Joe Lennon FCCA, on deciding between debt or equity financing to help fund business growth.
How to achieve your growth goals and take your business to the next level?
More specifically, how will you fund the things you need to do to achieve those strategic targets?
These are questions common to many owner managers and quite often the answer involves securing some form of external funding. If this describes your current business circumstances then it's likely that quite soon you'll be faced with a choice between debt vs equity financing. This then leads to the question, which is the right approach for your business?
In this blog we will provide you with an overview of these funding options, their definitions, and examine their benefits, as well as drawbacks, in order to assist you in making the best decision for your business. Specifically, this post covers:
Selling a certain percentage of your business in exchange for a cash investment is known as equity financing. Equity financing does not carry an obligation for repayment, in contrast to a loan. Instead, investors purchase a stake in your business in order to take a share of the profits accumulated. Eventually they will sell the shares with a view to generating a return on investment.
There is risk for investors because they can only make a return, if the business is successful. This means it could be in their best interest to help you manage the business strategically so that set financial goals are achieved.
What is debt financing?
Debt financing involves borrowing money from a lender, to inject funds into your business. You then repay the loan over time along with any fees and interest levied. Depending on the loan product, interest rates may be variable, or fixed.
Debt financing comes in many different forms, such as commercial mortgages, asset financing, business loans, and working capital facilities such as overdrafts and invoice finance. It can be secured against an asset you own, or unsecured. Due to the lower level of risk to the lender, secured debt is generally easier to obtain, and cheaper to service.
What is the difference between debt and equity financing?
There are several key differences to bear in mind when you’re considering which of these funding methods to choose from. They are as follows:
With debt financing, you must pay back the loan amount plus interest over a set period, usually in monthly installments. On the other hand, equity financing carries no obligation for repayment, allowing you to potentially set more money aside through your business budget to invest into expanding your operations.
Investors do, of course, usually require a return on their capital. This can only occur when your business succeeds in becoming profitable. Therefore, unlike debt finance which has a per-determined cost, the cost of equity finance is more variable, as it's likely to take a share in the future earnings and value of your enterprise.
Equity investors look to buy a stake in your business, meaning that your shareholding in turn decreases. When you look at debt financing, this doesn't happen as you retain full ownership of the business.
However, in exchange for reducing your shareholding percentage, investors may provide valuable support in the form of both financial and non-financial resources, professional guidance, and access to their contact network. This can help you to expand and build a better business.
Consider the following scenario, would you rather own 100% of a £100k organisation, or 70% of a £1m business?
When a lender provides you with finance, they may ask you to pledge an asset as collateral for the loan, such as property or equipment. The lender has the right to seize the assets to recover the funds if you are unable to service the debt payments. They may also ask for a personal guarantee. However, the need to put up a collateral is not required when using equity financing.
4. Alternatives to assets as security
It can be a challenge to obtain debt financing, at least from traditional lenders, if you're a start-up with no prior trading experience, or physical assets. In this case approaching an equity investor is not a bad idea, they are frequently willing to support businesses which are deemed too risky by debt finance providers.
Equity investors might request for a board seat in the business. This implies that they will participate in key strategic decisions, and have a say in the overall direction of the business.
Choosing the right investor will be a positive point as they will bring with them potentially, valuable experience and they could open doors to their business network. A lender, on the other hand, is not a shareholder and is not involved in the management decisions of the business. Their only job is to provide you with finance and ensure you have the means to pay it back.
6. The fundraising process
Choosing equity finance may not be the best choice if you need to raise money in a hurry. Finding the right investor can take time, and once you've done that, you will need to negotiate the terms of the deal and manage the due diligence process, among many other things.
Additionally, there is a lot of legal work required. Debt finance, on the other hand, is typically a simpler and therefore swifter process. You can receive funds from lenders in a matter of weeks, or even days.
The pros and cons of debt vs.equity financing
You remain in charge of the business.
You're giving up a stake in some of the business, and it's profits.
Must use some of the revenue to pay back the loan.
Can re-invest profits from revenue to grow the business
Harder to obtain if you're a start-up, have a poor credit history, or no security.
Support for businesses that traditional lenders are risk averse to.
Straightforward but can take time to obtain funds.
Pitches require time, and persuasion, and you'll need legal advice for the equity allocation.
Regular payments with fixed, or variable, amounts.
Dividend payments expected at some point in the future.
May roll in other banking and credit services, including insurance.
Access to investor know-how and networks.
Vary according to business risk, may be fixed rate, or variable.
A charge may be applied to your house, or other assets, to secure funding.
If the business fails?
You still owe the money/security.
Lenders need to know you will repay them.
Investors are looking for evidence the business will grow, and generate a return on investment.
There is no obligation once the funding has been repaid.
You're not the only person with a stake in the business, exiting can therefore be difficult.
There are usually no reporting obligations.
You'll have to provide regular reporting to shareholders.
Picking one funding option over the other
The finance strategy you select will ultimately depend on the circumstances your business is in, including the type of business you are running, and at which phase of lifecycle stages you're at.
Scenarios for choosing debt?
You have a reliable cash flow and an established business model
You prefer to continue being the sole business owner
You want a short-term contract that lasts until the loan is paid off
If you are aware of the amount of principal and interest that must be paid in advance, this will help you to manage your cash flow and budget accordingly
Why choose equity funding?
You lack collateral, or have a limited financial history
You don't want to be responsible for ongoing loan payments
You have growth plans that will cost a lot of money, like expanding your business or entering new markets (you can often raise greater amounts with equity)
You would gain from the experience and knowledge that an investor could bring
Please keep in mind that you don’t necessarily have to pick one option over the other! Your business can in fact decide that a combination of debt and equity is the best option. Below we explore how this can work:
Convertible debt is also known as convertible bonds, or convertible notes. It works as a bond that businesses can offer to investors. The bond requires interest payments, just like a loan would, however, the lender can choose if they wish to receive the loan repayments back in cash, or shares.
Your lender may want to be rewarded in shares if the value of your business increases. If the value has decreased, the lender may demand payment in cash. You can potentially pay lower interest rates because your lender may profit more from investing in your business.
Equity and Debt
It's not uncommon for an investor to fund a company through debt and equity at the same time. For example, you may want to bring on board an investor but limit how many shares they acquire.
If you're thinking about this kind of arrangement, make sure that it benefits your business as well as your potential investors.
The content of this post was created on 19/12/2022 and updated on 27/02/2023.
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