Debt Finance Or Equity Finance?
Posted on 31st March 2020
As an entrepreneur, you start your business from scratch, take a considerably large risk and go out into the world to offer a product/service that people will benefit from. As it grows, so does your need for finance. Choosing the right finance for your company, at the right time, can have a paramount effect on its future success. Two options commonly explored are Equity Finance and Debt Finance. At first, equity finance is cheap, and if your business plan is solid, relatively accessible; whereas debt finance, despite accompanying an immediate cost to service, can provide the extra push your business needs to get to its next stage of growth without the need to give away part your business.
What Is Equity Finance?
In 2017, a staggering £8.27bn was invested in UK companies via equity financing. What is equity financing?… Equity financing is where an investor or individual buys shares in your company. A business will issue these shares in order to receive an equity investment to expand and grow their business. Usually via purchases of additional assets, hiring key staff, completing the development of products and various other reasons.
Equity finance has often been seen as the most adequate form of finance. Mainly for the reason that we see shows such as The Dragons Den and Shark Tank and see the immediate value a well-informed investor can provide for your business. Although, there is a hidden catch. As mentioned, when we see shows like Dragons Den, the original deal agreed upon by an investor and entrepreneur is exhilarating. However, as time goes on and the business expands, the value an equity investor provides for your business does not always match the cost paid. As the equity investor continues to receive a larger chunk of profit from the same investment. This is why you should always consider ‘the opportunity cost of now’, before taking out equity finance.
What Are The Pros Of Equity Finance?
- Free Investment:
By issuing and selling shares in your business, it will receive a cash investment at no instantaneous cost (aside from legal paperwork and other miscellaneous costs) and can provide your business with the required capital it needs to grow.
- Equity Investor Expertise:
An equity investor can bring with them a plethora of knowledge, experience and relevant contacts that can have a huge impact on your business. Generally, these investors will have had years of experience in a specific sector and can help you to identify and solve problems promptly.
- No Cash flow Expenditure :
Your business will not have to pay monthly interest on equity finance and can use this extra cash to further invest in the company (unless a dividend or profit share was agreed beforehand).
What Are The Cons Of Equity Finance?
- Buying the shares back:
There will be a point in time where your business is doing well and you will want to buy the shares back from the equity investor. If this doesn’t come from an IPO, it will have to come from your business’s pocket, and this can be more costly than you may think. Moreover, this cost, unfortunately, cannot be forecasted in the initial deal as it will involve numerous bouts of negotiation between you and the equity investor to agree on a deal.
- Profit Share:
If an equity investor is not bought out, they will continue to take profits from your successful business from the same investment they had made quite some time ago.
- Company Management:
Giving up equity in your business can sometimes result in giving up voting rights to the new shareholder. This can ultimately influence the future management decisions of the company in favour of the new shareholder, and thus, interrupt your original vision.
What Is Debt Finance?
On the flip side of equity finance, is debt finance. What is debt financing?… Debt financing is where your business raises money from a firm or individual. This finance is then typically used for a number of reasons. In 2018, 32% of SMEs needed funding for working capital to help with cash flow, 16% to cover a short-term funding gap, 22% to invest in new plant and machinery, 18% to fund a new business opportunity with the remainder needed for other varying business activities.
Debt finance mainly differs from an equity investment as you do not have to give up shares in your company. In addition, debt financing will also have a set time frame of when you will need to pay the debt finance back. This will also be accompanied by a set interest rate that you will need to service each month, or in some cases, accrued from the loan at draw down.
Debt finance, used in the right manner, with prudent thought, can be used to facilitate your business’s growth without the need for giving up equity in your business. Debt can sound like a scary word, as it’s often the connotation of negative events and being ‘in the red’. However, a savvy entrepreneur/investor knows how to use debt to get ahead, and although your cash flow can take a hit through the servicing requirements, many entrepreneurs and businesses prefer to use this method of financing as there are no hidden costs. This also allows you to keep control of your business and it often does not surpass the cost of buying out an equity investor years down the line when business is going well.
What Are The Pros Of Debt Financing?
- Future Planning:
The cost of debt finance is very transparent. The interest on your loan can be accounted and planned for prior to taking on the debt, and a plan can be made to achieve a comfortable exit at the end, with, of course, a contingency plan B just in case the initially envisioned exit doesn’t go to plan.
- Full Ownership:
It allows you to keep full control of your business, whilst still giving you the opportunity to raise money and grow.
An equity investor will be entitled to a share of your company’s profits, whereas with debt, all your profits can be retained by you, and do not have to be distributed to investors with shares in the company. Thus, all profits can be reinvested back into your company to stimulate further growth.
What Are The Negatives Of Debt Finance?
- Bullet Repayment:
If your business were to take on an equity investment and then fail subsequent to that investment, you may not have to pay this money back. However, if your business fails to service a debt, or pay the bullet repayment of the full loan amount at the expiry date, this can make your business insolvent.
Following on from the possibility of insolvency, if your business has provided collateral to secure the loan, this can be repossessed if the loan isn’t paid back when due.
- Less Cash Flow:
As you will need to pay interest on the loan each month, this can make your cash flows tighter and may become problematic if your business has a sudden fluctuation in sales or income.
As a business owner, you know your business better than anyone, and where knowledge gaps might be, the true entrepreneurial spirit always prevails. This is why an entrepreneur should think twice before giving up part of their business to an equity investor but should also carefully plan prior to taking on debt. Always ensuring you do not borrow what you cannot afford to pay back in an attempt to expand the business.
Emphasising the statement that you should always ask yourself, what is the ‘opportunity cost of now’ for my business?