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Comment by bhouston | Hacker News Reader

Just to be clear though debt is actually a preferred type of financing because it is one of the cheapest forms.

A venture investor is expecting a 10x return on their investment. That means they are expected a much greater realized interest rate than debt - money that effective comes out of the pockets of the business owners.

If you can get debt, if is often preferred if you can figure out how to manage the default risk.

You do not give up equity (which could be worth a massive amount), rather you only have to pay back the debt at some future time with some much minor interest.

Also interest is often tax deductable, thus debt has further tax advantages.

One Nobel winning economic theory leads to an optimal capital structure of 100% debt: https://en.wikipedia.org/wiki/Modigliani%E2%80%93Miller_theo...

Example: Apple is buying back shares (the opposite of equity funding), while issuing massive amounts of debt.

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Words like "debt" can be tricky to pin down, which is why we have an accounting profession who's job it is to establish a cohesive and consistent language system with specific meanings.

Kickstarter money represents both revenue and a liability for the company that is doing the project. There are many types of liabilities which are not exactly debt in the sense that we think about a bank loan (which is also a liability). The thing that all liabilities have in common is that they represent an obligation of the company which could require them to spend money or other assets to fulfill. This does not mean they have to satisfy the liability, it just means that there is a financial justification for any work they do relating to that.

I am sure the accounting profession is continually being tested with new business models and trying to capture the financial reality for people who are playing very different games in the world of capital.

Right, but MM's "optimal capital structure" isn't taking into account if your company can't raise debt on the public markets while maintaining cash flow.

Debt is essentially selling a put option on your assets, but early stage companies don't have substantial assets. That's why convertible debt exist and why early stage financers demand equity.

i always enjoy the "x is essentially a <somewhat_obscure_financial_instrument>". I feel like it's moderately common in startup thought leader type posts

Put and call options are about as basic as it gets in finance.

Though, the more and more I think about the grand-parents comment, the less I understand it:

With debt, you can go into default: so all your assets go to the creditor, instead of you paying. That's like buying a put option, not selling one.

Yeah you're right. It should say something like the payoff of debt owned by the creditor looks like being short a put.

Stacking those together ("X is essentially an Y, 100K of Y are essentially Z, 100K of Z generally behave like U") is what got us the 2008 financial crisis.

No need to be dismissive - simple financial instruments are only obscure to those who willfully remain ignorant.

Your parent post's statement is a reference one of the basic financial models in asset pricing literature, the "Merton model" (Merton RC. 1974. "On the pricing of corporate debt: the risk structure of interest rates." J. Finance 29:449–70)

> Just to be clear though debt is actually a preferred type of financing because it is one of the cheapest forms.

Honestly? That statement seems a tad simplistic to me. Especially in the context of startups.

What makes a start up different than any other business?

The urge to aggressively, rapidly grow.

This is a distinction without difference. You could've also said, "Startups have fewer employees" for instance.

How does the urge to grow separate a startup from a business in the desire to obtain low cost debt?

Investing in getScale is vastly different to investing in IBM.

Lending to getScale is vastly different to lending to IBM.

Therefore the debt/equity argument and balance is vastly difference.

From a lenders perspective: Credit worthiness, free cash flow, ability to service loans, lack of collateral.

The big difference is that startups generally can't get bank loans on the scale they need, because the risk is so high that it's bad for the lender. If I could replace an investor with a 10% staake with a bank that I have to pay back at 8% interest, I'd take it in a heartbeat.

When the company has no liquid asset or property, the bank will use your personal assets (e.g. your house) as a security. These loans has to be continued at the year end or be paid back within a year (over-year loans have different regulations). This is what happened to me. After two years the bank didn't continue the loan because we couldn't show up 10% profit increase or 10 times of the loan in revenue, so I had 8 days to a) pay it back b) find an other bank to finance, but because the loan was in my books, and my personal assets were also the securities, it was very-very difficult to solve this situation.

Apple is doing it as regulatory arbitage which is distorting the normal signals.

I'm not saying you are wrong, more its a really bad example.

Apple is only issuing debt because all of its cash is overseas. At this point the interest is cheaper than paying US taxes.

> Just to be clear though debt is actually a preferred type of financing because it is one of the cheapest forms.

That is the central thesis of the linked article as well.

> One Nobel winning economic theory leads to an optimal capital structure of 100% debt

Too bad the theory is complete nonsense.

>> The basic theorem states that under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.

In short, the theorem states that in conditions that will never exist in the real world, the value of a firm is unaffected by how it's financed.

>> the value of the company increases in proportion to the amount of debt used

First they say "the value of a firm is unaffected by how it's financed", but then: "the value of the company increases in proportion to the amount of debt used", so if "debt used" counts as "financing" then the theory contradicts itself, at least as described by Wikipedia.

This is where I rambled about some other related stuff, but decided to just leave it out because fuck everything about mainstream economics.

In short, the theorem states that in conditions that will never exist in the real world,...

If only Modigliani and Miller weren't total idiots. Then they might have repeated their calculations with these assumptions relaxed.

First they say "the value of a firm is unaffected by how it's financed", but then: "the value of the company increases in proportion to the amount of debt used", so if "debt used" counts as "financing" then the theory contradicts itself, at least as described by Wikipedia.

If you bothered to read the article, you'd recognize that Modigliani-Miller actually did the exact calculation you previously criticized them for not doing. Similarly, if you read it, you'd recognize that the claims you think are contradictory actually apply to different circumstances (taxes vs no taxes).

What next, medicine is contradictory because "if you don't eat cyanide, you probably won't drop dead, but if you do eat cyanide you will"?

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