Debt or Equity Finance? Things to consider…
Posted on 31st March 2020
An entrepreneur starts their business from scratch, takes a considerably large risk and goes out into the big world to offer a product/service that people will benefit from. As it grows, so does the need for finance. Choosing the right finance for a company, at the right time, can have a paramount effect on its future success. Two options commonly explored are Equity and Debt Finance. At first, equity is cheap, and if the business plan is solid, relatively accessible. Whereas debt, despite accompanying an immediate cost to service, can provide the extra push a business needs to get to its next stage of growth without giving away part of the business.
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 a company. A business will issue these shares in order to receive an equity investment to expand and grow the business. Usually via purchases of additional assets, hiring key staff, completing the development of products and for various other reasons.
Equity 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 the 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 often provides does not always necessarily match the cost paid, as the equity investor continues to receive a larger chunk of profit from the same investment. Hence, why all entrepreneurs should always consider ‘the opportunity cost of now.’
Pros of Equity
- Free Investment:
By issuing shares the business will receive the cash investment at no instantaneous cost to the business (aside from legal paperwork and other miscellaneous costs) and can provide the business with the required capital it needs to grow.
- Investor Expertise:
An investor can bring with them a plethora of knowledge, experience and relevant contacts that can have a huge impact on a business. Generally, these investors will have had years of experience in a specific sector and can help business owners identify and solve problems before they have even arisen.
- No Cash flow Expenditure :
A business does not have to pay monthly interest on an equity investment and can use this extra cash to further invest in the company.
Cons of Equity
That all sounds great, although, it is also important to not get carried away and recall the actual negatives of equity investment.
- Buying the shares back:
There will be a point in time where the business is doing well and will want to buy the shares back from the investor. If this doesn’t come from an IPO, it will have to come from the business itself and this can often be more costly than a business may think. Moreover, this cost, unfortunately, cannot be forecasted in the initial deal as it will involve numerous bouts of negotiation between the two parties to agree on a deal.
- Profit Share:
If an equity investor is not bought out, they will continue to take profits from a successful business from the same investment they had made quite some time ago.
- Company Management:
Giving up equity in the 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.
On the flip side of equity, is debt finance. What is debt financing?… Debt financing is where a business raises money from a firm or individual. This finance is then typically used to 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 such as acquisitions 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 the funding must be paid back. This will also be accompanied by a set interest rate that will need to be serviced 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 business 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 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 the business owner to keep control of their business and it often does not surpass the cost of buying out an investor years down the line when business is going well.
Pros of Debt Financing
- Future Planning:
The costs of debt financing are very transparent. The interest on the 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 a business to keep full control of their business, whilst still giving the business the opportunity to raise money and grow.
An equity investor will be entitled to a share of the company’s profits, whereas with debt, all increased profits can be retained by the owner and do not have to be distributed to investors with shares in the company. Thus, all profits can be reinvested back into the company to stimulate further growth.
Cons of Debt Financing
Again, as with equity financing, debt financing also has its negatives.
- Bullet Repayment:
If a business takes on an equity investment, then fails subsequent to that investment, the business owner does not have to pay this back. However, if a business fails to service a debt, or pay the bullet repayment of the full loan amount at the expiry date of the loan, this can make the business insolvent.
Following on from the possibility of insolvency, if a 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 a business must pay interest on the loan each month, this can make cash flows tighter and may become problematic if a 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 not to borrow what they cannot afford to pay back in an attempt to expand the business.
Emphasising the statement that a business owner should ask themselves, what is the ‘opportunity cost of now’ for your business?