the business has to pay the interest: a)
The business is saddled with interest payments that eat in profits,
prospects of survival, and probably increase the needed amount of
investments overall to be able to pay that interest until
profitability/the loan is payed off; and b) as the loan is paid back,
the money is effectively going directly BACK to the person who loaned
it by going to the bank who loaned money based upon the equity of the
property (whereas if they invested cash, the business got it and got
to keep it).

Thus, it is clear that a loan is not nearly as advantageous an
investment for the business as cash is.  And, thus loans from a
partner should provide less than one share per dollar of loan given.
But not zero shares, since the person is providing needed funds to the
business, and risking their asset that is being used as collateral.
There MUST be some equation to estimate the relative value of a loaned
dollar to a given dollar.  And I'm assuming that the answer/equation
also has the interest rate figured into it, as a loan at 5% is far
more advantageous to the business than a loan at 10%.

That is my question:  how do people figure this out?  What is fair, or
what are the bounds of share per loaned dollar that are generally
considered fair in the business community?

Hello and thank you for your question.  You're right in assuming that
other people before you have faced the same issue.  The solution is to
understand the different consequences of debt and equity in a closely
held business, and then issue each investor the appropriate
combination of debt (an interest-bearing obligation of the business to
the investor) and equity (shares of stock) instruments corresponding
to what the investor has put into the business.

Let's start with your statement that a loan will not be as
advantageous an
investment for the business as cash paid in.  That's true mainly
because it obligates the business to pay interest even in
circumstances where it can't spare the cash to pay dividends to its
stockholders.  And if the business runs into trouble the lender will
have a higher right to business assets than a stockholder (so in
liquidation the loan is paid off first, and any shortfall is absorbed
by the stockholders).  The one advantage that debt offers the company,
however, is that interest payments are income tax-deductible for the
business (which saves the stockholders money either immediately or in
the long run) while dividends aren't.

Please read the following articles:

Structure of investor relationships can vary widely
http://www.att.sbresources.com/SBR_template.cfm?document=steve.cfm&article=2003Aug18
or
http://www.sbni.com/expert_aug10.cfm
or
http://www.usatoday.com/money/smallbusiness/columnist/strauss/2003-08-11-strauss_x.htm

Equity Financing Explained 
http://www.smallbusinessbc.ca/workshop/equity.php

Combining Equity and Debt Funding
http://www.toolkit.cch.com/text/P12_5235.asp

Financing - The Money you'll Need
http://www.campusaccess.com/campus_web/career/c3bus_fin.htm

What Type of Capital Does Your Business Need? 
http://www.onlinewbc.gov/docs/finance/captoo.html

How much to invest
http://www.smallbusinessmonth.nsw.gov.au/textonly/interest/Over50/firststeps.html#How%20Much%20to%20Invest

You'll note that none of these focus on how the individual investor
raised the cash--whether it was money he had in hand or whether he
mortgaged his home to raise the cash.  The significance of that is how
it affects what he needs to ask the business to give him in return for
his cash.  If I borrow $100,000 against my house to raise the cash
that I contribute to the business, I may not be willing to take all
stock in return because of the greater risk to me that the business
won't distribute enough profits to me to allow me to make my mortgage
payments.  So maybe I'll offer to contribute $20,000 for stock and
$80,000 for a note, or some other ratio.  For me, the debt that the
business issues is my 'bird in the hand' while the stock is the 'two
in the bush.'  That in short is how you should view the issue--in
economic terms it's sort of like your notion of issuing stock at a
discount--and the right way to achieve it is to offer part debt and
part equity to each investor.

One refinement to the above.  Equity ownership also determines in most
cases the decision making power and other control matters.  So if the
stock is issued say 40-15-15 to the three investors (separate from
whatever loans they're making) the 40 will have 40/70ths of the vote. 
If your business deal, economics aside, is to be equal in matters of
control, the answer is to issue voting and non-voting equity--in this
case 15 voting and 25 non-voting to the first guy, and 15 voting to
the other two.  The voting and non-voting interests will be identical
in all other respects.

One caution about issuing debt - - if the business also plans to
borrow from a bank, the bank will almost surely require both a pledge
(security interest) in the business assets and also that all of the
owners' debt be subordinated to the bank's debt.  The subordination
means that if there's an insolvency or liquidation, the bank will come
ahead of you all, even though you made your investments earlier in
time.  And this makes the bank debt the 'bird in the hand' But the
owners' debt is still ahead of the owners' equity.

Search terms used:
"small business" debt equity structure

Thanks again for bringing us your question.  If you find any of my
answer unclear, please request clarification.  I would appreciate it
if you would hold off on rating my answer until I have a chance to
reply.

Sincerely,
Google Answers Researcher
Richard-ga

Pretty good answer. We ended up deciding that if one of us gave a
loan, we'd get 10% on a shares per dollar loaned, as that "felt right"
to all involved.  Remember, even though the business is paying the
loan, there has to be SOME incentive for an individual to put their
house on the block. Just because they have preferred status to get
their money back if the business goes under ain't what I'd exactly
call incentive.  So, that was our solution.

Assuming that the company is paying the loan plus interest back in
cash, then the partner who is loaning the money should get no shares. 
The person contributing the cash gets all the shares, worth the value
of what he has contributed.

There are many reasons that the person who is loaning the money gets
no shares.  For one, instead of shares, they are getting a note
payable, plus the interest.  Because they are not really contributing
to the company (in simply accounting terms, they are adding assets but
they are also adding an equal value of liabilities).  Secondly, the
person loaning money doesn't need shares, because as a creditor they
have first right to the profits of the company, even above the rights
of the person who has contributed cash.

Giving the person who is loaning money to the company shares would be
like your bank still owning 25% of your house after the mortgage has
been paid off.

If you the person want stocks in the company, then they could receive
stock in lieu of interest payments.  This way, the person does receive
some portion of the company for their investment.

I would advise that you get a very strongly worded loan agreement
between the company and the person loaning the money.  In addition, if
this is going to be formed as a partnership, you should have a
strongly worded partnership agreement.

Thanks for the comments.  It's a LITTLE different than that situation,
although I certainly see your points.  The actual situation is that
there are effectively three parties involved in this business that is
considering expanding to another facility. All will put money into the
new site.  More money is needed.  Two of the three parties could take
out home equity loans and effectively pass those on to the business
for times of need (assuming no shares/credit would be given to the
individual if the money is never used).

Yes, the money would effectively be paid back to the individual, but
they wouldn't be receiving any of the interest paid- that would go to
the bank that has issued the home equity loan on their house.  If they
receive no shares, then they have no incentive whatsoever (esecially
compared to the partner who cannot provide loan funds) to take out and
offer this "pass through" loan.  They are taking the risk with their
homes, the business is gaining the use of this loan money, but they
are receiving neither shares nor interest payments.

Now, one might ask why they don't take out the loan, and then give
that money to the business, thus earning the financial shares, and
having to deal with the interest payments themselves.  Answer:  They
won't be able to afford the payments, while the business can.

Perhaps I'm crazy, but since there is value to the business to get the
loan, and since the person putting the house on the line is gaining
nothing financially, that they should be getting some "credit" in the
business for doing this.  Am I smoking crack?  The question was trying
to get at what an equitable share stake per dollar of loan they should
get for taking that risk with their asset.