I found the letter titled, ‘Tax issues to be considered before debt’ in the Daily Monitor of April 26 quite interesting. The letter raises the age-old issues of debt versus equity financing, though with a focus on tax implications. However, I need to point out the following:
Capital structure (in layman’s terms known as the mix of types of financing employed by a business). The most common types are the owners’ own funds, known as equity, borrowed funds, known as debt or external debt and shareholder loans which are loans to the business from the owners. Capital structure is the business owner’s decision. If an owner goes for external debt, he will be bound by the terms of the loan agreement. Conversion to equity is at the lender’s discretion, and not upon demand by the borrower. Conversion as Zuriat ably puts it, usually happens when the business has run into trouble and cannot service its loan.
When borrowing, it is better at the outset to agree or provide for conversion to equity at a later date. This can be effected through what is known as a convertible note, a little used instrument in Uganda. It is basically a short-term debt that converts to equity on given terms at a given date.
Business owners should make informed decisions on the capital structure they will adopt. Tax breaks on certain modes of financing do not in themselves guarantee that the business will stay afloat. One still has to pay interest on debt, no matter what the tax regime. Taxation is on the bottom line / profit, after interest. In fact in instances of loss, there is no income tax, so we cannot overtly blame the woes or the illiquidity of a business on income tax.
Traditionally Ugandan business has relied on commercial bank loans for financing. However, private equity is increasingly becoming a viable option. This is a situation where an individual or institution not listed on a stock exchange provides funding to a business in return for shareholding for a given period of time.
The private equity firm divests or sells out its interests after recouping its investments after a set time. This mode of financing is suitable for start-ups with great potential that do not have the stringent asset-based preconditions of commercial banks.