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Domainer Chris Stewart runs through the numbers for us and explains why Name Media’s leveraging up is a “good thing”. Chris is a very bright guy and this is an excellent post and argument. Posted in it’s entirity with permission:
Why Companies Borrow, and Why I Think NameMedia Borrowed Smart
This is the first post on our blog so I thought I would start off with something that is both timely and controversial: DEBT. Timely because of last week’s announcement that NameMedia had completed a deal to establish a $125 million credit facility; and controversial because of the topsy-turvy ride we have taken in the global equity markets this past month mostly attributed to the spillover from credit concerns in the US. Therefore, I believe that speaking to the topic of debt is a great starting point.
Before I go into some financial analysis let me first state that, admittedly, debt is an uncomfortable topic for me. I am not fond of debt, personally. As a business manager, however, debt can and often is the best friend to a growing company. It is cheap – let’s come to this a little later, and it is often easy to acquire. Quite simply, debt shouldn’t be a dirty word. And using debt to finance acquisitions or new capital projects should not be frowned upon.
Debt is cheap. What do I mean by this? Well, I should be more specific and say that debt is almost always relatively cheaper than other financing sources. It is cheaper than other financing sources because the interest payment on debt is also a tax deductible expense. The impact of this on the cost of debt can be significant. In financial terms, the amount of “benefit” you receive from being able to deduct your interest payments on your income statements is equal to your marginal tax rate multiplied by your borrowing rate. Wow, that was a lot to say. So, instead of trying to explain this let me illustrate this for you.
Let’s imagine a scenario where you are seeking $100,000 to finance new projects. You are given two choices. Your first choice is to use debt financing at a borrowing rate of 15% p.a. and your second choice is to sell shares of your company to an investor who demands a 12% p.a. return on his/her investment achieved through an annual dividend payment. And, let’s further imagine that you already have an opportunity to invest the funds into a new domain acquisition, which will cost $100,000 and yield $20,000 in annual gross cash flow. We will assume you are a profitable company with a 35% marginal tax rate. Which method of financing would you choose based solely on the “numbers”? Let’s take a look…
From this over-simplified analysis above you may be surprised to see that, despite having a higher borrowing rate it is the debt financing choice providing the most benefit to your company. This isn’t always the case because we could fiddle with the borrowing rate, the required rate of return from the investor, or the tax rate to achieve numerous different results. But what I wanted to show you here is that even when things appear to be cheaper (such as the investor who only wants a 12% dividend) they may not always be.
One of the quick and dirty ways to figure out your effective borrowing rate on debt is to do this quick calculation. Multiply your corporate tax rate by the rate quoted to you by the debt financier. If you are borrowing at 18% and your tax rate is 25% then your benefit is 25%*18%=4.5%. Then reduce your borrowing rate by the benefit you just calculated, or 18%-4.5%=13.5%, which is your effective borrowing rate. Recall, this benefit is attributed to your ability (in most cases) to deduct interest expense on the income statement.
Clearly, I have ignored all of the “soft” considerations when choosing between debt and equity financing. Some people, like me, don’t particularly like debt. Others prefer the benefit of having the inputs of investors who may be more experienced. No amount of value can be placed on having mentors guide you in the right direction and surely your debt financier won’t be answering the phone at midnight to “discuss the business.”
What’s more, my calculation doesn’t demonstrate when and IF you should choose either form of financing. There is a separate calculation to figure out if you should borrow to finance a new acquisition altogether. I can, however, give you a tip to remember: if the net return on the asset is greater than the effective borrowing rate then you should probably invest. That’s a great topic for my next post so come back to see me massage some numbers to make that one work out for you.
Speaking of debt, most recently we learned that NameMedia has established a new credit facility for $125 million, which will be used to pay down a prior credit facility and for continuing operations and new acquisitions. And while I am not privy to the specifics I can probably estimate that this deal is both positive for NameMedia and the domain industry overall. Having perused some of the other domain blogs I have yet to see anyone come out and give a good/bad opinion on this announcement. I have seen some comments from individual posters who believe that this news had negative implications. I couldn’t disagree more.
As I illustrated above, debt financing is typically cheaper than equity financing. And for a company, such as NameMedia, I would argue that equity financing is significantly costlier to the company than debt. Recall, NameMedia has recently filed for their IPO and I believe that investors would place a discount rate (a.k.a. required rate of return) of anywhere between 15-20% on the firm’s equity value. Such a significant discount rate would lower the equity value of the company, requiring NameMedia to issue a greater number of shares to raise the capital necessary to paydown its previous credit facility. This scenario (on a much larger scale) resembles the average Joe paying one credit card bill with another credit card carrying a higher interest rate. Using new debt, rather than equity, to paydown the previous debt is the better alternative.
I also believe that this new credit facility is positive because it signals to me that the creditors believe NameMedia’s cash flows are both stable and long-term, at least enough to cover the debt going forward.
I would not be surprised if we see NameMedia cancel or reduce the size of its IPO altogether, and here’s why. From my calculations, I believe that NameMedia’s cost of equity financing is north of 15% and as high as 20%. There is no similar tax benefit to equity financing when compared to debt financing. And if you are borrowing at 15-20% from the markets then any and all new capital projects suddenly have this rate of return as the benchmark for new investments,…anyone know someone selling generic domain portfolios at 5x? I didn’t think so. The prior need to “go public” was to paydown the prior expiring credit facility and with this need now answered to by the new credit facility I see no reason for the company to require a significant source of capital at such a high cost at this time. I think it’s also important to note that the planned sale of equity was not an exit strategy for the current shareholders, as stated in the IPO, it was merely an exercise in raising capital”"
***FS*** My personal aversion to debt is several fold. As the credit markets have shown this year, you can’t necessarily control when the bank will stop lending ..and for unforseen reasons, or when they’ll call a loan on you.. If everyone levered up and carried debt, we could get to a precarious place where no company operates to it’s full potential. There is no such thing as “no strings attached” and when you start taking money from strangers, their covenants on what you can/can’t do with your business often become restrictive and fail to allow the company to take risks and make investments otherwise possible if they were unleveraged. This can hold the company’s true potentiual back.. lastly.. not everyone operates from a tax jurisdiction.. Drug companies, and other multinationals often use transfer pricing to offset the tax benefit that debt provides.. Ditto with a domain biz which can be run from anywhere.. Even a little island 250 miles south of cuba. 
While $4+ million worth of domain names just sold at the Las Vegas TRAFFIC auction, the real story is that actual bidding totalled more than $30 million.. I bid at least a million dollars for names that I didn’t win.. Others did too. All-tolled there was more than $20 million of unrequited love, bids never to matter, a desire to own domain names that would not be satiated.
It’s wonderful being back after an extended vacation break. I used to scoff at vacationing (vacations are for the weak), but I was amazed that those friends and colleagues who took longer absences around the holidays skated circles around my productivity around March and April of the next year.
Danno writes: 
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